A Response to Pierre-Hugues Verdier by Eric Pan

[Eric Pan, an Associate Professor of Law and Director, The Samuel and Ronnie Heyman Center on Corporate Governance, responds to Pierre-Hugues Verdier, Mutual Recognition in International Finance]

Pierre-Hugues Verdier has written an extremely important paper about one of the key regulatory strategies in international finance.  As Prof. Verdier has noted, many jurisdictions have applied mutual recognition arrangements to provide cross-border access to financial services providers, issuers and investors, and he skillfully analyzes the challenges facing mutual recognition arrangements.  In order to provoke a further discussion about the importance of mutual recognition in international financial regulation, I wish to draw out some of the points made by Prof. Verdier and express additional thoughts regarding how mutual recognition arrangements have been used in the past, the implications for future mutual recognition arrangements and the main challenges facing mutual recognition arrangements.

First, mutual recognition is not a new regulatory strategy in international finance.[1] It dates back in practice at least to the late 1970s.  The European Community aggressively applied mutual recognition strategies in the context of establishing a single European securities market, starting with the Admissions Directive (1979), Listing Particulars Directive (1980) and Public Offers Directive (1989).  Prof. Verdier describes these early efforts as “first-generation” mutual recognition arrangements to be distinguished from the mutual recognition of financial services providers, which constitute “second-generation” mutual recognition arrangements.  One difference is that second-generation mutual recognition arrangements require a regulator to permit access to financial firms from a foreign jurisdiction on the basis of the approvals and supervision of a foreign regulator; whereas first-generation arrangements were limited to recognition of another jurisdiction’s rules and standards.

However, even second-generation mutual recognition arrangements arguably date back to the early 1980s.  The Basel Committee’s Principles for the Supervision of Banks’ Foreign Establishment (1983) is an example of one such arrangement.  In that case, the Basel Committee struggled with the problem of how to comprehensively supervise banks operating in multiple jurisdictions.  Its solution was to recognize the principle of consolidated home country supervision where bank regulators would permit foreign banks to open up local branches based upon the quality of supervision provided by that foreign bank’s home regulator.  In short, bank regulators mutually recognized the supervisory decisions of their foreign counterparts.

Since then, second-generation mutual recognition arrangements have appeared in many forms ranging from the European Union’s Investment Services Directive (1993) to the Commodity Futures Trading Commission’s acceptance of foreign trading screens (1996) to the Public Accounting Oversight Board’s reliance on auditor inspections conducted by European regulators (2004) to the US-Australia memorandum of understanding on broker-dealers (2008).

Second in looking at the history of mutual recognition arrangements, I disagree with Prof. Verdier’s premise that mutual recognition arrangements are alternatives to, or in competition with, transnational regulatory networks (TRNs).  Examples of multilateral TRNs include the International Organization of Securities Commissions and the Basel Committee on Banking Supervision and an example of bilateral TRN is the US-EU Financial Markets Regulatory Dialogue.  Instead I view TRNs and mutual recognition arrangements as complementary.  TRNs operate as means by which regulators from different jurisdictions share information, conceive of common regulatory approaches and objectives and, when they feel it is suitable, develop arrangements to coordinate regulation.  Mutual recognition, in turn, is one of those key coordination strategies.   Other strategies include harmonization and, in many cases, unilateral recognition.  Therefore, I refer to Prof. Verdier’s excellent earlier work on the shortcomings of TRNs and conclude that problems with mutual recognition arrangements stem from the same problems that plague TRNs.[2]

Third, it is helpful to review the mixed record of mutual recognition arrangements in the lead up to recent global financial crisis.  First, there was the difficulty the Icelandic Financial Supervisory Authority had in effectively supervising the branches of certain Icelandic banks in the United Kingdom.  When the problems with the large Icelandic banks became clear, the United Kingdom questioned the appropriateness of the principle of consolidated home country supervision.  Second, the U.S. Securities and Exchange Commission terminated its Consolidated Supervised Entities (CSE) Program when it became apparent that that the CSE program did not adequately supervise several of the large investment banks.  The SEC had created the CSE program in 2004 to satisfy EU demands for equivalent supervision of financial conglomerates pursuant to the EU Financial Conglomerates Directive.

