The Future of European Financial Centres (Routledge International Studies in Money and Banking)

The Future of European Financial Centres
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National regulatory authorities in small countries, particularly those with nascent financial sectors, are often looking to attract international capital, maintain or attain investment grade ratings from international ratings agencies, and stay on good terms with International Financial Institutions. In such contexts they face strong pressure to accommodate the interests of international financial actors, which helps to account for the maintenance of open capital accounts by many peripheral countries, and convergence on international financial standards Chwieroth, ; Gallagher, While there is undoubtedly some room for manoeuvre at the national level, the power politics of highly asymmetric interdependence severely restricts the range of policy options that national authorities in peripheral countries can pursue.

Over the past three decades, the international banking landscape has witnessed two dramatic shifts. First, the banking sectors of the largest developing countries became systemically important for global financial stability BIS, This is most notable in China, which now is the home jurisdiction for four of the ten largest banks on earth, with operations in over 40 countries The Banker, Moreover, emerging market economies account for a 20 per cent share of the global shadow banking sector.

A second shift, which has received less attention in international policy discussions, is that countries in the periphery are far more interconnected to the financial core and to each other than 40 years ago when the Basel Committee was created. This shift is particularly pronounced in developing countries. Following waves of privatisation and liberalisation in the s and s, foreign bank presence increased and by accounted for more than half of the market share in 63 developing countries. As a result of these changes, developing countries now have a higher level of foreign bank presence than industrialised countries, making them particularly vulnerable to financial crises and regulatory changes in other jurisdictions.

This heightened interconnectedness was powerfully illustrated during the —08 global financial crisis which, unlike previous crises, affected all types of countries around the world Claessens, Until , the Basel Committee membership centred on the G10 countries. Membership was expanded to incorporate ten emerging market economy G20 members following the global financial crisis.

However, even among Basel members, regulators from emerging and developing countries are less engaged in Basel Committee proceedings. Historical institutionalist scholars would attribute this to relative sequencing Farrell and Newman, : institutional capacity and regulatory expertise are important sources of power in global regulatory politics Baker, ; Posner, ; Seabrooke and Tsingou, ; Slaughter, The Bank for International Settlements conducts research and hosts meetings of central bankers, including the Basel Committee.

Its board of directors continues to be controlled by its six founding members, which are guaranteed a majority on the board 12 of 21 votes. This persistent gap between developed and developing countries generates challenges for the efficacy of international financial standards. In addition, implementation of banking standards among core countries generates adverse consequences for countries in the periphery.

The first challenge arises from gaps in financial infrastructure. For instance, the standardised approach to credit risk relies on credit rating agencies, which do not cover wide segments of developing country markets. A second challenge arises because international standards are often a poor match for the financial stability risks in LMICs. Basel II and III address financial risks that may be of little relevance in the simpler financial systems of LMIC, such as counterparty risk for derivatives exposures or liquidity mismatches arising from wholesale funding.

The third set of challenges arises from resource constraints and exacerbated information asymmetry between supervisors and banks. The complexity of these standards also exacerbates information asymmetries between regulators and regulatees, who may have greater space for regulatory arbitrage. A fourth challenge arises because implementing Basel II and III may take scarce resources away from other priority tasks of the regulatory agency.

Regulators in LMICs recognise the need to improve corporate governance, strengthen regulatory independence and bolster their authority for timely supervision and prompt corrective action in order to safeguard financial stability. These features of a strong regulatory regime are enshrined in the Basel Core Principles. The global standards embody a complex financial regulatory regime, not necessarily a strong one Basel Consultative Group, ; Powell, Finally, implementation may lead to a deterioration of credit composition.

Banks that implement Basel II and III may have an incentive to shift their portfolio away from sectors of the economy that are key for inclusive economic development. Higher risk weights for trade letters of credit due to the Basel III output floor for example may increase the cost of trade financing, even though previous rule changes have taken emerging markets into account.

Higher risk weights for loans to small and medium enterprises under Basel III may not properly reflect the potential benefit of diversification away from a few large enterprises and discourage financial inclusion. Regulators in developing countries have considerable scope for discretion in the implementation of Basel standards. Developing country members of the Basel Committee have to fully implement Basel II and III, although regulators can adapt the standards to suit the domestic context. Developing countries outside of the Basel Committee have even more scope for discretion as they are under no obligation to implement the standards.

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Our research shows that reasons for implementing Basel II and III are not confined to technical considerations about the best ways to ensure financial stability. More specifically, we find that countries are adopting international standards in a bid to signal sophistication and attract international investors Jones, Forthcoming. In Ghana, Rwanda and Kenya for instance, politicians have advocated the implementation of Basel II and III, and other international financial standards, as part of a drive to establish financial hubs in their countries.

Global finance generates very strong incentives for regulators outside of the Basel Committee to adopt international standards, even when there is a wide gap between international standards and the prudential regulations that are optimal for the local context. Regulators in LMICs recognise this gap and are selectively adopting international standards and tailoring them to make them suitable to their context. However, this process of adapting international standards is challenging and expensive, and falls on the regulatory agencies that can least afford it. It would be far preferable if the Basel Committee factored in the perspective of developing countries, particularly LMICs, more systematically at the design stage, building in a proportional approach.

A powerful argument has been made for a proportional approach to Basel III in Europe to accommodate small banks Dombret, The argument for a proportional approach to accommodate LMICs is even more compelling. The Financial Stability Board and Basel Committee are increasingly aware of the challenges for developing countries and have undertaken some reforms. Yet these fall far short of what is needed. However, little is known about the nature of participation and quality of dialogue because public summaries of the meetings carry very little information.

