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The Impacts of Post-Crisis Global Regulatory Reforms on Financial Markets

Commissioner Daniel M. Gallagher

Berlin, Federal Republic of Germany

Dec. 10, 2013

Meine geehrte Damen and Herren:

Guten abend.  Ich wollte die Rede ganz auf Deutsch halten, aber das Deutsch kann ich nicht mehr so gut sprechen.  Na ja, ich habe die Sprache nur fuenf Jahre gelernt![1]


Thank you, Gary [Smith], for that kind introduction.  I am very pleased to be here with you tonight in this lovely setting, and it is a privilege for me to be able to address such a distinguished audience at such a noble and enduring institution.  I am grateful to the American Academy in Berlin for its longstanding efforts to promote a vibrant trans-Atlantic dialogue between the German and American people, and for striving to maintain and strengthen the important social, cultural, and historical ties between our two nations.  It is, of course, inevitable that this friendship – like any friendship -- will be tested by crises from time to time.  It is especially important at those times that we work together to ensure that this relationship does not founder, but instead continues to thrive and flourish in the years to come.


The global financial crisis of 2008 was a complex phenomenon with many contributing factors.  And many different actors – including policymakers in the U.S. – played a significant role in bringing it about.  However, in the U.S., many in the government and the media have placed the primary blame for the crisis squarely at the feet of our financial institutions, regardless of how they behaved before, during, and after the crisis.  They have focused their anger not only at institutions that were part of the problem, but also at some institutions that were part of the solution.


The heavy-handed legislative response to the crisis, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), was not a carefully crafted product of bipartisan compromise.[2]  Rather, Dodd-Frank was a grab bag of legislative wish-list items, many of which had nothing to do with the crisis. 


Indeed, one of the most telling facts about Dodd-Frank – which has been pervasively marketed to the American public and our international colleagues as a direct response to the financial crisis – is that it was enacted before the completion of the official regulatory inquiries into the causes of the crisis. Following the stock market collapse of 1929 and the onset of the Great Depression, Congress established the Pecora Commission to investigate the causes of the stock market collapse. The Pecora Commission stayed true to its mandate, focusing only on the entities that contributed to the crash and laying the groundwork for specific, targeted legislation, including the Securities Act of 1933 and the Securities Exchange Act of 1934, that was designed to address the actual causes of the crisis.  In contrast, the Dodd-Frank Act became a vehicle for ramming through the long-held ambitions of policymakers, bureaucrats, and special interest groups.


I’d like to focus your attention tonight on one particular, and disturbing, aspect of the global response to the crisis, namely, the trend towards so-called “regulatory harmonization.”  It’s important to note here that this term in fact has two very different meanings.  The current meaning appears to be the top-down, forcible imposition of one-size-fits-all regulatory standards on sovereign nations – a “one world, one government” approach to regulation.  However, the term “regulatory harmonization” once had a very different, and much more benign, meaning.


Prior to the onset of the global financial crisis, many U.S. and EU financial institutions were subject to national regulatory standards that were duplicative, overlapping, and often inconsistent.  In an effort to reduce the friction caused by those national standards, regulators from both sides of the Atlantic worked together to find common ground.  These transatlantic efforts were rooted in the principle of comity and were marked by a respect for national sovereignty.


The concepts that steered these efforts were regulatory equivalence and substituted compliance.  The ultimate goal was for regulators in each jurisdiction to recognize that many of their foreign counterparts had regulatory goals similar to their own, and that their regulatory approaches were of a high quality despite their differences.  Indeed, there is usually more than one way to achieve any given regulatory objective, and it’s not always clear which way is “best.” 


We could have jointly chosen to permit compliance with a high quality foreign regulatory regime to substitute for compliance with our own.  In doing so, we could have avoided complicated cross-border regulatory disputes and lent greater certainty and predictability to cross-border transactions.  By avoiding layered, duplicative, and sometimes incompatible regulations, we could have facilitated smoother and more efficient interactions between our respective capital markets.


