Andrew Bailey, Chief Executive of the FCA gave a speech today at the Official Monetary and Financial Institutions Forum. Below is the speech as drafted and may differ from the delivered version:
Highlights
- We can learn lessons by putting the issues around Brexit into a historical context.
- Common regulatory standards are a necessary condition for free trade in finance.
- There are risks for disruption to financial services for the UK, EU and globally from Brexit.
- Regulatory cooperation can minimise the risks from Brexit and support a transition to a new relationship between the UK and the EU.
Thank you for inviting me to speak. The subject I am going to focus on concerns open markets and free trade in financial services. It is highly relevant today in the world of public policy for at least two reasons, one of which is a broad international issue and the other is much more specific to the UK. The broad issue is really a reflection on the ten years that have passed since the start of the global financial crisis and the implications of both the crisis and the subsequent regulatory and public policy reform programme for open markets in financial services.
The specific UK issue is, of course, Brexit and what that means for trade in financial services. I should emphasise that on Brexit, our job at the FCA is to roll our sleeves up and play our part in implementing the decision made by the people of this country to leave the European Union, and what goes with it.
The specific UK issue is, of course, Brexit and what that means for trade in financial services. I should emphasise that on Brexit, our job at the FCA is to roll our sleeves up and play our part in implementing the decision made by the people of this country to leave the European Union, and what goes with it.
I am also going to take advantage today of putting these issues into historical perspective. I think this is important because the history of trade policy points to some core issues that run through the various phases of history. This is not a case of “history repeating itself”, which is generally an oversimplification, but rather of extracting some of the more common themes and issues.
The organisation of what I am going to cover is broadly as follows. I am going to start with some history of trade policy. I then will draw out some salient points in respect of financial services over the last nearly fifty years. In doing so, I will cover the global financial crisis, and what this meant for open markets and free trade. And, then, I will try to pull it all together and draw out issues for today. I will set out principles and standards that I think can form the basis of agreement on outcomes from financial regulation to support open financial markets and free trade.
The bottom line is this: there are reasons for thinking that the circumstances today for a major step forward in open markets in financial services are unpromising. On the contrary, I think we can make the opposite argument, that now more than before there is an opportunity to achieve something on this front. For those who believe in free trade and open markets, it is a prize worth trying for.
Some broad history of trade policy
Of course, it is possible to go back in the history of trade almost as far as you want. I am not going to do that, but rather only start in the first half of the nineteenth century. In 1846, Britain repealed the Corn Laws, a unilateral move to free trade in the key area of agricultural trade. It was highly politically controversial, even my modern standards.
It involved the Government of the day reversing the policy on which it was elected – agricultural protection – and in doing so dividing the governing party by passing Repeal with the support of the opposition. The Government did not survive thereafter for long. To be very clear, I draw no lessons for today’s context. That is not the point of studying history in my view – history is not a version of Groundhog Day. But there are themes and issues in the Repeal of the Corn Laws which are relevant, and which do merit study. It was a unilateral action by Britain; it did not involve a Treaty with any other country. In fact, it involved no form of institutional structure in terms of any national or international agency. It was not a move to liberalise trade in an area in which Britain enjoyed comparative advantage – it was not therefore a move to push home comparative advantage, something that would have required international agreement since it would have involved import liberalisation by other countries. Rather, Britain liberalised its own import rules in the area where it did not enjoy comparative advantage, for the assumed benefit of greater trade in the areas where it did. Such a move was done in the teeth of domestic opposition from agricultural interests, hence the political controversy. It was the start of an embedding of the idea of unilateral free trade in Britain.
The next stage in the story starts in 1861 with the Anglo-French trade treaty, the so-called Cobden-Chevalier Treaty. This led to the growth of trade treaties in Europe over the next twenty years or so. Unlike the Repeal of the Corn Laws, the flavour was much more about taking advantage of areas in which comparative advantage was enjoyed. In terms of institutional structures, the glue was by modern standards quite weak, relying on time-limited treaties which therefore had to be renewed periodically. Importantly, there was a degree of embedding of a multilateral approach because a feature of the treaties was the inclusion of the Most Favoured Nation principle governing the terms offered to all other countries. The MFN principle involves countries negotiating trade agreements committing to extend to each other any more favourable trade terms that each might thereafter agree with a third country. It acts to support a multilateral approach at the expense of discrimination. Indeed, when Britain started to drop out of the leadership role in these treaties, it retained a good deal of the benefit of the Most Favoured Nation provisions.
