Friday, October 13, 2006

Regulating Creeps

Yesterday's Financial Times contained an op-ed by George Osborne, Britain's shadow chancellor of the exchequer,** on a topic near and dear to MDF's heart -- securities regulation creep (See "Preventing US regulatory creep"). Osborne takes a different position on creep than we do around here. Turns out that he's against it, at least when the US is doing the creeping. Anyway, I found this article interesting. And by interesting, I mean, not too terribly well thought out.

Osbourne's point is:

The question is crystallised by debate over Nasdaq’s interest in the London Stock Exchange. When I meet Nasdaq’s management in New York I will make clear that I have no problem with overseas ownership. I am not one of those opposition politicians who make a song and dance every time a British company is taken over. The openness of the British economy is one of its great strengths; to block foreign takeovers is to block foreign investment. Rather, the problem is fear of overseas regulation. If US regulation were applied to listing requirements, it would impose a burdensome, rules-based system on top of the lighter-touch, principles-based UK regime: US regulations could be applied to UK listed companies in the same way that the Securities and Exchange Commission tries to regulate UK hedge funds.

I welcome the fact that the British government has responded to calls from myself and others to act to protect London-based exchanges from the risk of regulatory creep.... How do we best regulate large international financial companies in a world where sovereign states have less independent influence? The current system is not working as well as it should. We have drifted to our current position without enough debate about how to tackle this challenge.

There are three potential approaches. The first is unilateral action: to build the best possible regime by improving domestic regulation and by taking the power to remove regulation imposed by others. That way we can set the level of regulation appropriate to the UK. The government’s proposed new powers on exchange regulation will accomplish that in their narrow sphere.

But action at home is only a partial solution. It can help to stop international regulatory creep from hitting all companies in the UK, domestic and international, but it fails to tackle the regulatory overlap for those wanting to operate in several jurisdictions. Worse still is the risk of tit-for-tat extra- territorial regulation. Some say that if, by opening a US operation, a company exposes itself to US regulation of the whole business, that is a cost of expansion. But I think we should be more ambitious in tackling this overlap.

The second approach would be to establish a supra-national institution that regulates at a regional or global level. But we know that this solution also has its flaws. Take the European Union. I want to see a single market in financial services, so that British companies can compete freely on the Continent. But sadly too many directives coming out of the Commission have been over-regulatory and bureaucratic, threatening London’s competitiveness. So I fear that taking a further step forward and creating a single European regulator would probably hamper our global position, not enhance it.

The third and best approach is for national bodies to work together. That will never be perfect, but the multilateral Basel accord shows how much can be achieved. We should promote the benefits of a principles-based system and lobby more strongly against future extra-territorial rules, whether from the EU or US. We should argue that the regulatory system sits at arm’s length from politicians and government. We should promote mutual recognition of standards instead of overlaying one regime on top of another.

I have no idea if regulatory creep exists or if it's a problem, but let's suppose it does and is. Well, why does it exist? Are regulations rewriting themselves? Are accounting regulations kind of like the creep in Starcraft, only scarier -- slowly expanding to cover the world in one thick layer of green eyeshades and 10-K forms until all shall know the true power of Sarbanes-Oxley? Probably not. Probably there's some person or group of people who have a desire to expand the scope and intensity of US regulation. If that group is the American public, then he's just plain silly. After all, cooperation is something that people do for their mutual benefit. If the US is imposing regulation as yet another way of taking over the world and extracting whatever it is that we want from the rest of the world (hey, that's entirely possible), then it hardly seems likely that we'd stop taking over the world just because the world asked nicely. (That kind of "talking over our differences" thing might work with pansy dictatorships like Saddam's Iraq or North Korea, but it doesn't work with us Americans.)

But what if it's not in the United States' interests either? That's probably what Osborne has in mind -- he says that "the current system is not working ... We have drifted to our current position without enough debate." Okay, sure. I'm going to go out on a limb and suggest that maybe most people don't know a lot about international securities regulation. I can't even be bothered to balance my checkbook -- there's no way that I'm going to know what is and what is not a good accounting rule or how much regulation is enough regulation. So maybe the story is that the SEC is trying to expand its power and influence and get a bigger budget by overregulating foreign markets, and since the issue is kind of boring (and about foreigners) most Americans don't follow it and so don't stop the SEC from doing what might not be in their interests. (Incidentally, ever notice how this issue is front page with the UK's Financial Times, and rarely, if ever, covered by the Wall Street Journal?) It's a basic principal-agent problem: the interests of Americans overall might not be the same as the interests of financial regulators.

Does this make the problem easier? Actually, it makes it much harder. If the SEC is nefarious, or corrupt, or just suffers from bad incentives that come from just being a bureaucracy, and this makes them overregulate foreigners, then it's not likely that they are going to cooperate with foreign regulators and stop doing that. If it's in their interests to overregulate, then it's not in their interests to cooperate in such a way as to stop overregulating. But if it's not in their interests to overregulate ... well, what is Osbourne worried about? If there is any regulatory creep, it seems to be entirely accidental.

What the other idea: creating a supra-national group to regulate the regulators? That, also, seems to be a bad idea--which Osbourne himself admits. If our financial regulation is inefficient or too burdensome or what-have-you because of a principal-agent problem and for reasons of rational ignorance, how can adding an even more distant, less accountable, and more bureaucratic group solve that problem? If voters are ignorant enough that we need an international group to protect us from a domestic group that's supposed to be working for us, how are we smart enough to know how to keep the international group in line?

But fundamentally, Osbourne really misses the entire nature of the problem (or, rather, he touches on it and dismisses it out of hand, as if securities regulation were just like regulating electrical socket safety). He implies that the United States is ready to export Sarbanes-Oxley "in the same way the Securities and Exchange Commission tries to regulated UK hedge funds." But this underscores the problem. The SEC hasn't tried to regulate UK hedge funds. It's tried to regulate hedge funds selling fund shares to U.S. investors. Some of these hedge funds just happen to have their headquarters in the UK because today's technology has rendered borders meaningless for many business operations. But regulation, of all sorts, is still a matter of national sovereignty--which is why this little hub-bub in the UK is so curious. The United States can't export Sarbanes-Oxley to other countries. But the SEC can apply it (and other regulations) on anyone operating within the United States. If NASDAQ were to buy the London Stock Exchange, there would be business pressure to harmonize NASDAQ's and the LSE's trading and listing rules, so that British investors could easily buy U.S. securities and American investors could buy LSE-listed securities. However, that can't happen under current SEC rules. By putting a regulatory hurdle in front of NASDAQ and the LSE merging their exchanges to combine London's international listings with America's enormous number of investors, UK politicians hope to make the LSE a much less attractive take-over target.

** "Shadow Chancellor" is just about the coolest job title since "Dark Lord of the Sith." Possibly cooler. Which is kind of fitting, because it's just about as interesting as the acting in the recent Star Wars movies. I mean, you get to be the guy who would be finance minister if only your party were in power? (But not the guy who gets to be finance minister if your party actually does come to power--that's someone else entirely.)

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