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PRINCIPLES OF FINANCIAL REGULATION 2 Principles of Financial Regulation JOHN ARMOUR, DAN AWREY, PAUL DAVIES, LUCA ENRIQUES, JEFFREY N. GORDON, COLIN MAYER, AND JENNIFER PAYNE 3 Great Clarendon Street, Oxford OX2 6DP, United Kingdom Oxford University Press is a department of the University of Oxford. It furthers the University’s objective of excellence in research, scholarship, and education by publishing worldwide. Oxford is a registered trade mark of Oxford University Press in the UK and in certain other countries © J. Armour, D. Awrey, P. Davies, L. Enriques, J. Gordon, C. Mayer, and J. Payne 2016 The moral rights of the authors have been asserted First Edition published in 2016 Impression: 1 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, without the prior permission in writing of Oxford University Press, or as expressly permitted by law, by licence or under terms agreed with the appropriate reprographics rights organization. Enquiries concerning reproduction outside the scope of the above should be sent to the Rights Department, Oxford University Press, at the address above You must not circulate this work in any other form and you must impose this same condition on any acquirer Crown copyright material is reproduced under Class Licence Number C01P0000148 with the permission of OPSI and the Queen’s Printer for Scotland Published in the United States of America by Oxford University Press 198 Madison Avenue, New York, NY 10016, United States of America British Library Cataloguing in Publication Data Data available Library of Congress Control Number Data available ISBN 978–0–19–878647–4 (hbk.) ISBN 978–0–19–878648–1 (pbk.) ebook ISBN 978–0–19–109005–9 Printed and bound by CPI Group (UK) Ltd, Croydon, CR0 4YY Links to third party websites are provided by Oxford in good faith and for information only. Oxford disclaims any responsibility for the materials contained in any third party website referenced in this work. 4 Preface 5 How We Came to Write This Book On Monday, 15 September 2008, Lehman Bros entered Chapter 11 bankruptcy proceedings. That afternoon, two of us were running a class on comparative corporate law in New York. As we arrived in class, one of us passed a note to the other: ‘I withdrew $500 before class. Don’t know if ATMs will still be working after.’ The class, ironically, was about ‘bubbles’. But when a student asked us how we could explain what was happening downtown, we realized we had no convincing answers. We began reading about banks and banking regulation; the more we read, the more unhappy we became. In a paper written a number of years earlier, Charles Goodhart and colleagues had forcefully criticized the then new Basel II accord—which by 2008 was the centrepiece of banking regulation around the world—on the basis that it would make the financial system more ‘procyclical’—that is, more prone to boom and bust. They observed prophetically:1 [The Basel II] proposals, taken together, will enhance both the procyclicality of regulation and the susceptibility of the financial system to systemic crises, thus negating the central purpose of the whole exercise. Reconsider before it is too late. Why had no one listened? We turned next to literature on banking regulators. In the US, we found that oversight of investment banks—like Lehman—under the Basel II framework was being undertaken by the Securities and Exchange Commission (‘SEC’). The SEC was a ‘market regulator’, and had no mandate to care about ‘financial stability’. But why should ‘market regulators’ not care about financial stability? And if they did not, why should investment banks be allocated to a ‘market regulator’? In the UK, the Financial Services and Markets Act 2000 had, to great fanfare, recently merged the oversight of all aspects of financial regulation in the UK, including banking. The legislation did not include ‘financial stability’ amongst the goals the new Financial Services Authority was required to pursue. Why was this not thought relevant? The more we thought about it, the more we felt convinced that the breadth and depth of the currents in the financial system had simply flowed past and around regulators tied to particular islands of jurisdiction and expertise. The lack of appreciation of the wider picture was startling. The starkness of the errors, and the gravity of the consequences, meant that financial regulation became a major research interest for us, in a way that it had not previously been. Financial regulation soon became a huge growth industry. Others had had the same reaction as us. Everyone had an opinion, it seemed, and everything was being changed, all at once. But if there were problems with the coordination of ideas before, how could these possibly be solved by proceeding in this way? The following year, a group of us in Oxford decided to launch a new course, ‘Principles of Financial Regulation’, for our graduate students—including those taking our new MSc in Law and Finance. We felt that people entering the professional world who might work in, or with, the financial sector would value the chance to engage critically with what was going on. It would also