Interestingly, commentary on Britain’s step back from leadership tends to point towards its ideological determination to pursue free trade on a unilateral basis in a world where negotiated reciprocity was increasingly coming to the fore. Important here was the growth and fostering of an ideological commitment to free trade in Britain which transcended reciprocal bargaining of producers’ interests by States in favour: “of a market between individual economic actors in which the interests of the consumer should reign supreme. The British thought of their viewpoint as universally valid and altruistic, though they were not, of course, disconcerted by the fact that it had served their national interests supremely well for 30 years.”
In Britain, the commitment to free trade lasted longer in the face of adversity as the twentieth century progressed than it did in other countries, and that has been attributed to the stronger ideological underpinnings and the association with the consumer interest. Free trade had deeper roots in Britain. But, when free trade was revived after the Second World War, it was not built around ideological foundations of unilateralism which eschewed the need for institutional glue, but rather around a stronger emphasis on reciprocity negotiated through an institutional setting.
Nineteenth century free trade was based around the classical economists’ notion of comparative advantage as fixed endowments of factors of production. It was thus largely exogenously determined as envisaged in the work of Ricardo and others. It did not need to be shaped by public institutions enacting the public interest on behalf of Governments. This notion survived well into the twentieth century.
But, increasingly, as Governments sought to define the public interest – often as a consequence of harsh experience – and pursue it through public policies, the shaping of comparative advantage became more endogenous. Also, while nineteenth century free trade was all about goods, the twentieth century saw the emergence of service sectors which became increasingly tradeable. The factors that determine comparative advantage in services can differ from those that determine comparative advantage in goods, and do not rely on fixed endowments of factors of production. Public policy choices may well play a larger role in shaping these endowments. Financial services is a prime example of this.
As the Second World War came to an end, the Bretton Woods conference envisaged the creation of three new international institutions, including an International Trade Organisation to oversee the negotiation and administration of a new multilateral world trade regime which reduced tariffs and liberalised a regime that had reverted to protection between the wars. Of the three Bretton Woods institutions, the ITO was the one that did not happen, largely due to opposition in the US Congress that it would constrain domestic sovereignty. Instead, the GATT came into being in 1947, envisaged as a temporary stop-gap based initially on a provisional agreement among 23 major trading countries but without any formal institutional powers and structure. That had to wait until the World Trade Organisation came into being in 1995.
We can see another parallel to contemporary debates around suspicion of international institutions in some quarters. If the story had stopped here, we would see a legacy of history which included an attempt to ground free trade in ideological commitment, which did not last, and an attempt to ground it is an international institutional structure which struggled to get off the ground.
But the story did not stop at this point. GATT was in many ways a success that exceeded the unpromising terms of its creation. But it was for a long time confined to goods trade only.
Its success was grounded in the principle of reciprocity even though economic theory continued to emphasise the gains from unilateral trade liberalisation. The focus of GATT was also more on so-called sectoral reciprocity or reciprocal market access in particular sectors. While this created the risk, and to some degree reality, of siloed trade arrangements, it was probably more manageable by dealing at any one time with a limited number of domestic policies of a few countries that were major players in a particular sector, and thus the negotiation process and the trade-offs were more focused.
One of the purposes of this review of trade policy is to draw out the themes that have run through history and continue to be with us today. One of those themes, the relevance of which today is obvious, is regional trading blocs. The essence of the debate over time has been whether such blocs can be complementary and mutually reinforcing to a multilateral trading system or inherently discriminatory and a threat to a vision of the non-discriminatory world system envisaged in the Bretton-Woods agreement? Another way of putting this, which as I will come to later is highly relevant today, is whether they violate the Most Favoured Nation principle in terms of the treatment of members and non-members. For reasons that I will come onto, this issue is particularly challenging in an area like financial services.
A reasonable challenge to claims of the negative effects of regional trade blocs is “negative relative to what alternative?” They may be negative to multilateral global free trade – the vision of pure comparative advantage theory at work – but that is not the system that actually prevails or really every has done. So, while one view is that such blocs increase intra-area trade, they do so by diverting from trade with the rest of the world, there is no easy answer to the costs and benefits of this. What does seem to me to be highly problematic is to set out to contradict the principle of non-discrimination which has grown out of the Most Favoured Nation treatment unless there is good reason to do so. More on that later.
