This interview was published in late September by the International Financial Law Review in its Cross-Border Financing Report 2016.
Cross-border financing is more complex than ever. And Nicolas Véron, a senior fellow at Brussels-based think tank Bruegel and visiting fellow at the Peterson Institute for International Economics in Washington DC is as well placed to unpick it as anyone. His research is mostly about financial systems and financial reform around the world, including global financial regulatory initiatives and current developments in the EU. Here he touches on the key trends in global cross-border finance, his views on transatlantic capital flows, how best to regulate such flows and the challenges of a Chinese economy gradually integrating itself into the global system.
What are the key trends, globally, in cross-border finance?
It depends where you look. In the eurozone, there has been significant financial fragmentation in the five years up until 2012-2013, and then a trend reversal. From a global perspective, however, and especially in emerging markets, cross-border financial integration has continued more or less on the pre-crisis trend. So Europe is an outlier, rather than indicative of a change in the global trend towards cross-border financial integration.
Europe has a very heavily bank-based financial system and certainly since the start of the crisis in 2007, banks have had to rely on implicit guarantees from governments. Whenever EU governments have triggered such guarantees, they have also asked that the bank in question focus its lending back to the country in which it's based. There's a famous quote – often attributed to Mervyn King but in fact from Thomas Huertas – that "banks are international in life, but national in death." That captures the European experience since 2007 quite well. What is happening now in Italy is a good illustration – triggered as it is by supervisory actions of the ECB under the new banking union regime, but still framed as a national banking sector problem. The eurozone is now a hybrid system: neither purely national nor truly integrated.
There are other factors as well. The wide-ranging reforms of over-the-counter derivatives markets, initiated by the G20 in 2009 and gradually implemented since, change significantly where some trades are booked, which has a large impact, especially on transatlantic capital flow numbers even if the real economic impact isn't that huge.
If we accept that capital flows are pro-cyclical, where are we in the cycle?
There is generally no such thing as a global cycle. To be sure, there was a coordinated moment of difficulty in 2008, but then the US resolved its financial sector problems much more quickly than Europe, and so did the UK compared to the eurozone. And that's leaving aside Asian and other emerging economies, where there was actually no financial instability in 2007-09 even though they were hit by the economic and trade shock.
So the big picture remains a long-term structural trend of global cross-border financial integration, and around that trend there are different financial cycles in different parts of the world, rather than one grand coordinated cycle globally.
How do you view the state of affairs regarding transatlantic cross-border finance?
Now we've had the Brexit vote everything is up in the air. As regards the large derivatives market already mentioned, it is important to remember that the pace of implementation of the G20 reforms, including mandatory central clearing for many derivatives, has been highly differentiated. These reforms are fully in place only in the US.
There are also a lot of unintended consequences. Two broad and perhaps interrelated issues come to mind. The first is the concentration of risk in clearinghouses, which are becoming systemically critical to financial institutions. The implications of this in terms of the regulation, supervision and potential resolution of clearinghouses hadn't been thought through when the G20 decisions were made, to put it mildly. Second, and even less thought through, is that there is no such thing as global supervision, and since clearinghouses require supervision and crisis management, and perhaps also some forms of public guarantees, the very notion of a globally integrated derivatives market is challenged. Supervision has to be conducted on a jurisdiction-by-jurisdiction basis, and actually country-by-country because the EU doesn't count as a single jurisdiction in this area. So there's a fundamental tension between the central clearing mandate on the one hand, and the global integration of OTC derivative markets as they existed before the reforms on the other hand.
We're only at an early stage of the learning curve as to how to address these challenges. It is also fair to say that having made such big decisions first, and then thinking about the consequences years later, is no great example of quality public policymaking. Personally, I remain somewhat agnostic on whether these G20 reforms were a good thing overall for financial stability. One problem is that many of the people who made these decisions are still those in charge. It's very hard for them to acknowledge that they had not properly considered the consequences when they made their decisions. That doesn't help bring about the debate that is needed.
And from a US perspective, how does that debate resolve itself on transatlantic issues?
The shenanigans between the EU and US on things like equivalent status for clearinghouses are in fact relatively marginal, compared to the challenges of finding a workable policy framework at the global level for these kinds of reforms. The policy debate on things like how to oversee clearinghouses lags behind the implementation of the reforms, which itself is way behind schedule. The risk of unintended consequences is very high, and some have crystalised already.
How easy do you think it will be for capital from the Americas to access whatever it is that Capital Markets Union (CMU) eventually becomes?
Until now, the CMU has been a very compelling rhetorical vision proposed by the European Commission, and largely inspired by the UK. But it has had little to show in terms of actual policy decisions, and that's also largely (though not only) because of the UK. This is because a credible CMU requires European enforcement of capital markets rules, and the UK didn't want to even consider such options as they would have been viewed as a Brussels power grab in the referendum campaign. So the question to ask now from an Americas perspective is whether the decision of the UK to leave the EU will kill CMU and destroy the rhetorical vision, or instead unlock CMU and make it more real, at least in the EU27 (current EU minus the UK). We probably won't know for some time.
And it was political too? An offer to the UK, in order to make staying in the EU more attractive.
