Arbitrage and Competition in Global Financial Regulation The Case for a Special Resolution Regime

Abstract

Regulatory arbitrage in financial markets refers to a number of strategies that market participants use to avoid the reach of regulation, in particular by virtue of shifting trading abroad or else relocating activities or operations of financial institutions to other jurisdictions. Where this happens, such arbitrage can trigger regulatory competition between jurisdictions that may respond to the relocation of financial services (or threats to relocate) by moderating their regulatory standards.This paper develops a framework for the assessment of both phenomena in the context of financial regulation and assesses their merits. I argue that regulatory competition has many advantages over alternative global approaches, notably international harmonization of regulation, by offering a dynamic process for the discovery of efficient regulatory standards. However, the risk is that countries lower their standards solely to attract businesses and thereby impose externalities on the worldwide financial market by undermining financial stability as a global public good.Policymakers worldwide are experimenting with remedies to respond to the phenomenon. I introduce the importance of an effective special resolution regime for financial institutions to the discussion. I argue that, within limits, a credible, worldwide resolution scheme can effectively contribute to reducing the dilemma. Its main benefit would be to tackle the problem of financial stability caused by systemically important financial institutions’ excessive risk-taking. If such risk-taking would be judged by market discipline instead of posing a risk to global financial stability, the main downside of regulatory competition could be restrained. Within the boundaries of such a system, competition could then operate and contribute to a market-led design of financial regulation.