The Centre for International Governance Innovation

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1 The Centre for International Governance Innovation Regulating Globally, Implementing Locally: The Future of International Financial Standards Layna Mosley This paper was presented at the CIGI Workshop "Crisis and Response: Whither International Financial Regulation?" on September 26-27, The paper has not undergone the editorial review accorded official CIGI publications.

2 In the wake of financial crises of the 1990s, IMF and US government officials, as well as private sector financial actors from the developed world, launched at effort to develop and promulgate a set of standards and codes to govern global finance. These codes varied in their institutional form, with some based largely in existing intergovernmental institutions, and others grounded large in private sector entities, such as the International Accounting Standards Board. In other issue areas, these governance arrangements reflected a mix of public and private sector authority (Mosley 2009). Despite this variation, these codes had several features in common. First, they tended to reflect the prevailing practices in developed financial markets, particularly in the United States. Second, while there was tension between developed country governments over the content of some standards (i.e. the continuing fight over accounting standards between the US and the EU; also see Drezner 2007), the standards reflected a basic assumption that, given the right information in a timely fashion, private capital markets would operate efficiently. For example, the more transparent provision of national economic data would prevent speculative boom and bust cycles in emerging market economies. Ultimately, the flaws were not inherent in capital markets, but in the way in which many governments especially in the developing world had failed to couple capital account liberalization with requirements for transparency and disclosure, with prudential financial sector oversight, and with efforts to reduce corruption (also see Best 2005). Third, given this assumption of market efficiency, the framers of the key codes and standards effort assumed that given market actors preferences for a global, effective set of good governance regulations there would be clear material incentives for developing country governments to adopt these standards and codes. The belief was not only that governments would sign on to the new set of codes, but also that they would implement them that compliance would flow from market-based incentives (like low risk premiums and greater capital inflows). To what extent have these assumptions been borne out during the last decade? And what are the implications of the efforts at standards and codes thus far for the future of global financial governance? I begin by briefly summarizing the effort at global financial standards. I then provide summary information on the extent to which various standards have been adopted by and implemented in various countries, with a focus on the developing world. I suggest that, while problems of implementation were not necessarily expected in the late 1990s, they are not surprising, given both the political interests and the technical capacity of regulatory authorities and government officials in the developing world. I conclude with a discussion of the future of this effort at global regulation, in light of the recent financial turmoil in US credit markets. To what extent do events in U.S. markets call into question the utility of the global standards model, in terms of both the desirability and necessity of implementing rules based on US best practices? I. The Global Standards Effort One of the underpinnings of efforts at financial regulation during the last decade has been an effort by developed nations (particularly the US and the EU, especially when there is agreement between them) to create a set of global financial standards. These standards aimed to govern a range of areas, 1

3 including the provision of macroeconomic data, the regulation of national securities exchanges, and the promulgation of international accounting standards. The impetus for the standards project came largely from the financial crises of the mid and late 1990s; policymakers in the developed world diagnosed the crises as due largely to problems of information, transparency and corruption in emerging markets (Best 2005), rather than to any sort of instability inherent in global capital markets. The solution, then, was to continue to advocate capital account liberalization in developing countries, but to couple this liberalization with an attention to regulation a proper sequencing of liberalization and regulation. This policy prescription was largely consistent with a view that weak and weakly-regulated domestic financial sectors might lack the capacity to absorb, and to benefit from, capital inflows (Prasad et al 2007) and that, more generally, that the benefits of capital account liberalization were contingent on meeting a certain set of pre-conditions (Edwards 2008, Kose et al 2006, Rodrik 2006). As part of the G-7 s efforts to encourage the global harmonization of regulation, the Financial Stability Forum (FSF) was established in the late 1990s. The FSF, the creation of which was recommended by G-7 finance ministers and central bank governors, serves as a coordinating body for an effort to create and implement a dozen key codes and standards related to global capital markets. While the FSF seeks to apply its standards to the universe of countries, it operates according to a cluboriented process (Drezner 2007), as indicated by its composition. 1 The FSF consists of G-7 governments (three seats per country, one each for the finance ministry, the central bank and the financial regulator); international financial institutions (7 seats total for IMF, World Bank, BIS, OECD and European Central Bank); international regulatory bodies (6 seats total for organizations focused on banking regulation, securities regulation, accounting standards and insurance supervision); central bank expert committees (2 seats) and single seats for Australia, Hong Kong, the Netherlands, Singapore and Switzerland. This network of networks (Slaughter 2004) develops and advances standards in the broad categories of financial sector operations (banking, securities), market integrity (money laundering, accounting), and transparency (data dissemination, fiscal and monetary policymaking). 2 Some of the standards (bank regulation, money laundering, data dissemination) were based on efforts that existed previously. In other instances, the FSF became the primary forum for developing rules, often coordinating the efforts of other private, quasi-governmental and governmental organizations (i.e. the OECD on the issue of corporate governance, and the International Accounting Standards Board s effort at global accounting rules). Governments of both developed and developing nations were encouraged to adopt these standards, usually mimicking practices based in major financial centers. 1 There are, of course, sometimes disagreements among financial centers. The development of the Basel Accords in the mid-1980s, as well as the more recent revision of the accords and the US-EU struggles over accounting standards illustrate these tensions. See Abdelal 2007, Drezner 2007, Oatley and Nabors 1998, Singer For a summary of the twelve key financial codes and standards, see Drezner 2007 or the FSF website ( 2