Yes, to begin with. Initially, European Commission President Jean-Claude Juncker saw the CMU as an unambiguously positive project for the EU's relationship with the UK. But then everyone realised that things weren't that simple. Commissioner Hill ended up advocating an ambitious CMU vision, but at the same time being structurally prevented from implementing it, largely because of the UK veto against any institutional centralisation in this area.
I am still hopeful that the EU27 will move towards better integrated and more developed capital markets. There's really no early indication that the EU will adopt a more closed, protectionist or corporatist model as a result of the UK choice to leave the EU. These are obviously extremely early days so this point has to be made with caution. But it would be misleading to see the UK as the only driver of liberalisation or reform in the EU.
Most cross-border capital flows are channeled through global banks. Do you see any competitive advantages for banks in the Americas, particularly the US, over European banks – or vice versa?
It's only natural that most market participants equate more regulation with being bad for business, but this is just not the full story. There's good regulation, and bad regulation. Smart regulation, and dumb regulation. If you only deregulate, if public oversight of markets becomes ineffective or powerless, there's ultimately a bad outcome for markets.
Markets need strong policy frameworks. They don't exist in a vacuum: to put it bluntly, capital markets don't work very well in Afghanistan. So a structured and effective framework of public policy and governance is needed for markets to thrive. One would have hoped that after 2008, the naïve and misleading view that less regulation is always better for business would have lost traction. But many people have short memories.
So, as an economist, if you close your eyes can you see the theoretical sweet spot for regulating cross border finance?
It's a constantly changing sweet spot, because there's always so much change in the financial world. Regulation has to change accordingly, and there's never really a perfect answer, let alone a steady state. It's not the same, over time, for the same place, let alone different places. Regulation really has to constantly adapt to its environment.
How will Brexit impact cross-border finance into or from the Americas?
At this point, there's simply a lot of uncertainty about everything. When we know more about the future trajectory for the UK then it might be clearer as to whether London is to remain in the single market or not.
That's what really makes a difference for financial services. For now we just don't know. If London stays in the single market, Brexit doesn't change much after all: it's a bit more complicated than that, but that's a good first-order approximation. But if the UK does leave the single market, then the City will probably hollow out. It might be gradual or it might be sudden, but in all likelihood, leaving the single market will be extremely bad news for the City of London.
It would mean a lot of business would be up for grabs from other jurisdictions – some would go to New York but a lot would probably remain in the same time zone, which may mean several different places inside the EU.
For US financial firms, then, there is a plus and a minus. The plus is that New York may gain some of the global business that's currently being done in London. The less good news is that there are transition costs to relocating from London to the EU. In the end, US financial firms can adapt. For them, London has been a great place to do business in the past 20 years, but there's nothing that forces them to stay there if London loses its comparative advantage. And outside of the EU single market, London will certainly lose a lot of its competitive edge.
After 2008, do you think globally unfettered capital markets can be justified – in theory or empirically?
Capital markets are not in fact unfettered. There are obvious regulatory challenges, including the obvious fact that we don't have effective structures in place at the global level with which to deal with global markets and firms.
Thus it is difficult to have deeply integrated cross-border systems that are also properly regulated. But even so, there has been incremental progress. For example, the Financial Stability Board (FSB) has made a positive difference. The Basel Committee now monitors how its standards are implemented, and that is a meaningful step in the right direction.
Currently, we have a hybrid model where most global regulation is applied inside jurisdictions. This creates mismatches with the notion of global cross border financial integration. If one looks only at the European aspect, Brexit is a big loss but Banking Union is a huge gain. So it's not all bleak.
An even bigger challenge is China. For China, gradually integrating itself in a functioning global system may be even more complex than anything that's happening in Europe. Of course, China already has membership of bodies like the FSB and the Basel Committee, but it remains largely a financial island, not just for historical reasons but also for structural reasons. China is becoming a massive presence in global finance, and that creates increasingly real challenges in terms of global financial stability.
Another big theme is that, before the crisis, the EU was a big champion of global financial standards. Now, Europe still talks the talk but no longer walks the walk. The European Commission says it's in favour of global standards, but the EU has the worst compliance record with Basel III in the world. That's a bigger change than we've seen in the US, which always had a stronger stance on the sovereignty of Congress. If anything in the US, we've seen a move towards greater international commitments, especially in terms of implementing Basel III.
There are also fundamental questions about the analytical lessons of the crisis for cross-border financial integration. There is surprisingly little good literature on the trade-offs of cross-border financial integration for advanced economies, as opposed to developing countries. The reason is the conventional wisdom which implies that for developed economies cross-border finance is always good. After the last decade, there are second thoughts. The complex relationships between financial openness, financial development and financial stability require a lot more research than there has been so far, including better financial statistics to start with. There is progress, but it is slow.
It's actually easy to underestimate the benefits of cross-border financial integration, including in terms of financial stability. For example, everyone knows about German banks being hit by US subprime losses in 2007 and that's clearly an instance in which cross-border finance propagates financial instability. But think of what happened in Eastern Europe, and in the Baltics in particular, where the financial system being foreign-owned was actually a big stabilising factor in a domestic boom and bust cycle.