Mutual Recognition in International Finance by Pierre-Hugues Verdier

[Pierre-Hugues Verdier, an Associate Professor of Law at the University of Virginia School of Law, describes his recently published article Mutual Recognition in International Finance]

In the absence of an international organization devoted to financial regulation, the rapid globalization of finance since the 1970s has taken place against a legal background shaped primarily by national regulators.  As the multiplication of large, transnational financial institutions and cross-border transactions increased the need for international policy coordination, regulators responded by setting up transgovernmental regulatory networks (TRNs) and adopting soft law instruments.  In an article published in 2009, I argued that TRNs suffered from significant limitations stemming from domestic legal and political constraints, their inability to overcome distributive obstacles to harmonization, and their lack of monitoring and enforcement capabilities.  In the aftermath of the financial crisis, many commentators agree that existing coordination mechanisms did not live up to expectations in pivotal areas such as bank capital standards.  Thus, while TRNs are likely to remain an important component of financial governance, we need a more complete understanding of the various means through which states can cooperate to ensure effective cross-border financial regulation and market access.

This article contributes to this effort by examining an alternative approach that has attracted increasing support in recent years-mutual recognition.  In a mutual recognition arrangement, each regulator agrees to recognize the other’s regulation and/or supervision as an adequate substitute for its own.  Accordingly, firms from the “home” state may access the “host” state without having to comply with its full regulatory requirements.  Mutual recognition is often seen as a substitute for harmonization, a process that involves systematically eliminating differences between national laws, usually by amending them according to international standards.  Instead, mutual recognition rests on an assessment that “home” regulation is “equivalent” or “comparable” to that of the host, and vice versa.   In principle, it has several advantages: it bypasses time-consuming efforts to harmonize national rules, allows some degree of regulatory competition, and preserves legitimate differences between national policies based on local needs and circumstances.  Also, unlike most harmonization initiatives, mutual recognition promises reciprocal market access.  In the right circumstances, it may therefore attract support from financial services “exporters,” a less diffuse and more powerful constituency than those-consumers and taxpayers-that typically benefit from better regulation and enhanced market access.

The first major part of the article is devoted to a theoretical examination of mutual recognition that draws on international relations scholarship to identify the cooperation problems raised by mutual recognition arrangements.  I argue that mutual recognition typically engages two important obstacles to international cooperation.  Because each state benefits from the other’s compliance with its obligations to maintain adequate regulation and grant access to its markets, but incurs costs in fulfilling its own reciprocal obligations, it has incentives to defect on the latter if it can do so undetected or unpunished.  Cooperation is further hindered by the fact that, given the nature of the obligations involved, compliance by each state is difficult for the other to observe accurately.  While the adoption of laws and regulations is easy to establish, many other factors are less transparent: the expertise, independence, integrity and zeal of its regulators; the effectiveness of their approach (such as reliance on rules or principles, or on public or private enforcement); and their commitment to policing cross-border activities, particularly when they benefit residents and harm foreigners.

The international relations literature suggests that, when states face such cooperation problems, they typically set up formal institutions, to which they delegate rulemaking and dispute resolution powers while often retaining the right to withdraw.  As the number of states involved increases and becomes more heterogeneous, use of those features increases, as does the scope of the issues covered, in order to facilitate linkages.  At the other extreme, it suggests that states may overcome complex cooperation problems without collective institutions by limiting membership to a small number of states, imposing strict requirements on adhesion, and including renegotiation clauses to allow adjustments over time.  While suggesting this bifurcation between multilateral and bilateral mutual recognition, however, this framework does not predict which one will arise in which circumstances.  The article proposes three hypotheses.  First, collective institutions with sufficient expertise and authority to monitor and enforce compliance may be so costly as to make the multilateral option inefficient unless such institutions are already in place.  Second, while private demand for market access is crucial for mutual recognition to succeed, several factors may limit it-such as alternative means of access, or non-regulatory obstacles like taxes or capital controls.  These will vary across regulatory areas and markets, and may often be outside the regulators’ control.  Finally, bilateral mutual recognition is unlikely to be an effective means for a dominant state to secure improvements in regulation in a smaller state, given the latter’s incentives to defect and the lack of means to verify compliance.

The second major part of the article consists of detailed case studies of two important mutual recognition efforts, namely the European common market in financial services and the SEC’s recent mutual recognition program for broker-dealers and exchanges.  Each of these efforts corresponds to one of the models described above.  While Europe could rely on preexisting supranational institutions with rulemaking, monitoring, and enforcement powers, the SEC attempted to design a bilateral mechanism to achieve mutual recognition without any institutions or explicit linkages.  Instead, it relied on prior assessments of regulatory compatibility, enhanced supervision and enforcement cooperation, and monitoring and enforcement by the parties themselves. In both cases, differences in private demand over time and across areas had a substantial influence on the success of the program.  Unlike the EU, the SEC carefully chose potential partners with well-developed financial markets, similar regulatory objectives, and comparable supervision and enforcement capabilities-such as Australia and Canada.  It also negotiated enhanced cross-border supervision and enforcement arrangements that go substantially beyond existing international standards.  The comparison suggests that, in the absence of supranational institutions, future international mutual recognition initiatives are more likely to resemble the SEC’s bilateral model.  Thus, despite its apparent demise during the financial crisis, it may turn out to be an important milestone.  However, while such arrangements may facilitate cross-border market access, they are unlikely to contribute significantly to enhancing global regulatory standards.

The article explores some of these implications, which I will discuss further in my response, as well as how the lessons learned in the case studies could inform ongoing mutual recognition efforts, such as within ASEAN and between the European Union and third countries.  These questions are also likely to gain in importance as the United States and Europe continue the massive process of reforming their financial regulation systems in response to the subprime crisis.  Indeed, some provisions of the Dodd-Frank Act and new European rules expressly contemplate recognition of foreign firms subject to equivalent regulation, which raises the question of how the relevant arrangements will be structured and whether they will require reciprocity.  To sum up, mutual recognition is illustrative of the many ways of structuring global governance that are emerging as cross-border financial activity continues to increase, more countries become major players, and crises highlight the need for more effective cooperation.  Neither it nor TRNs will be the last word in regulatory cooperation, but they are part of an expanding toolbox that may eventually add up to a coherent system of global financial governance.