Trade in Financial Services and Open Markets
I want next to move on to the area of financial services, the one that I have been most involved in throughout my career. As a general principle, the logic of gains from specialisation and trade can apply to service industries like finance. That said, the notion of comparative advantage is different to goods trade. It is not driven by natural factor endowments such as land or mineral resources but by human created factors such as knowledge and its application. This has sometimes led to a very sharp distinction being drawn between goods and services trade, with the suggestion that the latter are so intangible and ephemeral between production and consumption that they are not susceptible to trade policy in the traditional sense of the term. Thus, services did not feature in GATT rounds until Uruguay, which finished in 1993. By then, the appreciation of an increased potential for international trade in services, and the reduction or elimination of barriers in services trade had become an increasing priority for some developed countries. Financial services were an important part of that trend.
Before offering some reflections on the history of financial services relevant to the issue of trade, I want to emphasise some general points on the role of regulation in the institutional framework that enables trade. Because of the well-known externalities that can arise from financial services, in the areas of both prudential and conduct outcomes, the case for regulation is made both in a closed economy and as the source of assurance to enable trade to occur and thus in open economies. Effective regulation enables trade, and because of the capacity of the externalities to spill over, such trade requires good regulatory co-operation which enables sufficient harmonisation and mutual recognition. This means that effective and necessary regulatory co-operation depends upon trust between regulators. And, trust depends upon transparency of practices and consistent effective outcomes in terms of dealing with the potential for harm arising from the externalities. In other words, that trust has to be earned.
But regulation can also be a less benign influence on open markets, because it can operate as a barrier to trade itself, particularly where it is structured to prevent openness. It is a feature of recent times that liberalisation of services markets has come via regulatory reform in many countries, with the consequence of opening up to trade. Financial services are no exception to this pattern. The key issue has been to understand what harm the restriction on trade is designed to address and then deciding whether it is a legitimate restriction or not. In some cases the harm will be uniform – we don’t like what can arise from this activity – in other cases the harm can arise from certain providers for whom the standards of regulation are too lax. This laxity can either arise in the host market where the activity is undertaken or the home market from where the institution comes.
The fairly recent history of financial services is interesting in this respect, and instructive. I joined the Bank of England in 1985, just over 32 years ago. My first job in the Bank was as an analyst of developments in international financial markets, or what were often in those days called Euromarkets. What was noticeable about the role was how far removed it was from colleagues who worked on UK domestic financial markets.
Two years later, in 1987, I was lucky enough to be seconded for six months to the Federal Reserve Bank of New York, in a similar role. At the New York Fed too there was quite a sharp distinction between work on international and domestic financial markets. Why was that? I would argue that it was not random. At that time there was a strong bifurcation between domestic financial markets, which were extensively regulated and in doing so protected, and international financial markets which were not. Indeed, the existence of the latter tended in some circles to be viewed as the safety valve to preserve restrictions in the former.
If we think about this pattern of markets, the segmentation relied to be successful on being able to draw a sharp distinction between the products and services in each, and by implication between the harm and risk that could arise in each. As I will argue, the global financial crisis put the final nail into that coffin.
If we think about this pattern of markets, the segmentation relied to be successful on being able to draw a sharp distinction between the products and services in each, and by implication between the harm and risk that could arise in each. As I will argue, the global financial crisis put the final nail into that coffin.
But, if we go back to the 1980’s for a moment, two things stand out. First, the previous decade had seen not just economic stress in the form of high inflation and slow growth, but also an increasing pressure arising from the challenge of innovation in financial services to traditional regulations in domestic markets and to traditional definitions of things like monetary aggregates. These fed through into a lack of confidence in the indicators used by monetary policymakers and ultimately in the policy itself. A reading of the transcripts of the Federal Open Markets Committee in the US in the period before the revolution of 1979 initiated by Paul Volcker aptly illustrates this concern. Innovation took two broad forms, both within regulated domestic markets but also between the domestic and international markets.
Meanwhile, international markets were increasingly of interest to policymakers, but the full impact of them was only gradually being discerned. One of the first things I did at the Bank of England was to make a very small contribution to a Bank for International Settlements publication under the title of “Recent Innovations in International Banking” published in 1986. The report set out recent innovations, their causes, and the issues raised by them for policymakers. I had not looked at the report for long time until recently, and I was pleasantly surprised to find that it has a chapter with the title “Issues for macroprudential policy”, which reminded me that macroprudential has a rather longer history than we sometimes think.
