International Soft Law and the Formation of Binding International Financial Regulation
International Soft Law and the Formation of Binding International Financial Regulation
Abstract and Keywords
This chapter examines the theoretical framework of international soft law and how it embraces both legally nonbinding and binding rules and standards of international financial regulation. International soft law is defined as legally nonbinding standards, principles, and rules that influence and shape state behavior but do not fit into the traditional categories of public international law of legally binding general custom of states and bilateral or multilateral treaties. It is argued that international soft law in its various dimensions can contribute to an understanding of the development of legally relevant international financial norms and how they govern state regulatory practice.
Most international standards and rules for banking regulation and supervision have evolved from a purely nonbinding and voluntary role to an increasingly precise and obligatory status backed by both official and market incentives and sanctions. This has been demonstrated by the purportedly voluntary international financial standard-setting process in Basel, which was originally intended to apply only to the G10 countries but has now been extended by the IMF and the World Bank to most of their member countries through surveillance and conditionality programs. The haphazard development of these international standards and their uneven application to developed and developing countries has produced a vast, but loosely coordinated, international financial regulatory regime that is ill equipped to deal with the threats posed by today's globalized financial markets.
As discussed in chapter 3, binding international legal rules govern only limited areas of the international financial system. Most of the international rules, guidelines, standards, and other arrangements that govern financial regulation are not of a legally binding nature and are therefore generally referred to as “international soft law.” This chapter examines the theoretical framework of international soft law and how it embraces both legally nonbinding and binding rules and standards of international financial regulation. The theoretical framework adopted extends the analysis beyond traditional sources and principles of public international law to identify other relevant sources of state economic conduct that influence the development of international norms and standards of banking regulation.
(p.135) The chapter analyzes international soft law and the formation of binding international norms of financial regulation. As discussed in earlier chapters, international financial regulation may include a wide range of normative and institutional arrangements, from binding “hard” law (i.e., WTO treaty obligations) to various forms of nonbinding soft law rules (Basel Accord), to arrangements that share some characteristics of hard and soft law but are not legally binding (IMF Agreement). This spectrum of arrangements has occurred in other areas of international economic regulation, such as the efforts of the Organization for Economic Cooperation and Development to devise multinational standards of corporate governance and antibribery and corruption standards. This chapter suggests that international soft law has served as a flexible mechanism to develop international norms and standards of banking regulation, but increasing integration in global financial markets requires more concerted efforts to ensure that international standards apply to all countries and financial systems and that the process of standard setting is accountable and legitimate. We examine the role of international soft law in banking regulation and in particular its application under the Basel Accord and the Financial Action Task Force's antimoney-laundering standards. We argue that the particular form of international soft law that has emerged for banking regulation violates principles of global governance because the standard setting is controlled by the G10 and OECD countries and that other countries are subject to those standards through a variety of official and market incentives that undermine efficiency and legitimacy.
Although soft law once served as a useful instrument for developing international standards of banking regulation, globalized financial markets require a more coherent international legal framework that more effectively manages the use of official incentives by international economic organizations and channels the pressures of global financial markets to induce more efficient financial regulation. This will require greater institutional linkages between the IFIs and international economic organizations so that a greater number of countries can participate in international standard setting. Discriminatory trade barriers imposed by G10 countries to restrict market access to banks from jurisdictions that do not follow G10 regulatory standards should be reconsidered in light of different approaches to prudential regulation. Moreover, more empirical data are needed to analyze the extent to which certain prudential regulatory regimes attract foreign investment and foreign entry into the financial sector. As proposed in chapter 5, a multilateral treaty framework may be necessary to ensure that most states that regulate the major financial systems adhere to accepted principles of capital adequacy, payment system regulation, and antimoney-laundering requirements. This would promote a level playing field among competitors and enhance market confidence and regulatory compliance. Moreover, it would improve the pricing of financial risk and lead to more efficient and stable financial markets.
(p.136) SOFT LAW AND THE INADEQUACIES OF PUBLIC INTERNATIONAL LAW
An analysis of the concept of international soft law must be done within the context of an examination of the sources of public international law. There is a growing recognition of the inadequacy of the traditional sources of public international law, as enumerated in Article 38 (1)(a)–(d) of the Statute of the International Court of Justice,1 to explain and describe the normative development of many areas of interstate relations (Wellens and Borchardt, 1989). The traditional sources of international law are classified as follows: (a) treaties that establish rights and obligations expressly recognized by states; (b) international custom as evidence of a general practice of states and accepted by states as law; (c) general legal principles of the world's leading legal systems; and (d) subsidiary sources, including judicial and arbitral decisions (ICJ Statute). The two most cited sources are treaties and international custom (customary international law) (Oppenheim's, 1996).2 Treaties create legally binding rights and obligations between states and can take the form of multilateral, regional, or bilateral agreements. Many treaties (though not all) contain procedures for enforcement or dispute resolution that allow state responsibility to be invoked under a treaty for breach of obligation that may result in liability and/or reparation.
International custom takes the form of customary rules or principles that must be evidenced by (1) a general or uniform state practice with respect to the particular rule or obligation, and (2) accepted by states as a legal obligation (opinio juris) (Ibid.: 26–27).3 State practice forms the basis of customary international law. It consists of patterns of state behavior or conduct that contain both material and subjective elements that are necessary for a state (or states) to form or maintain legally binding customary rules (Mendelson, 1995: 177). The material element takes the form of actual deeds (e.g., administrative decisions and the adoption of regulatory rules) that are observable and manifest, while the subjective element consists of a state's attitude or intent, which may present itself in certain acts or behavior, such as official statements by heads of state or governments, diplomatic correspondence, or votes at international organizations, that provide evidence of a state agreeing to or believing it has a legal obligation.4 The actual practice of states is the material element of state practice, while the subjective element consists in the state's consent or belief that its performance or omission, or that of other states, is required by international law. To be legally effective, it is not sufficient for the state's belief to be evidenced by passive acceptance or acquiescence; there must be evidence of an active and deliberate effort to reaffirm or develop a rule of international law.