4 This most recent round of efforts at global financial governance is, in some ways, distinct from past rounds. One of the distinguishing features is that the new standards and codes tend to require not only changes in governments policies vis-à-vis external actors (i.e. reducing barriers to investments from abroad, or lowering tariff barriers), but also changes in national laws and policies (i.e. accounting practices of firms; banking sector regulation; prohibitions on insider trading; see Kaul et al 2003, Simmons 2001, Singer 2007). Many scholars have noted, of course, that the set of key codes and standards reflect the political and economic power of dominant nations, particularly the United States, and of large financial interests in the US. This reflects a more general pattern, in which rules of dominant countries often become the rules for other nations in the region or around the world, despite the different preferences of those nations (Eichengreen 2003, Simmons 2001). For instance, the 1988 Basel Accords on Capital Adequacy began as a US-UK agreement which then expanded to cover other G-10 nations (Kapstein 1992). Later, the agreement s main directives were adopted by a variety of developing nations, often under pressure from the IMF, the World Bank, and private investors. The Basel Committee, though, remains oriented toward practices in major financial centers (Oatley and Nabors 1998, Singer 2004). To take another example, the success of efforts to reduce money laundering in the early part of this decade likely was driven as much by direct political pressures from the United States as by national governments and private banks desire to maintain a reputation for doing legitimate banking business (Helleiner 2002). Another feature of the standards effort is that it reflects a mix of public and private regulatory authority. The precise nature of regulation and supervision (who writes the rules and who enforces them) varies across the twelve standards and codes, reflecting the fact that the FSF drew on existing networks and standards in some issue areas, but created new standards (sometimes relying on existing institutions, including the IMF) in other areas. The IMF, for instance, took primary responsibility for crafting the Special Data Dissemination Standard, aimed at ensuring the timely and accurate release of macroeconomic indicators by national governments. While the IMF and World Bank formally incorporated the twelve key codes and standards into their routine country surveillance in 2000, there is also a significant degree of reliance on the private sector. Private financial actors generally played roles either as creators of rules or as monitors and/or enforcers of rules. In some instances, such as the Basel II Accords, private sector actors functioned in both capacities, providing input in the making of rules, but also helping to implement the rules. And the development of accounting rules, auditing principles, and insurance supervision continues to rely largely on private sector actors, for rule establishment as well as rule enforcement. Given this combination of private sector influence and great power involvement, it is not at all surprising that the rule-setting process did not involve many of the ultimate subjects of the rules, particularly those based in developing countries. What is perhaps more surprising, though, is that those involved in that process discounted the importance of implementation issues in developing nations. That is, they appeared to overestimate the extent to which market-based incentives for compliance, as well as sometimes-direct pressure from the IMF and the World Bank, would override domestic political interests and institutions. I return to this point below, after briefly summarizing patterns of implementation of the key codes and standards. 3

