IFC Regulatory Innovation: Vital To The Maintenance Of A Healthy Global Financial Ecosystem

An ecosystem is simply units interacting with each other within a given environment, defined by geography, population, or some other factor. The distinguishing characteristic is that of units—large and small, dominant and recessive, strong and weak—interacting with each other and, in the process, generating effects on the entire system. Ecology also teaches that the more diverse an ecosystem, the stronger it is in surviving shocks. We can usefully consider the global financial regulatory environment as an ecosystem, recognising that it is populated by an array of regulators, whose diversity imparts strength to the regulatory system as a whole. IFCs fill a vital niche in the regulatory ecosystem as their regulators work as part of the whole but work differently from those in larger jurisdictions.

The common goal of all regulators around the world should be to have a regulatory ecosystem robust enough to absorb unanticipated shocks without injuring the global economy. When that robustness is not present because of multiple layers of regulations, we risk ad hoc responses that raise costs without a comparable increase in stability or safety.[i] Nassim Taleb’s idea of “antifragility” is the key to a successful regulatory ecosystem: antifragility means that stress makes something stronger rather than weaker.[ii] An antifragile regulatory ecosystem incorporates additional capacity to solve problems when stressed, rather than weakening or becoming more rigid and brittle. IFCs have repeatedly demonstrated the capacity to add antifragility to the global regulatory ecosystem and preserving their capacity to play that role is important to limiting the negative system-wide impact of a crisis, particularly as the global economy grows more complex.

This is particularly important given the dynamic character of the global financial system. Just as natural ecosystems are not static and react to major events like a firestorm, earthquake or drought that changes the environment, so too the environment in which regulators operate is subject to unanticipated events which stress the system. Diversity in regulators, as with diversity in species in a natural ecosystem, strengthens the overall system. It does so by providing greater opportunities for different combinations of resources and more iterations of trial and error to find an effective response to challenges. As we especially need financial regulators to find the balance between managing risk and facilitating growth, we need a diversity of approaches. Too much emphasis on growth can put the financial system at risk of a major meltdown while too much focus on controlling risks leads to economic stagnation.

Large Jurisdiction Regulatory Efforts Add Fragility

Most large economy regulators focus on top-down, prescriptive regulatory approaches. Large bureaucracies issue complex rules under lengthy (and often internally inconsistent) statutes. For example, the 2008 U.S. Dodd-Frank Wall Street Reform and Consumer Protection Act, passed in response to the financial crisis, was 848 pages long; it mandated that dozens of different regulators issue new rules and led to over 27,000 new restrictions on financial actors.[iii] The statute was drafted in an opaque manner involving lobbying by thousands of interest groups – one study found that almost 3,000 organisations participated in lobbying with respect to just the statutory and regulatory provisions involving the Securities and Exchange Commission (SEC).[iv] Whatever the merits of any of the immense amount of regulatory language and activity Dodd-Frank generated, it is difficult to imagine that the total effect of a statute and regulations created under these conditions improved the anti-fragility of the world financial regulatory ecosystem, as the effect of such massive top-down regulatory efforts is inevitably to reduce diversity within the ecosystem because of the increasing cost of compliance.

Dodd-Frank’s enormous size stands out, but it is far from alone in its impact on the regulatory ecosystem. In general, big jurisdictions regularly add fragility to the regulatory ecosystem for three reasons. First, their political systems are not conducive to nuanced regulation. Shifts in partisan control of regulators often lead to significant changes in orientation (Callaghan to Thatcher; Carter to Reagan; Clinton to Bush; Bush to Obama; Obama to Trump; Mitterand to Mitterand in the famous U-turn); large populations require regulators to account for a broad range of needs in financial regulation (consumer protection and stability), with ever increasing pressure to add yet more goals to regulators’ agendas (as with efforts to combat terrorist financing or more recently to have central banks address climate change).

Second, the combination of politics in the selection of top regulators and the massive sizes of the regulatory bureaucracies rarely allows people with extensive private sector experience to play significant roles in regulatory policy, creating an unfortunate gap in the understanding of how regulated entities behave individually or function as a system. For example, the Madoff whistleblower Harry Markopolous repeatedly provided the U.S. SEC with detailed memos describing how to see if Bernie Madoff was committing fraud (in particular, suggesting the simple expedient of checking the trade tickets). Not only did the SEC not take this straightforward action, the agency gave Madoff a clean bill of health when it did investigate him despite the numerous red flags present.[v]

Third, big bureaucracies require strong limitations on their ability to act to prevent abuse of their powers. Agencies must follow often cumbersome rulemaking procedures, enforcement actions are slowed by due process constraints, and top regulators must navigate often treacherous political environments. None of this is conducive to innovative thinking.