The absence of a binding international legal commitment to implement the Basel Accord and other international financial standards has taken these standards outside the scope of customary international law and treaties. Nevertheless, more than 100 countries claim to have implemented (p.137) the 1988 Capital Accord and are undertaking transition arrangements to implement Basel II. It should not be forgotten that the European Community has incorporated the Capital Accord into EU law and has committed itself to implement Basel II, as well. The growing consistency of state practice with the Basel Accord and other international financial standards suggests that it is possible to have a uniform practice of states without opinio juris, that is, a general practice of states which does not have as its motive the formation of customary rules of international law.5 In this sense, the subjective element of state practice does not contain the belief that it has a legal obligation. The absence of a legal obligation provides regulators and standard setters with the necessary flexibility to respond rapidly to developments in financial markets and to implement nonbinding standards in a particular manner that suits the needs of their jurisdictions. This is why international soft law will remain viable as an instrument for reforming international financial regulation.
Other sources of international law include general principles of law whose validity derives from the world's leading legal systems and from subsidiary sources such as judicial decisions and the works of leading publicists. General principles of law have derived mainly from private law principles, such as estoppel, reparation, and jurisdiction (Harris, 1991). The growing importance of public administrative law, however, in most jurisdictions means that commonly accepted principles of public law can potentially qualify as general principles of law and thereby become sources of international law. This appears to be taking place in a number of countries where there is growing convergence in public law principles with respect to banking and financial regulation that has been influenced substantially by international soft law principles. In fact, the standards of the Basel Committee and the Core Principles of banking supervision have directly influenced and shaped the development of national banking law principles, including liability rules for senior officers and directors and even the rules that define tier 1 and 2 capital. This dramatic convergence of domestic banking law principles could arguably constitute a future source of international law.6
As a general matter, however, the sources of public international law are increasingly viewed as unsatisfactory for explaining the variety of international obligations and commitments undertaken by states in many areas of international relations. This is especially true in finance, the environment, telecommunications and technology, and the regulation of multinational corporate groups where legally nonbinding international standards and codes play a prominent role in governing state conduct. The enormous expansion of activities by international organizations and standard-setting bodies and the increasing use by states of informal, legally nonbinding agreements and instruments to mediate and regulate their foreign relations have marked a dramatic shift away from formal international lawmaking and toward informal soft law techniques of standard setting and implementation. As a result, state behavior and conduct (p.138) have become increasingly influenced in a “permissive, prescriptive and prohibitive way” by an unprecedented number of international nonconventional or nontreaty agreements, which have been adopted by states acting through a variety of international organizations and bodies.
INTERNATIONAL SOFT LAW AND THE FORMATION OF BINDING PRINCIPLES AND NORMS
International soft law refers to legal norms, principles, codes of conduct, and transactional rules of state practice that are recognized in either formal or informal multilateral agreements (Wellens and Borchardt, 1989). Soft law generally presumes consent to basic standards and norms of state practice, but without the opinio juris necessary to form binding obligations under customary international law. On the basis of these characteristics, soft law may be defined as an international rule created by a group of specially affected states that have a common intent to voluntarily observe the content of such rule with a view of potentially adopting it into national law or regulation. Another important characteristic of soft law is that political bargaining controls the ongoing interpretation and application of rules to state parties and their nationals.
International soft law generally provides flexibility for states in taking measures to regulate complex and sensitive areas of international relations. Soft law permits arrangements whereby states can voluntarily implement standards and practices that are generated on the international level through informal consultations and negotiations among states and international organizations. The soft law process in the formation of international norms of state behavior can be crucial in finding the right mix between hard and soft standards by which to regulate particular issue areas. This is particularly important in determining what role, if any, soft law plays in facilitating the development of international standards of banking supervision. These nonbinding international norms shape and constrain the regulatory practices of major states and may eventually be implemented into national law in a manner that, at least in theory, respects states' sovereignty and independence.
The existence of international rules and obligations outside traditionally recognized legal sources (i.e., treaty or uniform customary state practice) has proved controversial among international economic lawyers. But their importance in influencing state regulatory practice has been recognized by leading international financial lawyers (Gold, 1982). Indeed, while evaluating whether certain IMF currency regulations constituted soft law, Gold defined soft law as:
[T]he essential ingredient of soft law is an expectation that the states accepting these instruments will take their contents seriously and will give them some measure of respect. Certain other elements are postulated. First, a common intent is implicit in the soft law as formulated, and it is this (p.139) common intent, when elucidated, that is to be respected. Second, the legitimacy of the soft law as promulgated is not challenged. Third, soft law is not deprived of its quality as law because failure to observe it is not in itself a breach of obligation. Fourth, conduct that respects soft law cannot be deemed invalid. (Gold, 1982: 156)
On the basis of this definition, the essential elements of international soft law are: (1) whether there is in fact a common intent among the parties that certain principles be implemented and observed, and (2) whether it is desirable to transform these principles into hard law. In order to accomplish the second element, one must take into account the various interconnections between soft law norms and national and regional processes by which they may be implemented as “hard” law.
Gold's definition of soft law has been applied to international banking regulation to hold that a particular instrument or report may become soft law if it has at least a quasi-legitimacy to it derived from the collective intent of those involved in the preparation of that instrument or report, and if the standards and principles advocated therein ought to be observed (Norton, 1995: 216). According to this definition, the normative content of the standard or principle in question depends on its legitimacy, which derives from the collective intent of those parties who adopted it. One can infer that the collective intent of the parties that adopted the standard must be based on their consent to be subject to that standard. It would be illegitimate, therefore, for a state to be expected to comply with a standard if its consent was not obtained beforehand. A state's consent can be based on proactive conduct or passive acquiescence. In either case, it should be voluntary and not obtained through duress or coercion. The emphasis on consent as evidence of the intent of states to recognize international soft law obligation is analogous to voluntarist notions of international law that emphasize the importance of state consent for determining the validity of international legal obligations.