Little has changed at the Basel Committee. It set up a Task Force on Simplicity and Comparability in , and has implemented some of its recommendations, such as an output floor for risk weight calculations using internal models. There have been calls for the Basel Committee to build greater proportionality into the design of its standards. Unfortunately, the Basel Committee has not engaged in a revision of the standard in line with Basel III even though developing country comments in consultations consistently emphasised the costs of complexity WB, A recent proposal to simplify the Basel approach to market risk has also been criticised by developing country representatives as still excessively complex BCBS, b.

There is a strong case for designing international standards on a proportional basis so that they can be readily adapted and implemented in a wide variety of jurisdictions. This goal is of vital importance: Lax financial regulatory standards increase the likelihood of a financial crisis both in core and periphery countries, the repercussions of which can wipe out years of development gains.

In the wake of the global financial crisis, policy makers around the world called for greater regulatory stringency, including experts that take into account developing country preferences Stiglitz, ; Sundaram, Yet developing countries also need to use financial regulation to pursue inclusive economic development and poverty reduction. It issued a report the following year that highlights the negative impact of stringent standards on financial inclusion. The GPFI report advocates for a proportionate application of financial standards, taking into account the nature of risk, regulatory capacity and the current level of financial inclusion GPFI, Others in turn have shown greater resistance to any departure from an exclusive focus on financial stability.

Yet, as with international banking standards, while the aims have been laudable, the standards and their implementation have not always reflected the interests of developing countries. The new standards apply a proportionality principle. In spite of such efforts, many developing countries have experienced the withdrawal of financial services by international banks in the past years. The global financial crisis highlighted the interconnectedness of the financial system and the destabilising role money market funds, monoline insurers and derivatives brokers can play.

Regulators recognised that concentrating on the banking sector alone is insufficient to safeguard the financial system Knight, It coincided with the beginning of G20 work on financial inclusion, but the overlap between the two issue areas was not apparent to policy makers for several years. The FSB concentrated its initial work on the kinds of shadow banking entities and activities that are prevalent in developed economies, such as money market funds, securitisation, and securities financing transactions.

While such kinds of shadow banking activity are currently concentrated in the world's most developed markets, they deserve equivalent regulatory scrutiny in developing countries. Peer to peer lending and mobile credit services perform similar financial inclusion functions, but they also fall under the FSB's definition of shadow banks. It is important to note that regulators from around the world agree that NBCI that contributes to systemic risk merit as much regulatory scrutiny and containment as its equivalent in the banking sector.

Where the interests of developed and developing countries diverge is in the treatment of NBCI that may not pose systemic risk but benefits domestic economic actors that are underserved by the banking system. Regulators from East Asian developing countries took the lead in voicing their dissatisfaction with the neglect of financial inclusion in the discussion of how shadow banking should be regulated. The FSB has shown a remarkable unwillingness to engage with this debate.

Its shadow banking information sharing exercise and thematic peer review do not entertain any of the arguments advanced by developing countries. The clarification that shadow banking is not intended to cast a pejorative tone is relegated to a footnote. The FSB also does not entertain the idea of a differentiated approach to shadow banking for developing countries. FSB members have not publicly voiced any intention to negotiate a common global standard for shadow banking in the future. The neglect of financial inclusion by the FSB and Basel Committee results in part from their mandates.

While this is of vital importance, there are other important policy objectives relevant to the design and implementation of financial regulations, including financial inclusion and financial sector development. At a national level many members of the FSB and Basel Committee have organisational mandates that go beyond financial stability.

Promoting the healthy development of the banking sector is among the mandates of both the Chinese central bank and the banking regulator PRC, , In advanced Western economies, some financial regulators that are independent of their respective central bank also endeavour to create a regulatory environment that is favourable to innovation and growth ACPR, ; FINMA, ; OCC, What reforms could be undertaken?

Taking on risk is an essential part of such activities. The principle of neutrality warns against using public funding for entrepreneurial finance: administrative procedures to allocate funding risk being gamed or biased against exactly the type of players that such programs intend to support. The financial system plays a central role in any modern economy; its primary functions include the efficient allocation of available savings and the provision of a secure payment system. In Europe, this system is bank-dominated and heavily institutionalized, with tight regulation and economies of scale conspiring to bias access to financial resources against small, young, and rapidly growing businesses.

Since adequate capitalization in the early stages of development is a major driver of venture survival and success, the proposals in this section attempt to rebalance the financial sector. Principle s Policy area Proposal Policy level a 13 Neutrality and transparency Private wealth Allow for more wealth to accumulate and remain in private hands and make it possible, easy, and attractive to invest such wealth in entrepreneurial ventures. EU, MS 15 Neutrality and justifiability Pension funds Pension funds and other institutional investors should, on an experimental basis, be allowed to invest more in equity in general and in venture capital specifically.

EU, MS 16 Neutrality and justifiability VC Develop competencies for private equity and venture capital investment in the field and avoid promoting VC capital with public funding directly. EU, MS 18 Neutrality and transparency Banks Ensure that appropriately anonymized credit decision information becomes publicly available in the system of bank loan guarantees for start-ups. EU 20 Neutrality and justifiability Banks Introduce central bank digital currency to replace deposits at commercial banks as the dominant medium of exchange.

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Financial centres after Brexit: a bonanza for Europe?

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