give us a chance to try to organize our thinking in a systematic way. There were two central challenges to this undertaking, however. The first was the breadth of potentially relevant material and the range of interconnection. The second was the pace of change. The breadth of material meant that it would be very difficult to offer a course that would 6 provide detailed engagement with regulatory measures to the level needed to advise about compliance. The pace of change meant that, even if it had been possible to offer such detail, it would have been futile, because the content stood a high chance of being outdated before students actually got to put it into practice. Besides, large law firms have tremendously sophisticated in-house teams who aggregate and analyse the latest information at a highly detailed level. There would be little comparative advantage to us trying to replicate this in a university. So we decided instead to develop what we think of as a ‘macro’ approach. Just as we think of the discipline of economics as split into macro and micro branches, so too might we approach legal scholarship.2 A macro project is one that looks at the level of the system as a whole, and understands the interrelation of the various components at the aggregate level. In particular, we thought it was important to offer a treatment that could comprehend the regulation of both securities markets and banks, which had traditionally been treated as entirely different, despite the increasing functional overlaps. Of course, a macro system must be built on sound micro foundations. But in order to give an understanding of how things work at the macro level, it is not necessary to convey all the detail of the micro foundations. What we wanted to do was to give a roadmap to the regulation of the financial system, which students could use to situate their understanding of the rules. In particular, we thought it would be helpful to present substantive rules from the major jurisdictions involved in the financial crisis—the US and the EU (and especially, within the latter, the UK, given our base)—as exemplifying policy choices. This allows for a treatment that presents large-scale principles, upon which examples of particular policy choices are hung. The approach emphasizes the interaction of policy choices and the consequences one piece of the jigsaw has for the others. But it is of course not comprehensive. Soon after we had launched the course, we decided it would be worthwhile to combine our research and pedagogical endeavours in the field and produce a book that would seek to deliver the ambitions of our course to a wider readership. Looking around, we found no existing book that offered the sort of roadmap we felt was necessary: an understanding of how financial regulation relates to the economic goals of the financial system, and how it can be improved. The idea of a ‘holistic’ approach proved very appealing to people with whom we discussed the idea, including our publisher. Unfortunately, there was a reason why no such book existed. And it was not that no one had previously thought it would be a good idea. It was rather that the project was so big as to be (nearly) unmanageable. There followed several years of intense meetings amongst the co- authors, at which we discussed and tore up each other’s drafts. Frustratingly, the more progress was made in understanding, the less progress seemed to be made towards completion. Fortunately, our publisher was very patient. Gradually, we inched towards a framework that we all felt we could subscribe to, at least at the macro level. (Of course, given the number and contentiousness of the issues, there are surely particular matters on which each of us may disagree with the book’s aggregate line.) 7 How to Read This Book We hope this book will be of use for a wide range of readers: students and academics (in law, business, public policy, and economics), regulators, and practitioners. With this breadth of potential readership in mind, we think it helpful to offer some guidance on how it is structured. The book is divided into six Parts. Part A is foundational material. Parts B, C, and D then consider, respectively, financial markets, consumer finance, and banking regulation. Part E— entitled ‘Banks and Markets’—builds on the preceding Parts to see how interconnections between different components create new regulatory challenges. Part F deals with institutional issues—the architecture of regulatory authorities—both within jurisdictions and at the international level, the challenges of supervision and enforcement, and the politics of financial regulation. Parts B, C, D, and E each begin with an overview chapter that is more theoretical in orientation than the rest of the chapters in the respective sections. In each case, the introductory chapter identifies the main underlying principles for the section; the following chapters then frame the regulatory norms around these principles. A general course on financial regulation can simply follow the whole book. To give a more institutional flavour, Part F could be set immediately after Part A rather than left to the end. If time is short, then the coverage