The concept of soft law has been analyzed from a number of perspectives and disciplines, which reveal its complexity as a social science concept. International lawyers have invoked legal doctrine to analyze international soft law principles by focusing on the main elements of a legal system, which are precision of rules, degree of obligation, delegation of authority for adjudicating compliance, and sanctions and enforcement (Wellens and Borchardt, 1989; Abbott et al., 2000).7 These elements are not static but evolve and develop according to interstate relations and state practice. These elements are often used to evaluate the legal scope and effect of a state's international obligations and commitments.
Precision of rules or standards is important for determining the content and scope of a state's legal rights and obligations. For instance, the level of precision in rules or standards can limit a state's discretion in determining how it should comply with a particular obligation or commitment. Soft law rules that are more precise and specific tend to be more obliging (p.140) for the addressee of the obligation, even though there may be no international legal obligation to comply, because the expectations are more clearly defined in the rule. In contrast, vagueness and ambiguity in a rule increase the ability of a state to interpret its entitlements and obligations in a biased manner that may depart from the original intent of the parties to the agreement. The lack of precision in soft law rules therefore can permit states to avoid their commitments more easily and potentially undermine the carrying out of the agreement by all parties. In politically sensitive areas, such as arms control or banking regulation, states may deliberately pursue vague agreements for the purpose of maintaining ultimate discretion regarding the interpretation and performance of their commitments. The lack of precision of a rule may also result from the rule's immaturity and from the state's inexperience in using the rule in practice. For contentious issues, however, the optimal precision of the rule may require a sufficient degree of ambiguity that respects political disagreements but which can form the basis for future negotiation. Too much precision in rule type may be inappropriate, especially where states are uncertain regarding how their obligations will be interpreted in the future. A sufficient level of ambiguity in the rule allows states to learn by doing and to extend the level of precision once they are aware of the implications of their obligations.
The second element concerns the degree of obligation, which can extend from legally binding obligations of a precise and specific nature to vague, hortatory norms of a divergent nature “which do not create enforceable rights and obligations” but nevertheless create commitments and expectations in softer form.8 A form of soft obligation can arise from legally nonbinding commitments that provide an indirect form of pressure on states that may restrict their freedom of action but nevertheless create no binding international legal obligations in a strict sense. In contrast, a legally binding obligation under international law can be created only by state parties or international organizations that have the competence to do so, and the subjects that are bound by such obligation must acknowledge the source of these obligations as authoritative (Schachter, 1977). Most international norms and principles do not fall under international law and therefore create a softer form of obligation or commitment that shapes and influences state behavior. Although it can be argued that the content of soft law lacks any type of obligation, the better view holds that various dimensions of soft law contain different degrees of obligation or “loose commitments” (Wellens and Borchardt, 1989). The degree of obligation often depends on the level of precision of the rule or principle, and therefore the elements of precision and obligation can be mutually dependent in certain cases.
The third element is delegation, which involves the extent to which states accept third-party resolution of their claims or disputes. This may also involve rule interpretation, rule making, and related fact-finding tasks. The extent of delegation to third parties to adjudicate claims or to deter (p.141) mine rights and obligations may vary according to institutional structures. In public international law, rights and obligations are usually recognized by arbitral tribunals and judicial bodies as the legal basis for their decisions. In contrast, international soft law instruments often provide that disputes and claims will be resolved by negotiations between the parties and not adjudicated by independent third parties (Aust, 2000). In the absence of third-party dispute resolution, states and the relevant international organizations are primarily responsible for assessing compliance with both hard and soft international norms and for holding other states accountable for complying with their commitments. A higher level of delegation to independent bodies to resolve disputes suggests a more legalized international regime, while lesser delegation suggests a softer, less legal framework that relies more on political negotiations and compromise to resolve disputes.
The fourth element involves sanctions, both direct and indirect, which can be defined as the withholding of a benefit or the imposition of a penalty on a state or its nationals for certain conduct that may not comply with international soft law norms. It should be recalled that sanctions that arise from the enforcement of rights and obligations under international law are not applicable in the soft law context, and therefore state responsibility does not arise in a formal sense. International soft law, however, provides various degrees of soft liability that may involve procedural requirements, such as reporting and consultation and mandatory negotiations to provide good-faith interpretations of soft law norms and rules (Seidl-Hohenveldern, 1979). As discussed later, international financial soft law provides a particular type of soft liability in the form of official and market incentives and indirect sanctions that play a significant role in influencing state economic conduct. The intensity and scope of these sanctions varies according to a number of factors that apply differently to different states. There is a lack of uniformity across states in the application of sanctions for the same type of breach of a particular norm.
On the basis of this descriptive framework, we find that there is no sharp division between hard and soft law; rather, a fluid spectrum exists through which the elements of precision, obligation, delegation, and sanctions can evolve at different degrees and sometimes independent of each other. International soft law norms provide a system of rules and principles in which these elements are either fully developed or undeveloped to various degrees. For instance, states may deliberately pursue policies and reach agreements that are initially nonbinding in nature but that may later develop into binding obligations that reflect increased trust and coordination between states in particular issue areas. But, as the collapse of the Bretton Woods par value system demonstrates, this process can switch into reverse and lead to a softening and even a dissolution of international legal obligations if states so decide.
The process of forming binding international standards of banking regulation involves testing various combinations of these elements to deter (p.142) mine the extent and scope of soft law. International soft law can provide a flexible mechanism for determining the proper mix of soft and hard law to regulate a particular issue area. As a conceptual matter, the process of devising international norms and rules for banking regulation has involved a particular form of international soft law that has precise, nonbinding norms that are generated through consultations and negotiations among the major state regulators. This particular form of international soft law has provided the necessary political flexibility for states to adopt international rules and standards into their national legal systems in a manner that accommodates the sovereign authority of the nation-state.
The conceptual framework discussed here suggests that, in devising international economic norms and institutions, states should adopt flexible combinations of hard and soft law to address particular issues areas of international concern. For example, states should define the specific threat to the international system and then develop a political consensus on what measures should be adopted at the national level. It is important to agree on the degree of precision and obligation of the standards adopted and equally important to avoid an inflexibly uniform implementation approach that relies excessively on a uniform framework that does not recognize diverse economic and legal structures.