This is true regulatory harmonization, and we have made some strides in this area, for example with respect to the regulation of credit rating agencies.  Although that process was not without its bumps and bruises, after extensive consultation with SEC staff, the European Securities and Markets Authority (ESMA) eventually reported to the European Commission (EC) its conclusion that the U.S. regulatory regime for credit rating agencies was equivalent to the EU’s own system.  Several months later, the EC formally rendered its equivalency determination for the U.S. credit rating agency regulatory regime.[3]


More recently, the SEC has made a concerted effort to apply principles of equivalency and substituted compliance in its implementation of Title VII of Dodd-Frank, which mandated regulation of the over-the-counter (OTC) derivatives market.  Regrettably, the U.S. Commodity Futures Trading Commission (CFTC), which has jurisdiction over nearly 95% of the derivatives market, has elected to take a far more invasive approach, and this has understandably led to substantial consternation here in Europe and elsewhere in the world.  Indeed, leading policymakers from the EU, the United Kingdom, France, Germany, and Japan wrote a joint letter to the CFTC requesting that it refrain from taking action that could fragment and damage the derivatives market, and urging it to adopt an approach grounded in principles of regulatory equivalence and substituted compliance.[4]


Unfortunately, earlier advances in developing a mutually respectful form of regulatory harmonization were largely derailed by the financial crisis.  The imposition of heavily prescriptive post-crisis legislation in the U.S. – by which I mean Dodd-Frank – has greatly complicated the task of arriving at a mutually beneficial agreement based on principles of regulatory equivalence and substituted compliance. 


In addition, the implementation of Dodd-Frank regulatory mandates has been poorly prioritized and in many cases, it has been carried out too rigidly, without appropriate deference to the real-world consequences.  For example, the SEC has expended scarce resources and significant time on implementing the conflict minerals and extractive resources disclosure provisions of Dodd-Frank.  While these “social disclosure” provisions were mandated by statute, they did nothing to address the problems that led to the financial crisis. 


Meanwhile, the SEC has failed fully to implement the few Dodd-Frank mandates that were truly responsive to the crisis, such as the mandate to federal agencies to remove all references to credit ratings issued by nationally recognized statistical rating organizations embedded in their rules.  In addition, I’m afraid to say, the SEC, working jointly with other federal banking and market regulators, made serious misjudgments in the proposed rules relating to credit risk retention for mortgage securitizations that I fear will return us to the disastrous housing policy that was the main cause of the financial crisis.[5]


As a consequence of Dodd-Frank’s heavy-handedness, as aggravated by these implementation problems, it’s hard to imagine a world in which the U.S. and European regulatory regimes could be harmonized peacefully, as opposed to coercively.  In addition, needlessly burdensome EU directives have not helped matters at all.


Indeed, the new form of regulatory harmonization that has arisen post-crisis is precisely that:  coercive.  Harmonization has become a euphemism for forcing nations to accept a unitary set of regulatory standards created by international bodies that exist outside of the formal constitutional structures of nations.  I am speaking here of bodies like the Group of Twenty (G-20), the Financial Stability Board (FSB, formerly known as the Financial Stability Forum), and the International Organization of Securities Commissions (IOSCO). 


These organizations, of course, were born out of legitimate efforts to engage in constructive multilateral dialogues on matters of mutual interest, including financial regulation.  However, following the crisis, they have taken on a new and more opaque character, and in some cases they have attempted to arrogate to themselves regulatory powers that properly reside with sovereign governments.


The G‑20, as you know, has directed the FSB to coordinate internationally the work of national authorities and multinational standard-setting organizations in the development of effective financial services regulation, with an emphasis on promoting financial stability.[6]  But the FSB is doing far more than merely coordinating the efforts of national regulators.  For example, it is developing methodologies to determine which banks and insurers are systemically important, and arguing that such institutions require “[h]igher loss-absorption capacity, more intensive supervision[,] and resolution planning requirements.”[7]  Additionally, the FSB has weighed in on the debate about money market mutual fund regulation, frontrunning national regulators’ efforts to enact reforms in that space.[8]  Regardless of where you come out on the merits of such policy issues, the FSB’s actions here cannot be considered mere “coordination.”