But, the main outcome of this work in the mid-1980’s was not macro-prudential policy as we know it today. It took the global financial crisis twenty years later for that to happen. The main outcome was the original Basel Capital Accord, or Basel 1 as it is known. Basel 1 was important and highly significant as the first introduction of an international bank capital standard. It tackled the reality that in the 1980’s banks were innovating and expanding their activities, domestically and internationally, but with very little capital backing. This was creating risks, but also affecting the pattern of competition since some countries appeared to be more prepared to tolerate such expansion in their banks than others. But Basel 1 did not tackle what we now know as macroprudential risks. To borrow from my fellow FPC member Donald Kohn:
Macroprudential policy is focused directly on financial stability – trying to assure the ability of the financial system to deliver essential services at reasonable prices in support of economic growth under a variety of circumstances, including after a severe stress. It does so mostly by putting a macroprudential finish on microprudential tools to take into account externalities of financial instability and damp inherent procyclicality of the financial system.
It took the global financial crisis, starting ten years ago, to get to this state of policymaking. By 2007, the financial system had arrived at a point where the old distinction between domestic and international markets had broken down. It was not possible to maintain the notion of the distinction, and that domestic stability could be insulated from international spillovers.
The Less Developed Country debt crisis of the 1980’s had demonstrated this forcefully, but it took another twenty years to prove the point violently. By then, almost all domestic market regulations of the old sort had been lifted and trade in financial services – cross-border activity – had been freed up. This, in turn, enabled larger current account imbalances to exist and persist. It was a world in which policy makers had few tools outside the increasingly common and helpful emphasis on inflation targeting and the Basel Accord.
The point has been well made that by the time of the arrival of the global financial crisis, policymakers were unusually denuded of tools that would, to use Don Kohn’s phrase, deliver a macroprudential finish. Ironically, a few tools had existed in the older regulated domestic financial markets, though their utility was compromised by the false distinction between domestic and international markets.
The toolbox needed a radical overhaul. And that is what has happened in the wake of the financial crisis. This overhaul is in my view highly relevant for open markets and free trade in financial services. The crisis laid bare the severity of the international spillovers. The consequences included a dramatic retreat from cross-border activity, including lending. It was a violent home preference shock of the sort that contributed to the loss of financial stability.
It would not be surprising if the consequence of these events had been a retreat from open markets and free trade, the more so because of their effects on economic activity including distributional effects. There is a parallel here in history. The period from the mid-nineteenth century to the First World War saw a powerful growth in the openness of economies in Europe and North America and signs of it extending to other regions. The period after the First World War saw a backlash as a response to the actual or perceived effects of this globalisation. As Kevin O’Rourke and Jeffrey Williamson have argued, globalisation can, at least in part destroy itself. The global financial crisis could have done something similar. That the process has been better managed reflects in good part the efforts of authorities to introduce a more effective, and I believe more trusted, financial regulatory system.
Looking forwards: A future for Open Markets
And today we find ourselves at another fork in the road. The progress, and dare I say it consensus, on the benefits of open and global markets, maintained following the financial crisis is once again being questioned.
I strongly believe in free trade and open markets in financial services, particularly wholesale services. I take some comfort that in spite of the severity of the financial crisis and its economic effects, the resulting actions have limited the likelihood of a return to protectionism. That depends on effective, efficient and very well co-ordinated financial regulation and the systems put in place over the last ten years being maintained.
The post-crisis reforms put us in a much better position to support open financial markets in which we can deal with the harm arising from externalities and spillovers. This does not, to be clear, mean we can expect today entirely frictionless trade, because like perpetual motion that does not exist. But it does mean that we should expect to reduce friction rather than increase it.
Almost since Bretton-Woods there has been a debate on whether regional trade blocs stimulate or restrict trade, and likewise whether or not they are consistent with Most Favoured Nation provisions. Today in the UK, we stand at a point where we have the basis for effective open financial markets and free trade supported by the regulatory reforms post-crisis, but a threat to achieving that outcome in the form of reactions to Brexit. Trade theory tells us that such a threat is bad all round, not just for the UK.
What would it take to go the better route and entrench open markets and free trade? For financial services, as I have set out, strong regulatory standards are an important pre-requisite.
But we have to recognise that today, international or global regulatory standards are a patchwork at best. They are most obviously present in the Basel Accord as augmented over time. Elsewhere, and particularly in the world of financial conduct – where wholesale markets are the most relevant to trade – they are more absent. But, we should start – to borrow a phrase – with agreement on principles which can form the basis for the negotiation of solutions. To state the blindingly obvious, time is of the essence.