Moreover, it should be mentioned that international soft law can have particular legal effects and consequences in national and regional legal systems. International soft law may serve as a basis for ongoing negotiations and consultations between states within existing institutional structures. Soft law that is promulgated in written agreements may contain such hortatory language as “all states shall endeavor to cooperate,” which can have the effect of removing a state's discretion not to cooperate from its domestic jurisdiction. Further, soft law rules and principles can be used to interpret treaty provisions or customary international law and can serve to shape and constrain the development of legally relevant state practice. International soft law has taken on a particular form in banking regulation, where the leading developed countries have promulgated voluntary international agreements and instruments that do not constitute traditional sources of international law but that aim to commit all states to adopt and implement these standards into their own regulatory systems. For instance, the Basel Capital Accord and the Core Principles on banking supervision have taken on a particular international status that serves as a normative basis for the adoption of national legislation to implement these standards into regulatory practice. Most states commit themselves to implement the Accord and the Core Principles into national law. The European Community has committed itself to implement the Capital Accord into EU law through directives.
Although international soft law has been criticized as a contradiction in terms and as a backdoor attempt to render legal certain areas of international relations that should remain political, it provides states with a flexible mechanism to develop norms and standards in complex and po (p.143) litically sensitive issue areas where the benefits of cooperation and of devising standards to regulate state behavior are significant and can reduce the transaction costs for states in pursuing their objectives. Soft law provides states with incentives to negotiate and exchange information, which can lead to a more informed understanding of state interests and provide the basis for more effective and efficient cooperative frameworks. States can use particular combinations of “hard” and “soft” law to regulate their behavior and to promote international norm building. Indeed, international soft law can arise from agreements that would otherwise not be possible in a treaty or other enforceable agreement because of the existence of fundamental differences among states and their reluctance to be bound by specific legal obligations in technical areas of law that significantly impact their national interests.
THE FORMATION OF BINDING INTERNATIONAL SOFT LAW NORMS: THE CASE OF THE BASEL COMMITTEE AND THE FINANCIAL ACTION TASK FORCE
In the area of international banking supervision, the formation of international standards of financial regulation has involved various types of “soft law” principles and rules that have been adopted by the national banking regulators of the G10 countries under the aegis of the Basel Committee. These soft law agreements have the overriding objective of reducing systemic risk in the international banking system and of promoting competitive equality among banking institutions. They do this by exhorting their members and other countries where international banks operate to cooperate in the exchange of information and to coordinate regulatory activities such as setting capital adequacy standards for all internationally active banks.
Although the Basel rules and standards are not enforceable under international law, they are sustained by a number of official and market measures that make the standards sanctionable without losing their soft law status (Giovanoli, 2002). For example, the International Monetary Fund uses the Basel principles as a benchmark of good banking regulation against which IMF members are evaluated under Article IV surveillance programs. The IMF also has discretion to make compliance with the Capital Accord and other international banking standards a condition for receiving financial aid. Similarly, the World Bank uses the Basel Accord as a benchmark in its lending programs, and has stated that “the international community is likely to expect all countries to adopt and implement the Basel Committee's recommendations” (2001). Moreover, market forces may impose a sanction in the form of a higher risk premium on capital investment for countries that fail to demonstrate adherence to Basel standards. It is not surprising, therefore, that more than one hundred countries claim to have adopted the Basel Accord into their national banking regulations (Hawkins and Turner, 2000), even though most countries exercise (p.144) little or no influence in its promulgation. The use of sanctions by international organizations and of capital cost penalties by financial markets undermines the so-called voluntary nature of the Basel framework. Moreover, the extent to which official and market sanctions are used to pressure states (especially in developing and emerging market economies) to comply with so-called voluntary international agreements raises the important issue of the nature of a state's obligation to implement and comply with international financial standards.
Most countries are exposed to certain disciplines and pressures to adhere to the Basel Accord. The most important of these are official sector discipline, market discipline, market access requirements, reputation, international spillovers, and economies of scale (Ward, 2002; Giovanoli, 2002). Alexander and Ward (2004) have examined how these factors influence the development of international banking norms.
Official Sector Discipline
Official sector discipline can take the form of IMF/World Bank financial assistance programs that require or induce the recipient countries to make economic and regulatory adjustments as a condition for receiving aid. IMF conditionality programs often take the form of standby arrangements whereby the Fund permits a member country to make purchases (drawings) from the IMF General Resources Account up to a specified amount and over a period of time in return for the member's promise to observe the terms of the arrangement (IMF, 2004b). The terms of the arrangement may require the recipient country to adopt and implement international “best practices” of banking supervision as a condition for making drawings. The World Bank also negotiates conditions in its Financial Sector Adjustment Loans that may include the recipient country promising to adhere to best international standards, such as the Core Principles for Effective Banking Supervision (BCBS, 1997). The Basel Committee's Core Principles Liaison Group (CPLG) adopted the Core Principles in 1997 as international benchmarks for bank regulators. The IMF and World Bank often conduct Core Principles Assessments (CPAs) for members undergoing Article IV surveillance programs and for determining whether a member qualifies for further drawings under standby arrangements or other financial assistance programs (IMF, 2000b).9
The Core Principles are stated broadly with a view to giving states flexibility in implementation and interpretation. For instance, core principle 8 states:
Banking supervisors must be satisfied that banks establish and adhere to adequate policies, practices, and procedures for evaluating the quality of assets and the adequacy of loan loss reserves.