5 II. Patterns of Implementation Evaluating governments compliance with international codes and standards is, of course, a difficult task, particularly in a broad cross-national context. One private sector entity that evaluates compliance with standards in terms both of individual standards and the general level of adoption is EstandardsForum. Estandards is a private sector-based effort to monitor country compliance with twelve international standards and to provide cross-national summary data to market participants and other observers. 3 Estandards provides monthly compliance scores for each standard; their data begin in January Each rated country receives a score ranging from 0 to 100, with lower scores indicating no or little compliance, intermediate scores indicating standards that have been enacted but not fully implemented, and high scores denoting full compliance. These assessments draw from the IMF and World Bank Reports on the Observation of Standards and Codes (ROSCs), as well as from other sources. For each year reported, I use the July 1 observation as the annual score. Since its inception, Estandards has rated approximately 80 countries compliance. These include all upper-income, developed nations, as well as many emerging market economies (25 of the nations rated also are those included in the MSCI Emerging Markets Index). Most of the developing nations rated are in East Asia, Eastern Europe and Central Asia, or Latin America. Only six of the nations rated are in sub-saharan Africa. The subset of countries rated, then, should be more likely than non-rated countries to adopt and implement the standards. Table 1 reports the average compliance scores, as well as the variation (standard deviation) in these scores, which weight each of the twelve standards equally. Several patterns are notable. First, the average level of overall compliance does increase from 2003 to 2005, before declining in 2006 and after. Regardless, though, overall compliance is greater in 2008 than in At the same time, though, the overall level represents a relatively low (or, perhaps, intermediate) level of implementation, given that scores are based on a zero to 100 scale. Second, and not surprisingly, wealthy nations comply with standards at higher rates, and with less variation among them, than do other countries. The annual difference in average compliance levels is at least twenty points, and the annual variance is significantly greater for non-oecd nations. Third, those countries categorized as emerging market examples include Argentina, Brazil, India, Russia and Thailand receive slightly higher scores than does the broader group of developing nations (which includes the emerging market nations). But, even among this emerging markets subset, average compliance levels are relatively low, and variance is pronounced. Finally, the trend over time holds for all three subsets: compliance increases from 2003, but declines after These scores suggest considerable challenges associated with the adoption of standards, both in terms of overall compliance and in terms of cross-country differences. Of course, these data also obscure 3 All data are from accessed September 1, The Institute of International Finance also has begun ranking countries according to investor relations and data transparency. See 4

6 variation across individual standards and codes. In mid-2008, for instance, compliance was highest for monetary policymaking transparency (an average score of 67.8 for all 83 nations) and data dissemination (63.7). Insurance supervision (19.9), insolvency (21.9), and accounting standards (23.2), on the other hand, displayed much lower levels of implementation. Table 1: Overall Compliance Scores, Twelve Key Standards and Codes 4 Year 5 Overall Average (Standard Deviation) (19.6) (20.4) (22.7) (22.0) (19.2) Developed country average (Std. Dev.) 50.6 (13.6) 52.2 (13.3) 66.2 (14.8) 64.8 (12.0) 60.5 (7.1) Non-developed country average (Std. Dev.) 27.7 (17.9) 31.6 (19.8) 38.9 (20.7) 36.3 (19.8) 33.4 (16.9) Emerging markets average (Std. Dev.) 32.6 (16.2) 36.8 (17.3) 43.9 (15.0) 42.5 (14.1) 39.9 (10.4) Another source of information regarding individual governments implementation of key codes and standards are the ROSCs. These reports, issued by the IMF or World Bank, are prepared at the request of the government; according to the IFIs, they are intended to contribute to discussions between IFIs and governments and to aid private sector actors in evaluating economic and financial risk. 6 Since its inception in 1999, the ROSC program has generated 657 individual reports, comprising both initial assessments and updates. 7 Some of these are completed in the context of FSAP programs, which generate multiple ROSCs (one per standard). As the IMF and World Bank (2005) pointed out in their recent review of the initiative, the majority of assessments have focused on developed and emerging market (rather than lower-income developing nations). The number of ROSCs declined in 2007 and 2008, perhaps reflecting the fact that many governments now have had an initial assessment ROSC completed. It also may belie the fact that many governments particularly those that have not implemented various standards and codes -- do not actively seek out ROSC assessments. 4 Number of countries included: overall (81 to 83); developed (22); non-developed (59); emerging markets (24 or 25, based on inclusion in MSCI Emerging Markets Index). 5 Data for 2007 were not available. 6 The IMF takes primary responsibility for preparing ROSCs related to data dissemination and fiscal transparency; the World Bank assumes leadership for reports on corporate governance, accounting, auditing and insolvency. Assessments of the financial sector (including banking supervision and securities regulation) generally are done as part of the IMF-World Bank Financial Sector Assessment Program (FSAP). 7 Data on ROSCs are based on the IMF s ROSCs site, accessed September 3,

