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Reframing International Financial Regulation After the Global Financial Crisis: Rational States and Interdependence, Not Regulatory Networks and Soft Law

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Reframing International Financial Regulation After the Global Financial Crisis: Rational States and Interdependence, Not Regulatory Networks and Soft Law Michigan Journal of International Law Volume 36 Issue 1 2014 Reframing International Financial Regulation After the Global Financial Crisis: Rational States and Interdependence, not Regulatory Networks and Soft Law Matthew C. Turk U.S. Court of Appeals for the Ninth Circuit Follow this and additional works at: https://repository.law.umich.edu/mjil Part of the Banking and Finance Law Commons, International Law Commons, and the Transnational Law Commons Recommended Citation Matthew C. Turk, Reframing International Financial Regulation After the Global Financial Crisis: Rational States and Interdependence, not Regulatory Networks and Soft Law, 36 MICH. J. INT'L L. 59 (2014). Available at: https://repository.law.umich.edu/mjil/vol36/iss1/2 This Article is brought to you for free and open access by the Michigan Journal of International Law at University of Michigan Law School Scholarship Repository. It has been accepted for inclusion in Michigan Journal of International Law by an authorized editor of University of Michigan Law School Scholarship Repository. For more information, please contact [email protected]. REFRAMING INTERNATIONAL FINANCIAL REGULATION AFTER THE GLOBAL FINANCIAL CRISIS: RATIONAL STATES AND INTERDEPENDENCE, NOT REGULATORY NETWORKS AND SOFT LAW Matthew C. Turk* INTRODUCTION ................................................. 60 I. HISTORICAL DEVELOPMENT OF THE INTERNATIONAL FINANCIAL ARCHITECTURE ............................. 65 A. Bretton Woods (1944–1973) ......................... 66 B. Financial Integration & Early Coordination (1973–1994) ........................................ 67 C. The New International Financial Architecture (1994–2007) ........................................ 69 D. The 2008 Financial Crisis ........................... 72 II. INTERDEPENDENCE PROBLEMS IN INTERNATIONAL FINANCIAL REGULATION ............................... 76 A. Harmonization of Standards ........................ 78 1. Defining the Interdependence Problem.......... 78 2. Evaluating Harmonization of Standards ......... 81 B. Crisis Prevention: Maintaining Capital Adequacy .... 85 1. Defining the Interdependence Problem.......... 85 2. Evaluating International Capital Adequacy Agreements .................................... 89 C. Crisis Management.................................. 94 1. Cross-Border Bank Resolutions ................. 95 2. An International Lender of Last Resort ......... 101 III. IMPLICATIONS .......................................... 110 A. Policy: Implications for the Design of International Financial Regulation ................................ 110 1. A World Financial Organization ................ 110 2. Incremental Policy Solutions .................... 115 B. Theory: Implications for the International Law Literature........................................... 118 1. Response to Critiques of the Rational State Approach ...................................... 118 2. A Critique of Transgovernmental Networks and Soft Law Literatures ............................ 121 CONCLUSION ................................................... 127 * Clerk to the Honorable Ferdinand F. Fernandez, U.S. Court of Appeals for the Ninth Circuit; J.D., 2010, New York University School of Law. 59 60 Michigan Journal of International Law [Vol. 36:59 INTRODUCTION The British bank Northern Rock failed on September 14, 2007; U.S. investment bank Bear Stearns collapsed on March 17, 2008 and was sub- ject to a government-engineered takeover by J.P. Morgan Chase; and, on the night of September 15, 2008, U.S. investment bank Lehman Brothers filed for bankruptcy and sent global financial markets into disarray the following Monday morning. These financial institutions shared several fea- tures in common prior to their downfall, but perhaps the most curious is that they were each considered fully compliant with the second generation framework for the Basel Accords on Capital Adequacy (Basel II),1 an in- ternational agreement requiring banks to maintain capital levels consistent with then, state-of-the-art risk metrics.2 Basel II, it turns out, was insuffi- cient to ward off the insolvency of many large, multinational financial institutions. The Basel Committee on Bank Supervision was not the only interna- tional body exercising oversight of financial firms and markets prior to the global financial crisis of 2008 (2008 Crisis). One function of the Interna- tional Monetary Fund (IMF) was to provide continuous “surveillance” of international markets.3 Among other occasions, it did so informally in September of 2008 by publishing statements of its president Olivier Blanchard, entitled “Blanchard Sees Global Economy Weathering Finan- cial Storm.”4 Contrary to the IMF’s forecast, however, Lehman Brothers collapsed just two weeks later and the global economy capsized in the en- suing financial storm. 