The Real but Exaggerated Threat of Financial Institution Mobility to Financial Regulation
71 Pages Posted: 13 Sep 2018 Last revised: 13 Oct 2018
Date Written: May 25, 2018
Prior scholarship advocates for international harmonization of financial regulation. The scholarship is theoretical, and rests on the contention that financial institutions can simply depart from an unfavorable regulatory regime. This paper contributes an empirical foundation to the concern that financial institutions relocate following regulation, while also showing that unilateral financial regulation can nevertheless be effective.
Using experience from swap markets following the implementation of the Dodd-Frank Act, this paper provides the first empirical evidence that financial institutions migrate in response to derivatives regulation. This paper supports that U.S. banks substantially shifted inter-bank swap trading offshore through reconciling trends in three different swap markets during this period: (1) U.S. customer consumption of swap services increased, (2) U.S. inter-dealer (i.e., wholesale) swap markets collapsed by almost fifty percent, and (3) on a global basis that includes their offshore subsidiaries, U.S. banks’ participation in wholesale swap markets remained steady. The delivery of swaps to U.S. customers did not decline, while the wholesale markets on which that delivery relies moved offshore.
A close look at the evidence supports a more nuanced view of the threat the mobility of financial institutions poses to unilateral financial regulation. Customers do not appear to have moved offshore to collude with financial services providers in achieving lighter regulatory conditions. These observations are consistent with theory developed in this paper. In brief, customers generally face low returns from partnering with financial services providers in avoiding regulation through the non-trivial effort of relocation. Regulations such as customer protection aimed at the market between financial services providers and their clients, or “Wall Street” and “Main Street”, are thus relatively immune to the migration of financial institutions. Prior literature is underdeveloped in that it does not account for (a) the need of both parties to a financial transaction to move in order to escape a nation’s regulatory ambit and (b) assumes the readiness of customers to collude in avoiding regulatory burdens.
The experience and theory presented in this paper support, however, that intra-Wall Street markets are mobile. Empirical evidence supports anecdotes reported in the news that wholesale markets have moved to offshore subsidiaries, where systemic risk may be accumulated. Relocation, however, does not necessarily entail the ineffectuality of unilateral regulation. While offshore subsidiaries may be outside the reach of unilateral regulation, the domestic operations of parents are well within regulatory ambit and provide purchase for unilateral regulation. This paper explores methods for stemming the inflow of risk from offshore subsidiaries to U.S. parents. The paper also shows, however, that these steps are challenging to undertake due coordination problems among U.S. regulatory agencies and Congressional committees, as well as the lack of political resolve in times of crisis.
International harmonization is often not necessary to achieve policy goals, but it does make it easier. Consistency across legal regimes forecloses the need for lawmakers to address interactions between regulated domestic activity and unregulated foreign activity. These observations qualify calls for international harmonization of financial regulation.
Keywords: international financial regulation, swap, Dodd Frank Act, clearing, execution, derivative, avoidance, arbitrage, subsidiary, dealer, intermediary, Title VII, foreign, domestic, future, substitution, regulation, bank, bank holding company, customer, end user, margin, collateral, systemic risk, policy
JEL Classification: K22, K23, K33, K20
Suggested Citation: Suggested Citation