We all begin with the same shared objectives. The overall objective of regulatory standards in financial services is to support the delivery of financial stability, consumer protection and open, innovative financial markets which enable growth and prosperity.
And to further this overall objective, regulators must work together and cooperate in international fora to ensure financial markets support these goals. I may have started this speech by talking about the unilateral repeal of the Corn Laws, but it is by working multi-laterally that the best progress can be made.
This means that where markets are global/cross border, we should cooperate to ensure frameworks are consistent in terms of outcomes and that opportunities for regulatory arbitrage are minimised. And, where markets are local, we should share best practice and promote common approaches wherever appropriate.
Financial stability and market integrity in a transition
The first objective I mentioned above was financial stability. The crisis of 2007/08 provides a painful lesson as to why this must be at the core of our thinking as regulators. We know that EU withdrawal has potential risks for disruption to financial services for the UK, EU and even globally. Some of these financial stability effects arise due to so-called cliff edge risks. But by working closely together as authorities we can minimise these risks and support a transition to a new relationship between the UK and the EU.
Going beyond the immediate transitional issues, we need to consider how we move towards our future relationship with the EU, whatever that may look like. If we are to promote open and innovative financial markets then, wherever firms operate cross-border, they should be able to continue doing so under the terms of the new relationship. This should be as seamless a process as possible, avoiding any interruption in the supply of services.
And if firms lose the right to operate cross border, then they should be afforded sufficient time to restructure or take other action necessary to avoid a cliff edge, including enabling firms to meet outstanding contractual obligations in order to ensure continued consumer protection in the EU and UK, and certainty for financial markets.
However, in my view there should be a strong preference to preserve cross-border operating where it is consistent with the overall standards. So what principles might we turn to when considering such an arrangement?
Any agreement on market access must be clear and sustainable to provide confidence in its long term operation. Trade in financial services can only flourish when built on a stable base that firms and regulators can understand and rely upon.
The Most Favoured Nation principle of non-discrimination should be at the core of any agreement. It should provide for equal treatment under its terms. It should not allow jurisdictions or firms to be discriminated against because of where they are based.
And where market access is predicated on commonality of rules, this should be determined by taking a proportionate and outcomes based approach, focusing on whether rules address the same risks while seeking to avoid market distortion or regulatory arbitrage. It should also take into account the extent to which rules are aligned with international standards. As I mentioned earlier, currently international standards remain somewhat patchwork, but as they develop – and I hope they will – then they can increasingly be relied upon for the purposes of cross border trade.
To help achieve this, we need to have cooperation. Regulators must work together to protect market functioning and integrity. Given the high degree of integration in financial markets, regulatory authorities should be able to share information without obstruction.
Authorities should explore mechanisms to support greater information sharing where appropriate given the degree of cross border business or to improve the functioning of the supervisory oversight system.
This could include building on existing college arrangements and other types of close working for certain categories of cross border entity, or in some cases developing new ones. Mechanisms should exist to ensure cooperation on enforcement and other supervisory matters. Put simply, the work of authorities to create a more effective and more trusted financial system since the crisis relies in good part on cooperation across jurisdictions. I do not believe that anyone is served by seeking to unpick that work.
Conclusion
There are reasons why trade in goods and services have had different historical experiences. It has been easier to determine and oversee public policy objectives towards trade in tangible goods, not least because they rely on the use of factors of production in their creation which are more fixed in location and thus easier to act on from of policy perspective. And the Most Favoured Nation principle and practice has a long history in goods trade.
Trade in financial services went down what looks like, with the huge benefit of hindsight, an odd road with the separation of domestic and international markets. It took the global financial crisis to finally lay this idea to rest. The crisis also reminds us powerfully that financial services carry risks which create severe externalities, which can be amplified by cross-border spillovers. The response to the crisis has, of necessity, involved a careful definition of the public interest and the re-design and re-building of the regulatory system at the international and domestic level in order to provide assurance that the public interest will be protected.
This leads to two important questions. First, can open financial markets and free trade exist on a stable basis? Second, is the regulatory system so complicated and delicate that it can only exist in a manner that supports free trade and open markets inside regional trade blocs? You will by now be unsurprised to know that my answers to these questions are – yes, free trade in financial services can exist on a stable basis, and – no, it does not have to be confined within regional blocs. Common regulatory standards are a necessary condition for free trade in finance, and they can also be a sufficient condition. Multilateral open markets are a prize worth having for all. Of course, they can only exist with the broad support, and to ensure that outcome the case for free trade has to be repeated.
Thank you.