The UK and Multi-Level Financial Regulation. Post-Crisis Reform to Brexit

This blog reports on a webinar on 19 October, 2021, in which the panel discussed a new book entitled 'The UK and Multi-Level Financial Regulation. Post-Crisis Reform to Brexit'. The panel included authors Scott James (King’s College, London) and Lucia Quaglia (University of Bologna) and was chaired by Daniel Hardy, EuPEP, Oxford. The discussants were Alexander Lehmann (Breugel) and Sam Lowe (Centre for European Reform). 

In their book Scott James (King’s College, London) and Lucia Quaglia (University of Bologna) look at the UK’s stance on and involvement in various international and EU initiatives to strengthen resilience in the financial system since the global financial crisis (GFC). They seek to explain why the UK took different approaches in different policy areas as a product of political forces within the UK, and of the situation in the relevant international and EU fora facing the UK. Contrary to the pre-GFC perception that the UK has always been on the side of lax regulation, and has foot-dragged on international and EU initiatives to strengthen regulation, the authors find a complex picture.

The authors select five important regulatory areas, related to: the level of bank capital; bank resolution; bank structure; hedge fund regulation; and derivatives markets, in particular the role of centralized credit counterparties (CCPs). Each of these has been subject to international and/or EU initiatives since the GFC—the Basel 3 agreement on bank capital, for instance, and the Financial Stability Board’s (FSB’s) “Key Attributes on bank resolution”. James and Quaglia divide the UK’s position on each issue into “pace setting”, “foot dragging”, and “sitting on the fence”. While the UK’s attitude to some of these initiatives, for example the regulation of hedge funds, can be characterized as foot dragging, the UK was pace setting on other issues, such as bank capital requirements.

From a comparative political economy perspective, a country’s position on financial sector issues will likely depend on the importance and strength of key economic interests, which will tend to press for regulations that will improve its competitive position. Hence the UK, with a large and powerful financial sector, would be thought likely to press to maintain its competitive advantages and profitability through lax regulation. Similarly, they speculate that theories of international political economy would lead us to predict that a powerful transnational coalition of financial interests would lobby to maintain the UK’s pre-crisis ‘light touch’ regulatory regime.

James and Quaglia assert that both of these approaches are misleading. Instead, they develop a ‘domestic’ political economy approach, focused on the particular interests and preferences of elected officials, the financial sector, and—the key innovation—regulators. From this perspective, they show how UK financial regulators (located in the Bank of England and its affiliated agencies) has a distinct set of interests aimed at preserving its bureaucratic autonomy and fulfilling its financial stability mandate, which includes a concern to minimize the risk of contagion from cross-border financial activity. To this end, the Bank is able to wield a range of powers to assert UK preferences in international and EU level negotiations, including leveraging the UK’s market power, regulatory capacity, domestic constraints, and alliance-building.

The book makes three main claims. First, UK regulators pursued tougher regulation in response to pressure from elected officials (e.g. bank capital and resolution) or by building political support (structural reform and derivatives). By contrast, the financial industry was more effective at shaping UK preferences when political support was lacking (e.g. hedge funds). Second, UK regulators acted as ‘pace setters’ for international harmonisation to avoid damaging the UK’s competitiveness (e.g. bank capital) and to address cross-border externalities (bank resolution and derivatives). But they were ‘foot draggers’ when EU rules threatened to challenge London’s dominant position (hedge funds and derivatives); and were ‘fence sitters’ when harmonisation was impossible (structural reform). Third, the UK was successful at shaping international standards by leveraging their market power, transnational networks, regulatory capacity and alliance-building (with the US). Although effective at shaping EU regulation in highly technical areas (e.g. bank resolution and derivatives), UK regulators were less influential as issues became politicised (e.g. bank capital, hedge funds and euro clearing), resorting to legal challenges to block reform to secure exemptions.

The authors end their book with a long chapter on Brexit, looking at the positions that the UK has taken in the Brexit negotiations, in particular at the apparent failure of the City of London to press the case for close post-Brexit regulatory alignment with the EU. Their three-sector model suggests the answer. For the government the main objection was to end freedom of movement for labour: this would mean giving up free movement also for services, and leaving the single market. For the Bank of England, the worst case scenario would be an EEA-type arrangement under which the UK would have to follow the rules set by the EU, which would severely restrict its autonomy. Especially in the event of a crisis it would wish to be able to take the remedial actions that it thought appropriate. That concern outweighed the recognized extra costs of a less close relationship with the EU, which was instead advocated by parts of the financial industry.

Alex Lehmann, broadly went along with the analysis, although he suggested that other case areas are currently more prominent. Traditional financial services are now less relevant than five years ago. From a Brussels perspective, the capital markets union is now central. The UK will be missed, because of its regulatory expertise, and because the UK has been a driving force. Lehmann thought also that further decomposition of domestic interests might have been useful, for instance, by including the House of Commons Select Committees as a distinct presence. He wondered if the regulators had overestimated their negotiating power: it is not clear that there are unbounded benefits in financial sector agglomeration. If the EU believes that it will be as well served by a financial sector, it has less incentive to accommodate UK post-Brexit preferences He also noted that, while the UK was indeed forceful in pressing for high capital standards, it was timid in addressing an equally relevant issue for strengthening the banks, i.e. banks’ excessive leverage levels.

Sam Lowe too welcomed the analysis. He agreed that the government’s desire to end freedom of movement for labor forced the UK into a position of having to leave the single market. He considered that the problem was compounded by the striking arrogance of the UK negotiators and lobbyists in the early stages of Brexit negotiations, and the lack of UK understanding of how the EU’s trade policy interacted with financial markets. The Bank of England might indeed have strong grounds to maintain its policy autonomy, for instance to put a positive risk weight on weak European sovereigns. He considered that such autonomy could have been achieved through a prudential carve-out within a deeper EU agreement, but the government’s insistence on ending freedom of movement effectively prevented such a discussion.

Other participants expressed their appreciation of the subtlety of the argumentation and the careful marshalling of evidence. Looking across several policy areas over time, as James and Quaglia do, offers more robust tests of their hypotheses and novel insights. The researchers were applauded also for recognizing the role of various interests groups even within government and industry, and how positions shift across time.

The analysis is insightful, and quite compelling. It would be interesting to extend it backwards to look at the UK’s position on other key elements of its relationship with the EU, most importantly on the single currency. At the start of the Blair government there was a possibility that the UK would join the Euro. Business wanted it, it would mark a clear break with the previous Conservative administration, and Tony Blair was comfortable in his European interactions. Successive Bank of England Governors were opposed. Eventually the issue became moot, as Chancellor Brown took a technocratic response and devised five economic tests that the UK would have to pass for him to support entry. And drilling down further would suggest an answer to another James and Quaglia conundrum: the UK will be missed in European fora, even though it has been foot dragging on some of the big initiatives, because the Bank staff’s regulatory expertise has been brought to bear constructively and skillfully across a range of issues, even when the strategy adopted was not fully in line with the UK regulator’s preferences.

Charles Enoch (EuPEP Project Leader; ESC Fellow at st Antony's College)