Protecting international standard-setting despite the resurgence of politics

Andreas Dombret, global senior adviser, and Oliver Wünsch, partner, at Oliver Wyman, describe the importance of international standard-setting amid increasing political interference.

In 1974, a small German bank in Cologne sent shockwaves through the global financial system. After the abolition of the fixed exchange rate regime under Bretton Woods, many banks discovered the profitable opportunities in foreign exchange trading. For Herstatt Bank, where the perceived ‘golden boys’, in the absence of risk management, non-existing supervision and a good degree of fraudulent activity, amassed an open FX position of 8 billion Deutschmarks, this strategy went terribly wrong. The creditors of Herstatt had not only been German depositors, but also banks in the US that were exposed to a failed FX settlement leg. It was certainly not the first, but it was the most visible example of how banking failures can cause havoc across borders.

The legacy of Herstatt, where the last liquidation proceedings were only completed in 2016, lives on. In Germany, it led to the establishment of a deposit insurance fund. In 2002, the FX settlement risk, dubbed ‘Herstatt risk’, was finally eradicated when CLS Bank started operating after more than two decades of preparation. Most importantly, the Herstatt failure demonstrated that an open financial system requires certain rules and standards to which banks must adhere, and that these rules need to be applied internationally to prevent trouble spreading globally.

In 1974, with a large part of the world considered developing and another part fenced off by the Iron Curtain, it took the small club of the Group of 10 countries to agree on some common standards to be developed, which would then cover the majority of the global financial system in terms of balance sheet size and macroeconomic relevance at that time. Still, it took 14 years until the Basel Committee on Banking Supervision finally agreed to the Basel Capital Accord – today known as Basel I – calling for a minimum capital level of 8% for internationally active banks and, for the first time, setting principles on how banks should be supervised. Subsequently, these rules were not only adopted within the Basel ‘club’, as nearly all countries with banks that have material cross-border activities took over these principles.

The benefits of international co‑operation

The standard was subsequently expanded to keep up with the increasing sophistication of the financial industry – in particular statistics (leading to the acceptance of internal models) and market risk. After the more contained episode of the 1997 Asian financial crisis was handled, the global financial crisis that began in 2007–08 demonstrated the benefits of international co‑operation, when the vulnerabilities of the US real estate market spread through the global financial system, which was – in many countries – burdened by its own issues.

Central banks acted swiftly to counter liquidity crunches. Bank crisis management was, however, not that co‑ordinated, leading to unilateral actions, such as ring-fencing, as authorities had neither the information nor the legal tools to do otherwise. The Basel Committee and the Financial Stability Board (FSB) – swiftly enhanced to include emerging markets countries to reflect the changes in international economy – received the mandate to strengthen the regulatory framework but also the mechanism for cross-border co‑operation.

While international standard-setting is a success story, we should not ignore the challenges. Banking looks different depending on the economy. US banks accustomed to an originate-and-distribute model for lending, and that rely on government-sponsored enterprises to underwrite risks, have a different balance sheet structure from European banks that often keep loans on their balance sheet until maturity. Emerging markets have less sophisticated operations with a highly differentiated approach. Basel and other standards aiming to cover the most complex and largest institutions do not necessarily provide benefits – on the contrary, a full-scale implementation of Basel rules would undermine the viability of small banks in emerging markets and developing economies (EMDEs) without providing any positive contribution to financial stability.

There is no one-size-fits-all set of rules. International standards are always a compromise that, while also subject to the usual power politics, aim to strike a fair balance that considers the interests of all involved without losing sight of the overarching objective of protecting financial stability. International standards also provide enough wiggle room to consider local specifics as long as the overall objective is not undermined.

It is also important to consider the alternatives. The first would be a clear segmentation of financial systems, preventing direct risk transfers between financial systems. In such a world, there would be no need for international standards because there would no need for international co‑operation. Countries would therefore be free to choose the rules they see fit, without any risk to spillovers or uneven playing fields. However, this would also impede international capital flows, effectively cutting off foreign investment and turning the clock back 50 years.

The world of international standards is by no means perfect. The model-based approach of Basel II shrank capital levels of international banks contrary to the original objective. It is also true that it is a challenge to protect the standard-setting process from political interventions. In the end, financial markets always receive political attention, and it is the unfortunate truth that political clout matters in all international organisations. Still, the rules-based system works well: once a country is deemed compliant with international rules – as assessed in complex processes under the auspices of the FSB, the Basel Committee or the International Monetary Fund, it provides a strong basis for mutual recognition of regulatory and supervisory standards, paving the way for international finance to succeed.

A system built on trust

Unfortunately, the system has been undermined in a few ways over the past decade. First and foremost, it is important to emphasise that the international system of financial sector standards is largely based on trust, as there is no enforcement mechanism such as that under the rules-based trade system of the World Trade Organization. When it comes to implementation and enforcement of rules, supervisory authorities rely on a mutual accord, often laid down in so-called (non-enforceable) memoranda of understanding.

Many supervisory legal frameworks include the explicit consent for and encouragement of cross-border co‑operation in supervision, delegating some competence on how to shape and implement the international rules. However, the political class increasingly looks to use its leverage over financial sector regulation in the pursuit of objectives unrelated to the safety and soundness of the system – or even to economic considerations. Unfortunately, it is not only financial sector regulation in which this is becoming more apparent. The departure from principles-based regulation to detailed rules that require firms to choose between compliance with one framework or another, even if the objectives and approaches are the same, does not help this.

It is important to be wary of the consequences. If a country complying with international standards cannot expect any benefits from it, the motivation to commit to a rules-based international system suffers – as does the credibility of the standard‑setting organisations. With this comes reduced engagement and, ultimately, the emergence of a club-based insider-outsider system, reversing the progress made over past decades. Such development would also be to the detriment of the insiders, as recent crises have shown, when the co‑operation of outsiders – such as EMDEs – were important in cushioning the economic downturn.

The experience gained from international rules-setting and implementation is relevant for another important field: digital services. Just as with the financial industry a few decades ago, certain digital services and their providers have become systemic, and their failure could send shockwaves into other industries and across borders. As before, governments and regulators have begun to grasp the potential implications and have started to regulate.

This time, regulation is not only about sufficient buffers to absorb losses and ensure continuity. Cyber risks play a key role, as do data protection and – because of concentration in the industry – antitrust matters. Again, political and sovereignty concerns emerge, as do different policy approaches to deal with them. For example, the US pursued a very market-oriented strategy, not interfering with and even protecting the emerging industry, but making all providers subject to the powers and capabilities of intelligence services. While there are now second thoughts given to the damage certain platforms have created in politics and society, the ‘light touch’ should be recognised as a key reason US firms are now the globally dominant players. The European Union is about to set a regulatory landmark with its Digital Services Act, addressing key issues on digital resiliency and sovereignty.

However, no large digital champion is headquartered in Europe, and the music is almost exclusively playing in North America and Asia. This shows that digital services are more cross-border in nature than finance ever has been. To avoid a regulatory race to fragmentation, one wonders if the creation of an international standard-setting architecture built for finance might serve as a blueprint for digital services in particular as finance becomes increasingly digital.

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