Monday, December 15, 2008

Chair of Dutch Financial Markets Authority Says Reform Must be Global; Demands Regulation of Credit Default Swaps

A global response to the financial crisis is critical in order to prevent regulatory arbitrage and a regulatory race to the bottom, in the view of Hans Hoogervorst, Chair of the Netherlands Authority for the Financial Markets and Vice Chair of the IOSCOI Technical Committee. In remarks at a UK seminar on restoring confidence in global markets, he also said that the moral hazard created by a public safety net of central bank lending and government bailouts, which he concedes was needed, must be counterbalanced by strong regulation.

Thus, while providing a safety net is inevitable to contain systemic risk, more regulation will also be needed in the opaque over-the-counter market for derivatives. In addition, the credit default swap market is in obvious need of enhanced transparency and a sound clearing and settlement system. For the longer term, the entire institutional regulatory structure will have to be reformed, he said, since the crisis makes clear that this review needs to include not only prudential regulation, but also conduct-of-business regulation.

More broadly, he noted a need to make sure that regulatory reform is structured nationally, regionally and globally. For this, regulators should look to the recommendations of the Financial Stability Forum, the European Union and the International Monetary Fund. The chair pointed to what he called the outdated, fragmented and hole-ridden US regulatory framework, which he said has contributed to serious lapses in oversight and created incentives for regulatory arbitrage. The need for far-reaching consolidation of the US regulatory system is now widely recognized.

But at the same time, he noted that Europe’s regulatory system does not seem to be in much better shape. Many European banks were allowed to fill up on mortgage-based structured products, he noted, and increased their leverage to levels higher than their American counterparts.

Europe’s regulatory system is burdened by a history of fragmentation. Although it rests on European law, he observed, considerable divergence remain in national legislation. Licensing and regulation are executed nationally through the principle of home country control by national regulators. While the home country control system was a very practical way to make progress in creating the European capital market, he conceded, the system is vulnerable to regulatory arbitrage, just as in the US.

The obvious regulatory shortcomings in recent years have shown that it is very difficult to prevent a regulatory race to the bottom. This is especially the case when competition between financial markets is fostered by government policies. In order to prevent this scenario, Chairman Hoogervorst called for the creation of a centralized European financial regulator. While we will continue to need national financial regulators, assured the Dutch official, there is also a need for an independent European regulator that could identify weaknesses in national regulation and ensure a harmonized application of EU law. This agency should have the authority to inspect and guide national regulators if deemed necessary. In his view, a European regulatory agency could help prevent arbitrage and shore up the passport system.

Having a centralized regulator would have the additional advantage of making it easier for the European Central Bank to fulfill its role in addressing systemic risks. The costs of the regulatory race to the bottom and subsequent failure have been colossal, he emphasized, and it is thus time to start building a 21st century regulatory framework.

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