- they can be too big to regulate since they have operations in many different countries; and
- they can be too big for their host country to save.
Why does having operations in different countries create a regulatory problem?
Regulation is national. Even when there is international agreement on standards, it is left to the discretion of the national regulators whether or not to enforce the standards.
For example, the Basel Committee, which is made up of regulators from several countries including the US, approved the Basel II capital requirements. However, the US elected to never formally enforce these requirements.
It is the differences in how regulation is enforced that allows the global financial institutions to engage in regulatory arbitrage.
Yves Smith expands on this point in a recent NakedCapitalism post
It isn’t discussed often enough that one of the roots of the inability to regulate banking properly is the so-called home-host rule. Even though banks that are licensed in foreign markets are subject to local laws in many respects (everything from securities compliance to branch hours), in most areas of bank regulation, the home country regulator is more influential than the host country, particularly as far as capital adequacy is concerned. Crudely speaking, the result is often that the host country operations are permitted to carry very little capital; they are treated as being able to ring the mother ship as needed. And if the host country sees practices it thinks are worrisome but are outside its scope, all it can do is alert the home country regulator, who may or may not act (in extremis, they can yank the local licenses, but first line responses are limited).
If in the wake of the crisis, we had decided to move to a system of more powerful national regulation of all financial entities in its borders, including having each bank licensed to do business in a particular country subject to its capital regulations, it would have reduced the tight coupling of the financial system by balkanizing them a bit (with certain customers, the banks would still have latitude as to where they booked the business, but for quite a few, the choices would be circumscribed).
Given the current debt loads of the major governments, is there any country that does not suffer from what Mervyn King described as a mismatch between the large, global financial institutions and the resources of the country they turn to in times of crisis?
This raises the interesting question of can effective international supervision be reconciled with sovereignty?
Yes. It requires a new approach. The new approach recognizes that the only entity big enough to really supervise the large, global financial institutions is the market. Specifically, all the national regulators have to use all the other market participants to help supervise.
How can this be done?
By following the FDR Framework and providing all market participants with access to all the useful, relevant information on the global financial institutions in an appropriate, timely manner.
With this data, the other market participants, including competitors and regulators from other countries, can help the national regulators assess the risk of each global financial institution. The more eyes looking at the data, the higher the chance of spotting and correcting a problem earlier.
Why is this solution not subject to regulatory arbitrage?
Since it can easily be linked to a requirement that financial institutions hold 100% equity against any exposure to another financial institution that does not disclose all its useful, relevant information in an appropriate, timely manner.
This capital requirement makes sense since the financial institution that does not disclose clearly has something to hide!