Should the EU embrace the Deregulatory Tsunami?

By José María Roldán Alegre, Senior Advisor Kreab

My friend Andrés Portilla, from the IIF, contacted me recently after the term “regulatory tsunami” was used in a conference he attended. He knows that I was the one who used that term for the first time, back in 2009, when I was part of the regulatory community¹. Alas, had it not been for Richard Barfield (now Adviser to Hogan Lovells but back then a Director at PWC), I would have forgotten the concrete circumstances. In the Risk and Management Insights PWC series of 2010, he wrote:

“Brace for impact, you are not going to escape!” warned José-María Roldán, Chair of the Standards Implementation Group of the Basel Committee, as he warned the 2009 Geneva Risk Minds Conference of the “tsunami of regulation” that was about to hit the banking industry. As we know, tsunamis cause indiscriminate and widespread destruction. This is clearly not the regulator’s intention, but the impact will be unprecedented.

Indeed, the last 15 years have seen a regulatory process in the financial sphere of a scale and complexity never seen before. And although most of it was related to the consequences of the Global Financial Crisis (GFC) and to the efforts of authorities to avoid a repetition of the GFC in the future, other areas of political interest were added to that financial regulation tsunami. We are referring to the efforts around the transition to a sustainable economy (ESG issues, and particularly those related to the Green Transition), to the fight against crime (Anti-Money Laundering), to operational resilience (DORA) and, more generally speaking, to the innovations coming from IT.

Why we have a problem

Accepting the nature and reasons for that regulatory tsunami as legitimate and valid, why should we think of reverting it, even if only partially? Well, there are two main blocks of justification for the process. The first is related to the side effects generated by such a complex regulatory paradigm. The second is related to geopolitics and the change of direction that we can observe, particularly in the US.

But the core issue is that we still live in a financial market that is global in nature (and will remain so even in these protectionist times). Anything that impacts the competitiveness of European financial companies will end up impacting the competitiveness of Europe and the well-being of its citizens in the long run. It does not make any sense to run your own game. In other words, there is a reason why we have the Basel Committee, IOSCO, the BIS, the FSB, the IMF, etc.

The drawbacks of a complex regulatory environment

We have made the arguments around the problem of complexity elsewhere, but let us revise them, albeit briefly. There are three main problems: opacity, costs, and distraction.

Regarding opacity, a very complex mechanism is equivalent to an enormous black box. It is full of unwarranted effects, and it contributes to the breakdown of cause and effect. From an administrative law point of view, it deprives regulated entities of legal certainty.

Second, complex regulation entails a lot of costs. We usually talk about the costs on the side of the industry, but there is also a sizable impact on the public sector. Since any regulation is only as good as the supervision that ensures it is respected, complex regulation will require enormous resources on the side of the public sector to ensure its implementation. Also, complex regulation will create greater litigation incentives, thus overburdening the courts of justice.

And third, complex regulation may provoke a huge distraction for both private sector participants and public sector supervisors from what really matters. The recent crisis of mid-sized banks in the US, which failed miserably due to a well-known problem of Interest Rate Risk in the Banking Book (in short, a mismatch of repricing between assets and liabilities), is a stark reminder of the risks of distraction for both firms and supervisors. Additionally, complex regulation incentivizes a tick-the-box mentality of compliance instead of concentrating on good risk management.

By design, we should not be running a zero-risk system

Another element of the change in the direction of the regulatory pendulum is that we do not intend to run a zero-risk system whereby there are never banking crises. In other words, we aim to operate a financial system in which there are no systemic crises, but in which individual, contained failures can occur.

Initially, that was the intention with the regulatory reform after the Global Financial Crisis. But somehow the initial objectives were increased in a reversal of the bargain towards lower standards seen before the GFC. For instance, the leverage ratio, intended to act as a backstop for outliers, started to operate as a capital constraint for most of the banks in the system. The levels of total capital, which have reached heights of more than 20% (when the minimum capital requirement set up in the Basel III accord is 8%, or 10.5% if we include the capital conservation buffer), are well above what should be required to minimize systemic crises.

The world is moving fast

Alas, while we argue within the EU whether we should go down the deregulatory path, most of the jurisdictions that have strong financial markets and institutions, competing with the EU ones, have already started the change. And there is a crucial element that differentiates the EU from other jurisdictions: the autonomous rulemaking capacity of supervisory agencies.

The US supervisory agencies (The SEC, the CFTC, the OCC, the Fed Board, the FDIC), the UK PRA and FCA, and the Japanese FSA (Financial Services Agency) have autonomous, independent rulemaking capacity, on top of their capacity to determine supervisory priorities. They have already announced changes in their approach towards a softer and simpler framework, and if they need legal changes to become operational, they can do it in months rather than years. Their parliaments will be informed, but they are not required to enact legislation.

The EU starting point is radically different. Rulemaking capacity resides with the European Parliament and the Council (with the European Commission having a monopoly on legal proposals) and, in the case of Directives, with parliaments in Member States. We have the ESAs (European Supervisory Agencies) and the SSM (Single Supervisory Mechanism), but their room for maneuver is radically narrower than that of the jurisdictions mentioned above (in fact, the legal powers of each ESA are also quite heterogeneous).

A heavy multiyear regulatory project

Since the EU is fundamentally a regulatory power engine, any change in the regulatory pendulum towards softer, simpler, lighter financial regulation will require a very long, complex, and protracted process of reviewing a multiplicity of regulations and directives approved in the past. And since calendars are so long and heavy in the EU (it takes several years for a new regulation to be rolled out), this process will mean that we will be revising new legal texts that have only recently been approved.

But even with the greatest acceleration in legislative agility, a reversal of the current regulatory pendulum will require a good two to three years in the best-case scenario. The sooner we realize the urgency of starting this process, the better.

Conclusion

The world has changed, and not just in terms of geopolitics. If the EU does not want to be left behind, it must react, and given its complex regulatory structure, it must react fast. Even if we do, it will require several years to reposition the EU (compared to several months, or even less, in other relevant jurisdictions). This is why the EU should embrace the deregulatory tsunami coming to our shores. And do it fast!

¹ Although, for full disclosure, I think I heard Joaquín Almunia, then European Commissioner for Economic and Financial Affairs of the European Commission from 2004 to 2010, describe the coming regulation as “a tsunami” in an informal Q&A after a speech. He nevertheless fell short of using the term “regulatory tsunami” that I coined.