7 In any case, the ROSCs highlight many of the issues associated with implementing standards and codes, particularly in developing nations (also see Mosley 2008). Recent ROSCs point out that many governments have made progress in increasing bank capital adequacy ratios, improving the oversight of banks, and regulating securities markets. At the same time, however, low- and middle-income nations face a variety of challenges, such as a lack of political independence (vis-à-vis finance ministries) of financial regulators; a lack of technical resources and skilled staff among regulatory agencies; a lack of knowledge among private banks regarding prudential requirements; weak corporate governance practices; and a failure to implement perhaps because they are inappropriate to local small and medium-sized firms international accounting rules. Much of the information presented in ROSCs, then, calls into question the success thus far of the standards and codes effort, as well as the suitability of these standards for middle- and low-income nations. A final issue related to the success of the standards and codes project is that many issues now central to global capital markets have not been part of the codes and standards effort. Many of the entities that have played a role in the current US crisis, for instance, would not be covered directly by the codes. This includes hedge funds and various non-bank financial institutions (investment banks, mortgage companies that issue asset-backed securities). At the international as well as the national level, there is an important process of selection at work: it is not only a question of how (private versus public, club versus universe) rules are created, but of what sorts of rules are created in the first place. III. Explaining the Standards Outcome The issue of compliance is central to any effort at international governance: while it often is cheap for national governments to announce adherence to, or to complete ratification of, a treaty or standard, actual implementation can be costly, both politically and economically (Mitchell 1994, Simmons 2000). It is no surprise, then, that a bigger challenge than negotiating standards (great power conflicts over these notwithstanding, as in Drezner 2007) is effecting widespread adoption of the standards. If the concern, though, is that a lack of regulatory oversight in one jurisdiction can cause problems that reverberate throughout the financial system, compliance is central to success. Several features of the standards and codes effort render compliance difficult. To begin, the subject of many of the rules are firms and individuals (rather than simply national governments), adding a layer of delegation, enforcement and monitoring. Moreover, the standards commitments are not legally binding treaty obligations, perhaps reducing the reputational incentives for compliance. And many of the rules are highly technical; this means that implementation requires that government regulators have necessary professional training (and that such well-trained individuals are willing to work for public sector bodies, rather than in the private sector). From the point of view of theories of economic globalization that highlight the power of global markets vis-à-vis national governments and, particularly, the relative weakness of the South (i.e. Wibbels 2006), the lack of compliance and implementation with the key standards and codes may be surprising. But, if we approach the standards efforts with an emphasis on the importance of existing domestic institutions and practices in developing nations, such variation in implementation is much less surprising. International codes that are based on the domestic regulatory systems of developed nations 6