could be abbreviated in various ways. Chapters 7 (Market Infrastructure), 11 (Financial Advice), 12 (Financial Products), 17 (Bank Governance), and 18 (Payment and Settlement Systems) are each relatively self-contained, as are most of the chapters in Part F. The book can also be used as a supplement for more traditional courses on securities or banking regulation, on either side of the Atlantic. In this case, the relevant material would be Part A, then Part B or D (for securities or banking, respectively), then Part E (to appreciate cross- sectional issues). Chapter 10 (theory of consumer financial regulation) is likely to be relevant insofar as behavioural finance forms any part of a securities law course. For students in business schools or economics departments, the theory chapters—all of Part A’s Chapters and then Chapters 5 (markets), 10 (consumers), 13 (banks), and 20 (market-based credit intermediation)—would be the most natural points around which to hang a course. Substantive chapters could then be used as case studies. In this respect, the topics in Chapters 6 (information intermediaries), 7 (market structure), 14–16 (bank capital, liquidity, and resolution), 19 (macroprudential oversight), 21 (market makers), 22 (collective investments and financial stability), and 23 (structural regulation of financial institutions) will probably be of most interest. For those already working in the field of financial regulation, we hope that the book will provide some generalist insights about linkages between fields. So, for example, a specialist in banking will, we hope, find the material on other aspects of financial regulation, as well as the general framing, useful. 1 J Daníelsson, P Embrechts, C Goodhart, C Keating, F Muennich, O Renault, and HS Shin, ‘An Academic Response to Basel II’, LSE Financial Markets Group Special Paper No 130 (2001), 5. 2 There is in fact a very venerable tradition of studying ‘macro law’, in the form of Roman Law. 8 9 Acknowledgements The book grew out of the course we teach to graduate students in Oxford under the same name. It is impossible to acknowledge fully the degree to which development of these ideas has been strengthened and focused over a period of several years through intense debate with the exceptionally talented group of students—and latterly alumni—with whom we have been fortunate enough to interact. We also owe a significant debt to the reviewers who read and commented on the book outline for OUP; in particular, Niamh Moloney, whose patience and generosity in this regard went far beyond the course of duty. In the course of writing, many of the individual chapters have benefited from comments and feedback from seminar and workshop presentations, as well as colleagues who generously read drafts. In particular, we thank Johnathan Chertkow (Chapter 10), Mathias Dewatripont (Chapter 15), Stavros Gadinis (Chapter 8), Zohar Goshen (Chapter 10), Ed Greene (Chapters 8 and 9), Kevin Haeberle (Chapters 8 and 9), Mathias Lehmann (Chapter 3), Ronald Mann (Chapter 18), Geoff Miller (Chapter 17), Joseph Raz (Chapter 10), Roberta Romano (Chapters 19 and 23), Chuck Sabel (Chapter 10), Michel Tison (Chapter 11), Andrew Tuch (Chapters 8 and 9), Peter Zimmermann (Chapters 19 and 27), and especially Bill Williams, who read and commented on the entire manuscript and saved us from many errors. All remaining errors are exclusively our responsibility. We also thank participants in the following for helpful feedback and questions on presentations of, or drawing on, particular chapters: a Staff Seminar at the University of Edinburgh Law Department (Chapter 1); Seminars at the Oxford-Man Institute for Quantitative Finance (Chapters 1, 19, and 27); a lecture at Norton Rose (now Norton Rose Fulbright) in London (Chapter 3); a Faculty Seminar at Columbia Law School (Chapter 10); Business Law Workshops in Oxford (Chapters 10 and 17); a Cambridge/LSE conference on ‘New Legal Thinking in Financial Regulation’ (Chapter 15), a seminar at the National Bank of Belgium (Chapter 15), Commonwealth Central Bank Governors’ Meetings at the World Bank in Washington DC (Chapters 16 and 28); an ETH/NYU Banking Regulation conference in New York (Chapter 17); a Blue Sky Workshop at Columbia Law School (Chapter 23); and a conference on European Banking Regulation at the Centre for Advanced Studies at the Ludwig Maximilian University of Munich (Chapter 23). The ideas in the book have also benefited from thoughtful comments from and discussions with many others, including Franklin Allen, Mads Andenas, Patrick Bolton, Ryan Bubb, Charlie Calomiris, John Coates, Veerle Colaerts, Matthew Conaglen, Luis Correia, Eilís Ferran, Julian Franks, Xavier Freixas, Merritt Fox, Simon Gleeson, Talia Gillis, Ron Gilson, Joanna Gray, Gerard Hertig, Elizabeth Howell, Howell Jackson, Robert Jackson Jr, Kate Judge, Reinier Kraakman, Marco Lamandini, Rosa Lastra, Iain MacNeil, Ignacio Mas, Nicholas Morris, Andrea Polo, Eric Posner, Roberta Romano, and Michael Taylor. In addition, in working on this project we have been extremely fortunate in the assistance, engagement, support, and critique provided to us by our colleagues at Oxford, including Paul 10