Here again I slightly disagree with Prof. Verdier’s focus on the relative robustness of bilateral mutual recognition arrangements over multilateral arrangements.  In my opinion, bilateral arrangements are fraught with the same weaknesses as multilateral arrangements.  One reason given by Prof. Verdier for why multinational mutual recognition arrangements are more difficult to maintain than bilateral arrangements is the likelihood of cheating by states and the difficulty of monitoring and enforcing compliance.  I would argue in the alternative that the mixed record of mutual recognition arrangements shows not a problem of compliance or strategic cheating but failure of existing arrangements to keep up with changing market conditions.

The main challenges for mutual recognition arrangements is two-fold, and the difficulty states have had in answering these challenges explains why mutual recognition arrangements to date have continued to be broken, fragile or underused.

First, states have not developed a reliable method of determining comparability.  At the heart of the establishment of any mutual recognition arrangement is the conclusion that the regulatory requirements of the foreign jurisdiction are substantially the same as those of the host jurisdiction.  If true, recognition of foreign supervised entities should not result in a lowering of regulatory standards, exposing the host jurisdiction to little additional threat of systemic risk, fraud or other regulatory failures.  The problem is that developing metrics of comparability is difficult, and efforts to date have been ad hoc.  Such determinations require an analysis that go beyond examining what rules are “on the books” to the effectiveness of the regulator in promoting compliance with such rules (see, e.g., the literature on enforcement intensity) and the relative sophistication of affected market participants.  Until we develop a better understanding of how to measure comparability, mutual recognition arrangements will continue to be acts of faith that are highly susceptible to failure.

Second, even if the comparability problem is solved, mutual recognition arrangements have to be capable of producing new regulation to respond to changing market conditions.  The regulation and supervision of financial services firms is a dynamic process.  Successful mutual recognition arrangements must be able to respond to financial product innovation (e.g., derivative products), rise of new financial actors (e.g., hedge funds, alternative trading systems), consolidation of existing firms (e.g., too-big-to-fail entities) and technological advances (e.g., trading screens).  In order to do so, mutual recognition arrangements must accompany legal frameworks designed to expand regulatory cooperation and coordination to address these new conditions.  Thus, the main threat to mutual recognition is not failure of states to comply with their commitments but failure of mutual recognition arrangements to stay effective in the face of market developments.

As a consequence, we find ourselves on familiar, yet unsatisfying ground.  I have argued elsewhere that the nature of financial supervision and cross-border markets demands the creation of an international administrative law body to produce and coordinate financial regulation across jurisdictions.[3] Unfortunately, Prof. Verdier is likely correct to describe the prospect of any such “supranational regulator” as “distant” or “perhaps impossible,” but the political realities preventing the formation of such a body does not make the case for such a body any less sound.  In the meantime, mutual recognition will remain a useful, but limited tool.

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[1] Mutual recognition arrangements also appear under different guises.  They sometimes are referred to as “equivalence” (a term popular in European Union directives when referring to comparability of non-EU regulatory regimes) and “substituted compliance” (the term coined by Ethiopis Tafara and Robert Peterson of the SEC in their paper A Blueprint for Cross-Border Access to US Investors: A New International Framework, 48 Harv. Int’l L.J. 31 (2007)).

[2] See Pierre-Hugues Verdier, Transnational Regulatory Networks and Their Limits, 34 Yale J. Int’l L. 113 (2009); Eric J. Pan, Challenge of International Cooperation and Institutional Design in Financial Supervision: Beyond Transgovernmental Networks, 11 Chi. J. Int’l L. 243 (2010).

[3] See Pan, supra note 2.