In contrast, Core Principle 6 provides a more prescriptive rule that encourages states to set minimum capital adequacy standards for “internationally active banks” that “must not be less than those established in the (p.145) Basel Capital Accord.” For example, an emergency IMF recapitalization program for a member's banking sector would likely involve a CPA to ensure that the country's regulatory regime required banks to adhere to the Capital Accord (IMF, 2004c). Basel II, however, will create ambiguity regarding implementation of the Accord because of the discretion it grants regulators under pillars 1 and 2. Indeed, it is not clear how much discretion the IMF and World Bank will give to countries subject to a CPA, and whether this may lead to significant differences in implementation between countries depending on the terms of their IFI financial assistance program. Although the generality of the core principles can probably be reconciled with the regulatory discretion granted under Basel II, there exists potential for conflict between, on the one hand, implementation of the core principles and Basel II, and, on the other hand, adherence to official sector programs.
Although the World Bank continues to use financial sector adjustment loans to influence state regulatory policy, it began in the 1990s to utilize conditionality programs less for prudential regulation and more for bank privatization and recapitalization programs (Cull, 1997). This research shows that 63 percent of the adjustment loans before 1990 had conditions related to banking supervision, while 88 percent had conditions related to prudential regulation. In contrast, between 1990 and 1997, 79 percent of the loans had conditions related to banking supervision, while 71 percent had conditions related to prudential regulation. The percentage of loans listing conditions for banking supervision and prudential regulation was less than the percentage of loans listing privatization and recapitalization, the latter two both exceeding 90 percent. Moreover, since the debate over Basel II began, the World Bank has expressed a concern that developing countries may not have the proper incentives to adopt and implement Basel II (Ward, 2002) and that this could serve as a focal point for future Bank conditionality programs. The significant role played by the World Bank in overseeing implementation of so-called voluntary international banking norms calls into question the legitimacy of the standard setting process and raises important issues regarding the desirability of exporting international financial standards that are devised by the rich countries for the most sophisticated financial markets to developing countries.
The objective of market discipline would be to show that compliance with international financial standards would lower funding costs for the sovereign and its financial institutions. But Kenen (2001) has criticized the use of market discipline on the basis of two reports by the Financial Stability Forum (2000a, 2000b) that suggest that market participants and ratings agencies would likely be concerned with absolute compliance with international standards and less concerned with a country's progress toward implementation. The FSF reports state that official incentives are (p.146) required because there is no guarantee that market participants will always base their decisions on the need to comply with international standards. Moreover, market participants will always have an incentive to focus on the upside of risk because of principal-agent problems and may be unconcerned with aggregate losses. This may lead them to avoid focusing on a country's compliance or progress in implementation and may lead many weak financial systems to ignore the need to upgrade their regulatory standards and to improve implementation, which may lead to significant negative externalities for international financial markets (Kenen, 2001).10 Market discipline will at best encourage countries to state that they have implemented international standards, even if they have not in fact implemented them.
Restricting Market Access
A national authority's decision to restrict market access is likely to influence more countries to adopt international standards. For example, the Basel Concordat provides that host countries review the supervisory and regulatory regimes of home countries with a view to determining whether the home country regime is adequate. The Core Principles and the Capital Accord have defined “adequate” as being in compliance with the Basel Committee framework and other relevant international standards. In the European Economic Area (EEA), the Second Banking Coordination Directive allows member states to restrict access to third-country banks (i.e., branches or agencies) outside the EEA whose home country regimes do not meet EU standards, but in no case can they treat non-EEA banks more favorably than banks based in EEA states.
To this end, the U.S. Financial Services Modernization Act of 1999 and the Foreign Bank Supervision Enhancement Act of 1991 grant the Federal Reserve authority to issue banking licenses to foreign banks only if they are “subject to comprehensive supervision or regulation on a consolidated basis by the appropriate authorities in its home country” and if they are “well-capitalized and well-managed” on a global basis. U.S. regulators have discretion to relax the requirement to permit authorization of banks not subject to comprehensive regulation where “the appropriate authorities in the home country of the foreign bank are actively working to establish arrangements for the consolidated supervision” of the bank.11 U.S. regulators can withdraw the license if they determine that the home country regulator has failed to make “demonstrable progress” in establishing comprehensive supervision or regulation of the foreign bank. Moreover, under the Financial Services Modernization Act of 1999, the Federal Reserve has authority to evaluate the quality of the home country supervisor, including an assessment of whether it applies and enforces international standards such as the Capital Accord, before it decides whether to permit a bank incorporated or based in that jurisdiction to conduct universal banking activities in the United States as a financial holding company.
(p.147) The EU Financial Conglomerates Directive requires U.K. authorities to judge the equivalence of the supervisory regime of a third country (non-EU) state. If the third country regime fails the equivalence test, the U.K. authorities are required to apply its regime to the global operations of the third country financial firm as a condition for the issuance of a license permitting the firm to operate in the U.K. market.
U.S., U.K., and EU regulatory practice in this area has been supported by the FSF report (2000b) that states:
National authorities should be encouraged to give greater consideration to a foreign jurisdiction's observance of relevant standards as one of the factors in making market access decisions.
This means that the supervisory regimes of developing countries and other non-G10 states will be judged adequate if they adopt a regime that is at least as strict as, but not necessarily identical to, the Basel framework and other relevant international standards. As a practical regulatory policy, the best way to gain access is for them to adopt the international benchmark. In addition, banks in non-G10 countries may have an incentive to lobby their governments to seek adoption of the Basel framework because such a comprehensive regulatory regime may limit entry, and thus reduce, competition in the banking market. The type of banks that would seek the adoption of Basel regulations would normally be larger, more sophisticated banks with the resources to comply with the requirements. They would be in a strong market position to limit competition and foreign access to their markets.12
The other option for a bank based in a non-G10 jurisdiction that seeks to gain access to the G10 markets is for it to establish a subsidiary in the host state. Indeed, the U.K. FSA requires the banks from countries whose regulatory regimes are judged inadequate by the U.K. authorities to incorporate locally (Ward, 2002a). If the foreign bank already has a branch operation but its home country regulator is later judged inadequate, it will have to convert to a subsidiary or exit the market.