IFCs’ Enrichment Of The Regulatory Ecosystem

IFC regulators are different in kind from large jurisdiction regulators in three important ways. First, today they have a much greater degree of private sector experience than most large jurisdiction regulators. This experience gives a greater degree of insight into how transactions work, enabling IFC regulators to understand the points of vulnerability. Second, IFC regulators themselves work far more collaboratively with regulated entities than is possible for large jurisdiction regulators. Because the regulated professionals within IFCs have a strong interest in the IFC continuing to thrive – as their future income stream is tied to its continuing ability to attract clients – they are able to credibly commit to provide information to the regulators. Third, IFC regulators generally have far fewer formal legal constraints on their powers than do large jurisdiction regulators. In a small jurisdiction, informal constraints operate more effectively than do complex procedures. This enables IFC regulators to act quickly when necessary and to benefit from informal consultation with the professional communities.

Further, if we look at the development of IFCs from the perspectives of networks, innovation, and governance, we see some key characteristics which distinguish them from large jurisdictions:

• The successful IFC is generally an open economy that supports a strong and effective legal infrastructure and an active and creative service sector. Its regulators are thus regularly exposed to innovations in finance, motivating them to stay on top of new developments.

 

• Because they function in a smaller geographic environment, bringing industry personnel together with regulators is not a complicated task – sometimes the matter of an elevator ride between floors. This physical proximity enables regular informal contacts that keep the regulators abreast of new developments. And because development of the sector is the result of a close collaboration of the government, independent regulator, and financial industry professionals, their regular interactions builds the informal, personal ties critical to fostering trust.

 

• IFC regulators, politicians, and the regulated community share an awareness of the importance of the financial sector to the overall economic well-being of the jurisdiction. This depoliticises consideration of measures related to the financial industry and allows a greater focus on maintaining competitiveness, including maintaining the jurisdictions’ reputations, than is possible in larger jurisdictions.

These characteristics allow for both speedier innovation and higher levels of trial and error carried out by a combination of knowledgeable government officials, regulators, industry professionals, and courts. These individuals further bring hands-on international and cross-jurisdictional experience to their work in contrast to the increasingly academic orientation of the expert studies relied on by many international institutions.[vi]

The development of IFC regulators and their associated legal frameworks shows these characteristics in action. Since the comparatively unregulated 1960s and early 1970s, IFCs have progressively built comprehensive regulatory statutory regimes, created independent regulators, and developed substantial regulatory capacity. Evaluated on a per entity basis, they generally provide equivalent regulatory resources to large jurisdictions.[vii] Many IFCs have passed – and regularly updated – specific regulatory frameworks for banking, business entities, insurance, investment funds, securities, and other finance sectors. IFCs are also at the forefront of developing “regulatory sandboxes” for new products, such as cryptocurrencies. And they readily seek ways to transfer expertise acquired in one area to another, as some jurisdictions have done with e-gaming and cryptocurrencies, where a common regulatory issue is being able to verify that computer code does what it is advertised to do.

What differentiates IFCs’ regulatory approaches in these areas from what we might term the “Dodd-Frank approach” of complex statutes and regulations taken by big jurisdictions is that IFC regulators are able to focus more on providing up-front guidance to regulated entities via informal guidance and through regular conversations with regulated professionals operating in IFC jurisdictions. The IFC situation further contrasts with regulators in larger jurisdictions who work hard to avert legislative interference not wholly because they resist scrutiny, but because of the sometimes haphazard and “heads will roll” approach of post-crisis regulatory reform.[viii] This leads to a vulnerability to pressures from special interests as the regulators often lack understanding of the system-wide interconnections.

Creating A Healthy Regulatory Ecosystem

Understanding the role IFCs and other small jurisdictions play in the larger global financial regulatory ecosystem is crucial to securing the ecosystem’s long-term stability. We know from nature that efforts to control or to limit the number and type of species only create conditions for wider systemic risk, not less, i.e. a single action affecting a key player can cause system-wide collapse. Attacks on IFCs threaten that critically important diversity in financial regulation.