8 (especially the US) often are inconsistent with prevailing political interests and regulatory regimes in low- and middle-income nations. Part of this relates to technical capacity: if, for instance, developing-nation banks lack the skill to implement their own risk assessment procedures, then the Basel II system of banking regulation (with its focus, in Pillar I, on self-regulation by financial institutions) will be largely inappropriate. Indeed, various observers (and some IFIs) have noted that capacity-building is particularly important for lowand middle-income nations that are contemplated (or already have enacted) further financial liberalization (Bhinda and Martin 2005). Of course, in the context of generally low levels of foreign aid flows, the level to which such assistance will be provided remains to be seen. But issues of compliance also have a political dimension, related to the domestic politics of regulation. Local financial institutions in Southern nations may have privileged access to policymakers (just as they do in many Northern countries), and they are likely to have very different preferences over policy. For instance, while local entrepreneurs may welcome an inflow of foreign capital, local banks may worry about competitive threats from foreign financial institutions. Or government officials may worry that, while the timely release of economic information could avert crises, it also may generate volatility, particularly if foreign investors lack the country-specific knowledge necessary to interpret data. Such actors, who are likely to oppose the adoption of international standards and codes, lack the voice to make their concerns heard at the global negotiating stage. But, domestically, they often have the political resources to block implementation. As a result, Northern efforts to put in place a global (or almost-global) set of standards may have mixed results. Added to what may be high domestic political costs of implementation is a possible lack of benefits for compliance. If investors reward (via interest rates and capital flows) governments for compliance with global financial rules, governments will have greater incentives to follow the rules (e.g. Simmons and Elkins 2004). Implementing standards could also render financial crises less likely (see Bhinda and Martin 2005, Schneider 2005). Market discipline, then, may increase regulatory bite. If, on the other hand, private capital market participants have little awareness of the standards, weak enforcement pressures can be expected. Empirical studies of the benefits of standards do developing nation governments that adopt or comply with various international codes pay lower interest rates, all else equal have produced mixed findings. In some cases, the adoption of codes is associated with smaller sovereign spreads. In other cases, however, standards and codes do not have a significant impact on market behavior (see Mosley 2009 for a review of these studies). From the point of view of domestic politics, then, the material benefits of standards are not always clear. What policymakers may have failed to appreciate with respect to the codes and standards project, then, was that domestic politics was often more important than external pressures, for several reasons. One reason is that local regulatory authorities have incentives and interests that are embedded in local political networks, rather than in the global financial system. Most of these individuals are concerned more about their political success and survival at home than about their performance vis-àvis private actors in wealthy nations. This success often hinges on, for instance, protecting the local banking sector from international competition, and from closures as a result of non-performing loans; or 7

9 it depends on preventing a transition from national to global accounting rules, as the revaluations generated by such a shift could harm the fortunes of numerous local firms. IV. The Future of the Standards Project What, then, does the current crisis, centered in US capital markets, mean for the global effort at standards? Here, the literature on diffusion, as well as the flight to safety phenomenon may be instructive. First, the political science literature on the cross-national diffusion of economic policy practices has identified (although not always differentiated among) a variety of mechanisms that might explain the global spread of privatization, capital account liberalization, and other such policies (see Simmons et al 2006). One mechanism is coercion, whereby intergovernmental organizations or powerful states pressure weaker states to adopt a given policy. Another mechanism is competition: governments adopt practices because other governments are doing so, and because private actors reward those jurisdictions that adopt certain practices. Other diffusion mechanisms are less material and more ideational: policy learning occurs when governments observe the success (or failure) of policy changes in peer countries, while social emulation reflects the spread of ideas regarding appropriate policies among government officials. Applying these mechanisms, the effort at global standards could be interpreted largely in material terms: the IFIs and the US government attempted to pressure governments to adopt standards. Compliance with various standards often is mentioned as part of the IMF s regular member surveillance process, reviewed in its ROSCs and, occasionally, included in standby agreements. But given the haphazard effectiveness of IMF conditionality more generally, such direct pressures may not lead to sustained implantation. The proponents of global standards also suggested that competitive pressures would increase the incentives for countries to implement standards and codes. And, as early adopters gained from the new standards, in terms of attracting capital inflows or avoiding financial crises, other governments would come to see the value of various standards and codes adding a learning component. In terms of the latter, the current crisis, in which weak regulation of capital markets within the developed economies has played a central role is likely to diminish the desire for emulation. If one of the principal advocates of standards has market regulation problems of its own, it may be more difficult to convince others of the utility of standards that often reflect US best practices. In terms of the former, a key question is whether there are market-based rewards for the adoption of standards. As noted above, the empirical literature on this subject has produced very mixed findings. This also leads to the second general issue the extent to which emerging market economies (or some subset of them) have become flight to quality locations for investors. The financial crises of the 1990s were preceded by a risk-acceptant global capital market environment, in which investors search for higher returns was associated with a discounting of investment risks (i.e. a very short-term debt profile and an overvalued exchange rate in Mexico). Crises in emerging markets were followed by a flight to quality a return to the relative safety (and lower returns) of US and European markets. In this panic phase, even emerging market economies with strong fundamentals faced difficulties in accessing private capital markets. 8