Many countries will perceive adherence to the Basel standards as a mark of good regulatory practice that will enhance their reputation with market participants and help them to obtain lower-cost funding from banks and the capital markets. Banks and other financial firms that operate outside the G10 will adopt Basel II and other international standards, not necessarily because there will be capital savings or because it may be more convenient for risk management purposes but because they will want to signal to the world that they have moved to the latest, most sophisticated models and have received the approval of the G10 regulators.
Moreover, regulators will want to be viewed as sophisticated, as well and, even if they are reluctant to implement the Basel framework because of its high costs, they may be induced to do so for signaling reasons. If (p.148) we assume that here are two types of states, one for which the adoption of the Capital Accord will be much more costly because its regulatory and financial system is at a lower level of sophistication and another for which adoption of the Accord will require relatively lower compliance costs because of the sophisticated nature of its economy, then both types of countries will be able to signal that they are sophisticated by implementing the model. There are obvious inefficiencies in such an approach, which does not allow the less sophisticated jurisdiction to adopt a framework that more adequately suits its stage of economic and financial development.
One solution could be to allow non-G10 regulators, for signaling purposes, to implement “a simpler and harsher version” of the Basel framework (Ward, 2002), one that would not require, for instance, that non-G10 banks implement some of the more complex and technical requirements of pillar 1 of Basel II. In the area of financial crime, banks would be allowed to adopt less onerous disclosure and transparency standards under the FATF Forty Recommendations that would reflect the degree of development and sophistication of their economies. They would therefore be able to signal to the world that they operate adequate antimoney-laundering controls.
The spillover of negative externalities from one jurisdiction to another may arise from the implementation of a regime that has more relaxed standards than the G10 regimes and thus may lead banks to arbitrage between regimes. Regimes with perceived lower standards will then collect underpriced financial assets. This is a type of adverse selection.
Moreover, regarding Basel II, if banks on the IRB approach in pillar 1 are able to lower their regulatory capital charges for an asset that would be priced higher by a bank that uses the standardized approach, regulators will be pressured to adopt sophisticated internal ratings models along the lines proposed by Basel II but that may not be beneficial for banks and financial markets of less-developed countries.
The design of a regulatory regime incurs high fixed costs because a high level of expertise is required for regulators and staff to design regulatory policy. This can be especially expensive for developing-country regulators, who have often fewer skilled staff and whose regulatory regimes suffer from relatively high design costs. A global regime therefore may be viewed as a lower-cost option, because it can be taken off the shelf. Nevertheless, implementation and enforcement costs can be prohibitive for many countries.
Enforcement also requires skills and other institutional costs. An international regime may be cheaper to enforce if it involves coordination and collaboration with other authorities. An international regime of precise rules requires less skill and resources to enforce than a regime of stan (p.149) dards, whose more general and vague nature requires greater skills in interpretation and implementation. Precise rules are easier to copy and involve less interpretation and discretion in implementation than do more broadly stated standards. It may be more efficient for a state to adopt an international regime than to devise its own, especially if that regime is based on a prescriptive set of rules that lends itself to adoption in different jurisdictions, but the introduction of external or international rules always leads to higher costs of implementation and possibly enforcement.
Most national regulators outside the G10 regard the Basel Accord and other international standards as soft law. The official and market incentives outlined earlier create pressures that may exercise undue influence over their national policies. The real incentives and sanctions are determined by the IFIs in their assessments and funding choices and by the G10 countries in determining market access. IMF and World Bank conditionality is likely to take account of a country's progress, rather than its actual compliance with international standards at any one point in time. By contrast, Core Principles Assessments do take account of actual compliance. U.S. and U.K. regulatory standards look to the foreign regime's equivalence with either U.S./U.K. standards or international standards. Although the IMF/World Bank may allow states to implement standards at a phased pace, market access rules in the EU and in the United States encourage foreign regulators to move quickly in implementing standards in a way that may threaten to undermine financial stability.
This discussion argues that the adoption of IFI standards, especially the Basel Accord, may not lead to the most efficient development of financial markets in the non-G10 countries. This international soft law framework also raises issues of accountability and legitimacy. Indeed, the adoption of standards and rules in the Basel framework may create a governance gap. The Committee has attempted to address this, at least in the Core Principles, by creating a Core Principles Liaison Group (CPLG) that creates a forum for discussion of these issues with non-G10 regulators. Although this allows some non-G10 countries to influence the development of the Core Principles, the G10 retains sole authority over developing the Capital Accord. Although non-G10 countries can make comments to the Basel Committee, the Committee has no obligation to recognize them. The standard-setting process remains dominated by the G10, even though, as demonstrated earlier, these standards are increasingly being applied on a global basis.
The factors discussed suggest that international financial soft law can influence state behavior in a number of ways, including the creation of official incentives by international economic organizations and of market incentives that penalize countries whose international equity and bond markets carry higher costs of capital. These official and market incentives assume varying degrees of intensity depending on the type of conduct and the state involved. These incentives and indirect sanctions, however, suffer from a lack of uniformity in application and often work against the (p.150) interests of small and developing countries, in contrast to countries with more political and economic influence, which often have the capability of minimizing and withstanding the costs of noncompliance with soft law norms.
The Financial Action Task Force
The development of international antimoney-laundering standards by the Financial Action Task Force has been a more inclusive process than the development of standards in international banking generally. Regulators have involved more countries and have provided a peer review process that involves consultation and mutual assessment of regulations and laws with a view to adopting standards that reflect a broad view of economic and legal structures.