At the domestic level in the U.S., we have a similar situation developing with the Financial Stability Oversight Council, known as “FSOC,” a creation of the Dodd-Frank Act that shares much in common with the EU’s European Systemic Risk Board.  The original conception of the FSOC was as a collegial council of regulators[9] – an expanded version of the Presidents Working Group on Financial Markets, which had served for over two decades as a consultative group for the harmonization of financial market regulatory policy and the facilitation of communications between U.S. financial regulators. 


FSOC, on the other hand, was given extraordinary regulatory powers, in particular the authority to make a “recommendation” to a member agency to engage in a particular rulemaking, as it did to the SEC with respect to money market mutual funds.[10]  The agency receiving this recommendation must either comply with it, take alternative steps that yield a comparable result, or explain in writing why it has elected not to carry out FSOC’s wishes.[11]  Imposing this requirement on frontline regulators represents an unprecedented interference in the affairs of ostensibly independent agencies and heightens the risk of “regulatory sabotage” – the use of legislative and/or regulatory bodies by one set of market participants to competitively harm another set of market participants.[12]


This is particularly troubling because the FSOC is, by nature, a distinctly partisan body – all of its individual members are handpicked by the President and are generally from the President’s political party.  Bipartisan agencies like the SEC and the CFTC have minority party principals, like myself, but we have no voice at the FSOC, which is composed of only the heads of each agency -- who are under no obligation to represent their agency as a whole.  It is truly an awkward and dysfunctional dynamic.


I don’t mean to suggest that any of these post-crisis regulatory trends are in any way intentionally malignant.  To the contrary, these efforts at so-called “harmonization” are well-intentioned, and, to be clear, I wholeheartedly support efforts to carry out true regulatory harmonization through substituted compliance wherever possible.  But well-intentioned or not, the negative consequences that may flow from these new regulatory trends will have far-reaching economic effects, and will negatively impact the continuing evolution of capital markets around the world.


My friend and former SEC Commissioner Troy Paredes once stated, “I often boil down what we do as regulators to this:  We draw regulatory lines that influence – and sometimes definitively determine – the economic activity that can and will occur.”[13]  That is an awesome responsibility, and regulators should proceed with due caution and a healthy dose of humility.  The aggregate impact of post-crisis rulemakings is positively massive, and the costs imposed on financial markets and market participants – including the investors whom we at the SEC are charged with protecting – are enormous.  It’s also important to be mindful of the fact that we are taking these steps at a point in time when many economies around the world are still fragile and are, at best, only limping towards recovery.


It is incumbent on regulators at all times – but particularly in these times – to favor a careful and methodical approach towards regulation.  We should discard the notion of promulgating sweeping changes that will reshape the face of the financial markets, for we have no idea where such radical and rapid change will take us.  We must not believe that we completely understand the consequences of the regulations that we are imposing, because we do not.  We must, in short, avoid regulatory hubris. 


Instead, we should take an incremental approach to regulation, and we should monitor the impacts of our rules and compare them with the impact assessments made at the time of promulgation.  We should review and refine our rules as markets react to them, and we should recalibrate them as we learn more by gathering and analyzing the relevant empirical data.  If we instead continue to charge ahead with a top-down, coercive approach to regulation and harmonization, we will be taking on risks that we cannot even remotely assess at the present time.