Systems with multiple actors in different sizes functioning in different environments are better able to absorb shocks, as the diversity of actors increases the chance more will survive the initial disruption and then generate a variety of responses to the stress. This preserves the system and its ability to adapt and to identify viable system-wide responses through trial and error. For example, the global financial system’s ability to absorb the shock of the collapse of the Bretton Woods monetary system with the U.S. ending dollar convertibility into gold in 1971 is one example of an anti-fragile response to a crisis. Once financial institutions developed tools to cope with floating exchange rates, the global economy adapted to the increase in exchange rate risk to the point that we rarely hear about fears of devaluations today – something that was a regular feature of the global economy in the 1960s and 1970s.

Large jurisdiction regulators show much less flexibility and have instead moved in the direction of greater emphasis on formal rules (e.g. Dodd-Frank) and greater reliance on theoretical analysis. Taleb flagged this move towards more abstract expertise as a potential weakness in a regulatory system because it moves regulators further and further from personal experience with what they are regulating, thereby reducing their practical understanding of how these systems operate as well as reducing their personal “skin in the game.”[ix] Unfortunately, many efforts in large jurisdictions to insulate regulators from politics have also insulated them from accountability until there is a crisis, and even then few seem to be held accountable for their errors. For the international civil servant working in one of the world’s large international centres, the cost of getting something wrong is not as great as it would be for someone living and working in a small jurisdiction. As Taleb notes, “At no point in history have so many non-risk-takers, that is, those with no personal exposure, exerted so much control.”[x] While there may be legitimate concerns about capture in the regulatory environment, this highlights the importance of ensuring the existence of alternative regulatory models that can experiment more freely and quickly without sacrificing quality.

The IFC network plays an important role in deepening connections among economies thereby making trial and error and experimentation easier. The ability to draw on the practical know-how embedded in IFC professional networks provides a means of bringing expertise to bear on problems in a way both to enhance the value of investments and contribute to a resilient regulatory infrastructure to assure the long-term security and profitability of those investments. This know-how helps to counter the concentration of power in the financial system and allows for diversification not only in products offered, but also in regulatory and policy strategies resulting in a stronger regulatory ecosystem.

Large jurisdiction regulators have an important role to play in the global regulatory ecosystem, of course. But they cannot provide what the world’s economy needs on their own: a robust, anti-fragile regulatory ecosystem that does not grow endlessly more complex and brittle in response to crises. The world economy needs IFC regulators as participants because it needs a channel through which regulatory responses to financial innovations are crafted quickly by people who understand them. We can ill afford neither another 2008 financial crisis nor another Dodd-Frank if we want economic growth to continue to lift the world’s poorest from poverty.  Diversity in a regulatory ecosystem should be encouraged so that it regularly expands the toolkit available to all regulators to enable them to address potential crises when stress to the system is experienced before that stress turns into a traumatic event or waiting until after a collapse from a major rupture triggering a more costly system-wide response.

 

Footnotes:

[i] See, for example, reports of anticipated regulatory changes in Geoff Cook, Mourant Consulting and Sarah Huelin, Mourant, “Eyes up from the dashboard – is your regulated business future-proofed?” available at https://www.mourant.com/news-and-views/updates/updates-2021/eyes-up-from-the-dashboard---is-your-regulated-business-future-proofed-.aspx

[ii] Nassim Nicholas Taleb, Antifragile: Things That Gain from Disorder (2014).

[iii] Patrick MacLaughlin, et al., Dodd-Frank is one of the biggest regulatory events ever, Mercatus Center (Aug. 31, 2017) https://www.mercatus.org/publications/regulation/dodd-frank-one-biggest-regulatory-events-ever

[iv] Pamela Ban & Hye Young You, Presence and Influence in Lobbying: Evidence from Dodd-Frank, 21(2) Business & Politics 267-295 (2019).

[v] See Harry Markopolous, No One Would Listen (Wiley 2011).

[vi] See Gillian K. Hadfield, Rules for a Flat World: Why Humans Invented Law and How to Reinvent It for a Complex Global Economy (Oxford 2017).

[vii] Andrew P. Morriss & Clifford C. Henson, Regulatory Effectiveness and Offshore Financial Centres, 53 Va. J. Int’l L. 417 (2013).

[viii] See David Andrew Singer, Regulating Capital: Setting Standards for the International Financial System 21-25 (Cornell 2007).

[ix] Nassim Nicholas Taleb, Skin in the Game: Hidden Asymmetries in Daily Life (Random House 2018).

[x] Taleb, Antifragile, supra note 1, at 6.