The Financial Action Task Force has been in existence only since 1990, but it has had an extraordinary impact on the development of international norms to combat financial crime and money laundering. Despite its rather limited membership and informal legal status, FATF has seized the agenda in setting international standards and rules that must be adopted not only by its membership but by all other states under threat of sanctions. Although the FATF Recommendations do not reflect a common practice of all states with opinio juris and therefore cannot be considered customary international law as such, they have had a significant impact in shaping the policies and laws of many of the world's leading economic powers and emerging economies and in fostering recognition that money laundering is a threat to the systemic stability and integrity of financial systems. Moreover, FATF's compliance review process and designation of noncooperative countries, which carries the threat of sanctions, has created a limited international legal regime that has the potential to be transformed into a more comprehensive international legal framework for the control of financial crime. FATF has become the single most important international body in terms of formulating antimoney-laundering policy and developing international standards for disclosure and transparency for financial institutions.13
FATF's efforts to establish and enforce standards and rules impose a higher level of obligation than the Basel Committee framework because of the institutional willingness to impose sanctions. The so-called FATF Forty Recommendations have been extended beyond merely nonbinding voluntary standards and are considered binding principles backed by the threat of sanctions. As discussed in chapter 2, FATF's threat to impose sanctions in June 2000 against fifteen designated jurisdictions led most of them to adopt and implement the necessary changes in their legal systems to become compliant with FATF requirements. The designated jurisdictions that failed to comply with the FATF requirements were blacklisted by FATF and subject to further sanctions that prohibit OECD-based firms from doing business in these targeted jurisdictions. In October 2001, FATF adopted antiterrorist financing recommendations that require all OECD (p.151) states to adopt strict controls to prevent third-party intermediaries and professionals from facilitating transactions with designated terrorists. The FATF antiterrorist financing sanctions are also backed by United Nations Security Council Resolution 1373.
Although the FATF approach owes much to the Basel Committee approach, it has evolved into a more ambitious undertaking because its member states can agree to impose sanctions against noncomplying countries or territories. FATF took the work of the Basel Committee a step further by stressing the importance of requiring its member states to implements its standards. In 1991, FATF issued a statement indicating that its members had agreed to a process of mutual assessment to ensure that the Forty Recommendations were being put into practice (FATF, 1996b). The members also agreed to expand the membership of the task force and to influence nonmember jurisdictions to follow the forty points (FATF, 2003). Significant components of FATF's work thus have been devoted to promoting compliance with the Forty Recommendations and to cultivating antimoney-laundering efforts in nonmember nations or regions. As part of its agenda, therefore, FATF conducts on-site peer evaluations of member adherence to the Forty Recommendations. An evaluation team composed of legal, regulatory, and law enforcement experts from the comember states visits the subject country and conducts a thorough review of its antimoney-laundering infrastructure. The results of this evaluation are published in a report that is reviewed internally by the FATF membership.
In addition, multilateral treaty frameworks may indirectly influence the formation of binding international financial norms. Treaties addressing corruption, financial crime, and terrorism often contain language that is deliberately left ambiguous because state parties prefer not to incur specific and precise obligations that may impinge on sensitive areas of state policy. Although the Forty Recommendations are generally viewed as voluntary soft law standards where states have discretion regarding implementation, some multilateral treaties dealing with corruption and money laundering make reference to international soft law standards in order to clarify the meaning of vaguely drafted treaty provisions. For example, the United Nations Convention against Transnational and Organized Crime (2000) (the Palermo Convention) is the most significant multilateral treaty addressing organized and financial crime. Article 7 addresses a state's obligation to implement measures to combat money laundering, and Article 7(3) provides that, “[i]n establishing a domestic regulatory and supervisory regime,” states “are called upon to use as a guideline the relevant initiatives of regional, interregional and multilateral organizations against money laundering.” The treaty's interpretative notes make clear that the relevant multilateral and regional initiatives include the FATF Forty Recommendations and the various standards adopted by FATF regional bodies. Subsequent implementation programs cross-reference the FATF standards to add clarity to the obligations under the Conven-tion (Gilmore, 2003). Similarly, the United Nations Convention against (p.152) Corruption (2003) contains identical language in Article 14 (4) and (5) and makes reference to the FATF Forty Recommendations and regional agreements in the interpretative notes.
The Palermo Convention and the FATF Forty Recommendations mark an important development in the formation of binding international financial norms in which ostensibly voluntary FATF standards are used as benchmarks for defining legally binding obligations under a multilateral treaty. In one way, it could be called international law through the backdoor, but for the global governance debate, it raises important issues regarding the legal relevance of international financial standard setting and the need to ensure that the decision-making process is accountable and legitimate.
One may argue that FATF's efforts, with the institutional support of the OECD, have been instrumental in developing and formalizing international antimoney-laundering norms and standards and in shifting such standards from voluntary recommendations to an increasingly binding international regime. Moreover, the increasing legal relevance of the regime is indicated in part by its high degree of precision and obligation, although the requirements are denoted as recommendations. The existence of a peer-review compliance assessment exhibits a degree of delegation, although one that is not as forceful or as independent as an independent tribunal or arbitrator (e.g., the WTO dispute settlement body). Moreover, peer review undertaken by the same countries that promulgate the standards provides a higher level of legitimacy than the Basel framework and also offers a more direct form of accountability.
FATF's use of various procedures and compliance evaluations that allow all assessed jurisdictions to offer input on the development of standards and programs for their respective systems enhances the legitimacy and accountability of the standard setting and implementation process.14 Nevertheless, the FATF regime suffers from serious weaknesses, discussed in chapter 2. Although the regional inspection panels engage local officials in a dialogue regarding their needs and capabilities, the standards that are applied are essentially determined by the OECD member countries. Despite significant improvements in transparency and accountability, FATF standard setting lacks legitimacy because of the threat of countermeasures that can be imposed against any jurisdiction that fails to comply. The weaknesses in governance of both the Basel Committee and FATF suggest the need for further reforms in international standard setting.
The substantive content and scope of international financial regulation has been influenced chiefly by the regulators of the world's major financial systems, and the standards and rules they have produced do not find their origins in traditional sources of public international law but rather are a result of bargaining and softer techniques of implementation that seek to utilize indirect forms of pressure on states to adopt these standards. These indirect forms of pressure include a variety of official and market incentives that play a crucial role in shaping the development of state regula (p.153) tory practice. It is important to note that the present international financial regulatory regime derives primarily from these sources and should be viewed with concern because most countries that are subject to these standards have not played a role in their promulgation and have not consented to their adoption. As evidenced by the aftermath of the Asian financial crisis, these standards often result in poor regulatory and economic policy for many countries and thereby undermine economic growth and development (Stiglitz, 2001). Reform efforts should focus on devising decision-making and institutional structures that are more accountable and legitimate and on developing a regulatory framework that relies less on the role of official and market incentives.