10 The turmoil witnessed by U.S. (and other) financial markets during the last year is somewhat different. We could think about the pre-crisis buildup as somewhat similar; indeed, there was a search for higher returns and an acceptance of risk, but that search occurred in both developed country markets (expanding credit to individual borrowers with a lack of credit history) as well as in developing ones (expanded flows to frontier markets; the development and growth of equity markets in sub-saharan Africa). To some extent, the latter was justifiable from an economic point of view, given the rise in prices of many commodities and the high rates of economic growth (in India and China, but also in many parts of Africa). The former, of course, seems quite similar to past crises: investors ignored the underlying risks in favor of a focus on high returns, but this was sustainable only in the short to medium term. The latter, though, suggests an opposite pattern from earlier crises: financial markets at the center of the global system became unsafe locations as the crisis unfolded, while markets in (some of) the periphery benefitted from a newfound status as safe (or, at least, safer). During the last two years, private capital flows to developing nations have expanded. Problems in mature markets have been coupled with vigorous capital flows to emerging markets (IIF 2008). The composition of these flows has shifted away from debt and toward portfolio equity and foreign direct investment. As a result of the increased pool of capital, as well as improvements in sovereign creditworthiness, spreads on developing country debt have declined markedly, facilitating lower-cost public sector borrowing. The rise in private capital flows coincides with a decline in net official lending to developing nations. For instance, several African nations (i.e. Kenya, Nigeria and Zambia) have expanded their local bond markets by attracting foreign participation. Several Africa-specific investment funds have been launched recently, including New Star s Heart of Africa Fund (November 2007) and Aureos Capital s Africa Fund (February 2008). Market participants with recent interest in Africa s capital markets cite high rates of growth and investment opportunities in natural resources, telecommunications and banking as their primary motivations. Others note that movements in African markets are largely uncorrelated with movements in other capital markets, providing an opportunity for diversification. 8 This surge of flows has occurred despite the fact that very few African governments have adopted or implemented the key standards and codes (for instance, only six African nations participate in the Special Data Dissemination Standard, which governs the release of macroeconomic data). It may well be that investors are far more interested in the prospects for economic growth and the ability to avoid turmoil in developed-country markets than in the adoption of internationally-accepted standards and codes. The current crisis and its aftermath, then, may lead to a renewed emphasis on global standards, but with an effort to address regulatory issues in mature as well as emerging markets. Private sector actors may redouble their efforts at governance, perhaps in an effort to avoid expanded regulatory activities by national legislatures. Or government regulators themselves, eager to respond to market pressures and to political demands (see Singer 2007), may seek to enhance national and global 8 For instance, see Carol Pineau, Hey, Here s a Tip: Try Africa. Washington Post, July 6, 2008, p. B02; Jeff D. Opdyke, The Street s Rush into Far Frontiers Offers Big Game and Bigger Risks, Wall Street Journal, June 16, 2008, p. C1. 9

11 governance. Such an effort could include recognition of the role of emerging market governments and financial actors in crafting truly global standards. In April 2008, for instance, the director of the Institute of International Finance suggested that the G-7 be expanded to include key emerging market economies that are playing an increasingly role in global economics and finance and who need to be involved in providing collective leadership (Reuters, April 3, 2008). Of course, this statement refers more to nations like Brazil, China and India than to small- and medium-sized developing nations, who might still find themselves excluded from new rule-making efforts. Another possibility, though, is that the global movement toward standards and codes will fade, as IFIs and major financial center governments focus more on maintaining liquidity and solvency in mature markets, and as the ability of the US government to spread its regulatory practices abroad fades. The private financial actors who played a key role in the global standards movement (through the FSF) may retrench, as they focus more on maintaining solvency, and on avoiding greater regulation within US markets. Moreover, market actors faith in standards as signals of credit quality might wane, especially given that the key codes and standards do not cover many of the risks related to the current crisis. These trends might lead to a slow withering of the movement toward global standards. 10

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14 Author Biography Layna Mosley is Associate Professor of Political Science at the University of North Carolina at Chapel Hill. Her research focuses on the governance of global capital markets, as well as on the political implications of financial market openness. She is author of Global Capital and National Governments (Cambridge University Press, 2003), and she is currently completing Working Globally? (Cambridge University Press), which considers the relationship between multinational production and workers' rights in developing nations. Mosley's research also has appeared in International Studies Quarterly, International Organization, Comparative Political Studies, and Review of International Political Economy. Mosley received her Ph.D. from Duke University (1999), and she previously held a faculty position at the University of Notre Dame. 13