1. BASEL COMM. ON BANKING SUPERVISION, INTERNATIONAL CONVERGENCE OF CAPITAL MEASUREMENT AND CAPITAL STANDARDS: A REVISED FRAMEWORK (2006) [here- inafter BASEL II], available at http://www.bis.org/publ/bcbs128.pdf. 2. In fact, Northern Rock executives testified to paying a dividend months before the bank’s failure because of a substantial regulatory capital surplus above Basel II requirements. See Press Release, Chairman Christopher Cox, Chairman Cox Letter to Basel Committee in Support of New Guidance on Liquidity Management (Mar 20, 2008), available at http://sec .gov/news/press/2008/2008-48.htm (“[A]t all times until its agreement to be acquired by JP Morgan Chase during the weekend, [Bear Stearns] had a capital cushion well above what is required to meet supervisory standards calculated using the Basel II standard.”); U.S. Sec. & Exch. Comm’n Office of Inspector Gen., SEC’s Oversight of Bear Stearns and Related Enti- ties: The Consolidated Supervised Entity Program, Report No. 446-A, at 10–11 (Sept. 2008). See generally, John F. Rosato, Down the Road to Perdition: How the Flaws of Basel II Led to the Collapse of Bear Stearns and Lehman Brothers, 17 CONN. INS. L.J. 475 (2011) (providing a critical account of Basel II’s role in capital adequacy regulation). 3. See IMF Executive Board Adopts New Decision on Bilateral Surveillance Over Members’ Policies, Public Information Notice (PIN) No. 07/69, INT’L MONETARY FUND [IMF] (June 21, 2007). See generally, Marcel Fratzscher & Julien Reynaud, IMF Surveillance and Financial Markets—A Political Economy Analysis, 27 EUR. J. POL. ECON. 405 (2011) (analyzing the increasing role of surveillance in the IMF’s agenda). 4. Blanchard Sees Global Economy Weathering Financial Storm, IMF SURVEY ON- LINE (Sept. 2, 2008), http://www.imf.org/external/pubs/ft/survey/so/2008/int090208a.htm. The IMF president’s optimistic analysis turned largely on speculation over future fluctuations in oil prices, rather than the robustness of the subprime mortgage market or large financial institutions. Fall 2014] Reframing International Financial Regulation 61 Other disheartening anecdotes regarding international financial regu- lation abound. But the essential point is that, leading up to the 2008 Crisis, the performance of the so-called “new international financial architecture” (NIFA)—the constellation of international agreements and institutions de- veloped in response to the financial crises of the 1990s5—was unimpres- sive. The 2008 Crisis revealed the weaknesses of the international financial architecture, and has made regulation of the global financial system a cen- tral problem facing international law and the world economy. This Article analyzes the post-2008 efforts at institutional develop- ment and international cooperation in finance, and seeks to identify which regulatory projects are likely to succeed and which are not. The overarch- ing aim is to reframe the discussion concerning international financial reg- ulation by taking a step back to investigate the big questions: What exactly are the externalities of cross-border finance that make international regu- latory cooperation worth attempting? What are the specific incentive and informational barriers that sovereign states face when addressing these ex- ternalities? Which of the tools that states have employed—whether in the form of organizations or particular rules and agreements—have proven useful, and why? Do post-2008 reforms avoid the underlying causes of pre- vious regulatory failures, or not? In answering these questions, this Article captures the value added by applying a back-to-the-basics rational choice approach to this increasingly complicated and important area of international law.6 The analysis pro- ceeds by assuming that rational states are the ultimate actors in interna- tional law.7 States craft international rules and institutions to capture the joint gains available from correcting international externalities, referred to here as “interdependence problems.” The starting point is to identify in- terdependence problems, and examine the ability of rational states to overcome them given the specific strategic incentives and information con- 5. See Michael Camdessus, Towards a New Financial Architecture for a Globalized World, Address at the Royal Institute of International Affairs in London (May 8, 1998) (pro- viding an early use of the term and laying out the regimes basic principles). 6. See Kenneth A. Shepsle, Rational Choice Institutionalism, in OXFORD HANDBOOK OF POLITICAL INSTITUTIONS, 23, 24–27 (R.A.W. Rhodes et al. eds., 2006). See, e.g., ANDREW GUZMAN, HOW INTERNATIONAL LAW WORKS: A RATIONAL CHOICE THEORY (2010); ROB- ERT O. KEOHANE, AFTER
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