Moreover, increased integration and interdependence in international banking markets suggests that the existing international soft law framework is no longer a second-best arrangement for generating efficient standards of banking regulation. Indeed, increasing integration and cross-border activity may require further institutional and legal consolidation at the international level to promote more effective and accountable international regulation. This would require states to move forward through the soft law process by building on the collective intent of most states to develop binding international rules of banking regulation. States could potentially delegate the adjudication of violations to an international financial authority, but states would retain ultimate enforcement authority, including sanctions.
The development of a substantial body of international regulatory norms for banking and financial regulation has raised important normative issues for international economic lawyers regarding the sources of state regulatory practice and the role of traditional sources of public international law in explaining state conduct in these areas. International soft law may be defined as an international rule created by a group of specially affected states in a particular issue area that have a common intent to observe voluntarily the content of such a rule with the intention of possibly incorporating it into the national law or administrative regulations. The chapter suggests that, although international soft law has provided a flexible framework for developing standards of international financial regulation, the efficient regulation of financial systems requires “harder” legal standards that create more stable expectations for market participants in their cross-border activities. The existing framework of using official and market incentives and sanctions to promote adherence to international standards is haphazard and is unevenly applied to developed and developing countries, undermining principles of accountability and legitimacy. Therefore, the instrument of international soft law should be modified to incorporate some legally binding standards of banking regulation that can be applied flexibly within and across different economic systems.
(p.154) In addition, the effect of official and market incentives has been to create a type of obligation that is relevant in a normative sense and influences the development of state practice in the areas of bank regulation and antimoney-laundering controls. However, an optimal set of international regulatory standards has been difficult to develop because uniform international standards can have widely diverging effects in different economic systems. This is why the existing Basel framework and FATF Recommendations may be inappropriate for many countries on economic grounds. Moreover, the process through which these standards have been promulgated, applied, and implemented under IMF/World Bank supervision raises issues of political legitimacy and accountability. The particular type of international soft law that has fostered the widespread application of these standards outside the small circle of countries that devised them raises important issues of global governance and whether the legalization process through which these international standards assume a more binding character is an efficient legal framework for the effective regulation of systemic risk.
(1.) See Article 38 (1)(a)–(d), ICJ Statute, in D. J. Harris, Cases and Materials on International Law, Appendix I (London: Sweet and Maxwell, 1991), pp. 990–1002. The traditional sources of public international law as stated in Article 38(1) are:
((a)) international conventions, whether general or particular, that establish
((b)) rules expressly recognized by the contesting states;
((c)) international custom, as evidence of a general practice accepted as law;
((d)) the general principles of law as recognized by civilized nations;
((e)) judicial decisions and the teachings of the most highly qualified publicists of the various nations, as subsidiary means for the determination of rules of law.
(3.) See “Military and Paramilitary Activities in and against Nicaragua (Nicaragua v. United States of America),” ICJ Reports (1986), p. 97, paragraph 183 (observing that to determine “rules of customary international law,” the court must look “to the practice and opinio juris of states”). The Lotus case, Permanent Court of International Justice, series A, No. 10 (1927), p. 18 (emphasizing the voluntary or consent-based nature of opino juris); North Sea Continental Shelf cases, IJC Reports (1969), p. 3, paragraphs 71–72 and 78 (emphasizing the belief-based nature of opino juris).
(4.) The subjective element can generally be satisfied in two ways: (1) by the state's voluntary agreement or consent to be bound by the customary rule or obligation in quesiton, or (2) by the state's belief that its conduct is legally permitted or obligatory (Mendelson, 1995: 184, 195).
(5.) The Lotus case, Permanent Court of International Justice, Series A, No. 10 (1927). In fact, the Basel Accord and other international financial standards represent what Mendelson (1995) has called opinio non-juris, in which states expressly state that although they may act in a certain way, they do not consider their acts to be motivated by any legal obligation or that their behavior should serve as a precedent to restrict their future conduct (Mendelson, 1995: 198–201).
(6.) This view holds that international soft law principles and rules have converged at the international level and have filtered down to the national legal systems and domestic regulations of the world's leading states and thereby have produced certain general principles of public regulatory law that may have legal relevance as source of public international law.
(9.) IMF CPAs have been conducted for over fifty countries, including recent ones for Argentina, Gabon, Turkey, and Uruguay. For example, in 2000, Angola affirmed its commitment to adhere to the Basel Capital Accord and Core Principles as part of a staff-monitored program (IMF, 2000c). In 2002, the Turkish government had a SDR 12.8 billion ($17 billion) standby arrangement with the IMF. In its Letter of Intent of June 19, 2002, Turkey committed itself to recapitalize its troubled banks in accordance with the Capital Accord and to adhere to other of the Core Principles. Uruguay's standby arrangement commits it to adopt a bank regulatory regime that complies with the Core Principles so that it may draw on a SDR 2.13 billion facility (IMF, 2004c).
(10.) Also, market participants are not allowed to use IFI assessments, because they cannot be published (except when the assessed country requests it).
(11.) The Federal Reserve Board shall also consider whether the foreign bank's home authority complies with international antimoney-laundering standards (i.e., FATF Forty Recommendations). See U.S. Patriot Act, Title III, section 327.
(12.) This would especially have implications for a state's obligations to liberalize access to its financial markets under the WTO General Agreement on Trade in Services.
(13.) FATF has extended its international institutional scope to include closer cooperation and coordination with regional antimoney-laundering bodies in investigations and exchange of information (FATF, 2001c: 9–11). These bodies include the Caribbean Financial Action Task Force, the European Commission, and the Financial Action Task Force on Money Laundering for South America. Moreover, the major international financial organizations (IMF and World Bank) and international supervisory bodies (e.g., Basel Committee and IOSCO) announced in 2001 that they had adopted the FATF's Forty Recommendations as their standards, as well.