Some would counter that a more coercive approach to harmonization is necessary to avoid a “regulatory race to the bottom” and regulatory arbitrage.  But my direct contacts with regulators and market participants around the world, and particularly in emerging markets, leads me to believe that regulatory arbitrage is not as much of a concern as the harmonists would have you believe.  Instead, I have found that many so-called “emerging market” regulators and market participants have already created intelligent, high-quality regulatory schemes that have accompanied the development of orderly and efficient financial markets in their jurisdictions.  In many cases, they look to the examples of the U.S. and the EU as a starting point for developing their own regimes tailored to their own markets’ needs.  This is a logical and healthy approach to regulation, and it should not be stamped out by an arbitrary call for uniformity.


In fact, so-called regulatory arbitrage can in fact be a useful feedback mechanism for regulators.  To the extent that we over-regulate or mis-regulate in a particular area, it is important for market participants to be able to vote with their feet.  In that way, we will know that we got it wrong and can recalibrate.  But if instead we have a single, uniform, international standard of regulation in that area, then we will be drawing a lasting line that determines what economic activity will and will not occur.  If we get that line wrong in the first instance, then we risk doing serious and widespread harm to the financial markets and the global economy.


Take, for example, the attempts to create a unitary set of banking standards by means of the various Basel Accords. Among other things, these standards classified residential mortgages and residential mortgage securitizations as lower risks than corporate or commercial loans, and gave such mortgages lower risk weightings.[14]  Banks naturally responded to those incentives in constructing their balance sheets, resulting in banks around the world following a similar business strategy, with similar assets held, securitization programs undertaken, and risk models used.[15]


One expert commenter has argued that these “harmonization” efforts led to extraordinary unintended consequences, noting, “Thus, when that business strategy failed catastrophically, the crisis was not restricted to one nation and a few institutions, but was instead worldwide….  The bottom line is this:  when regulators make an error in a globally harmonized framework, they, in fact, can dramatically increase systemic risk.”[16]  Against this backdrop, it may be sensible for all of us to ask whether having harmonized standards is part of the solution or part of the problem, especially when the very same regulators are at it again with Basel III. 


I would like to highlight another dynamic that concerns me about the FSOC, one that could apply equally to international bodies that aspire to harmonize national regulations.  Banking regulators came away from Dodd-Frank with sweeping new authorities and play a significant role in the implementation of FSOC rulemaking and designations.  As a consequence, the strong voices of the banking regulators on the FSOC often drown out the voices of non-bank regulators such as the SEC and the CFTC.


As a result, I have observed a tendency at the FSOC to attack capital markets problems with banking-style regulation.  Take, for example, the FSOC recommendation to the SEC on money market funds.  This recommendation prominently features a capital buffer proposal.[17]  Regulation of capital requirements is a sine qua non for banks, which operate in a principal capacity and are levered institutions.  It makes absolutely no sense, however, to apply those requirements to money market or for that matter, any, mutual funds, which operate in an agency capacity.  Their assets belong to their clients, and they are not acting in a principal capacity.  Additionally, money market funds are not levered, and thus are not afflicted with the risks associated with leverage.  Thus, simply grafting bank-like capital requirements onto money market funds is deeply illogical.


Another expression of this problem is derived from the fundamental, but often ignored, differences between the banking sector and the capital markets on the issue of risk.  If a bank loses the confidence of its depositors, it is on the road to ruin.  As a result, we want banks to take limited risks and we want regulators to be concerned with banks’ safety and soundness.  But in the capital markets, risk plays a completely different role.  Rather than wanting to limit risk, we want investors and other market participants to take risks – informed risks that they freely choose in pursuit of a return on investment.   


Consequently, applying banking regulatory principles to capital markets regulation is a fundamentally misguided approach.  Eliminate the risk of an investment, and you eliminate the opportunity for a return as well.  Any attempt to de-risk the capital markets would only constrain the choices of investors and the financing options of issuers.  This, I fear, is a potential consequence of the dominance of the banking regulators on the FSOC. 


I am also concerned that this approach may take purchase at the international level, through the activities of the G-20, the FSB, and even IOSCO.  In the post-crisis world, it is understandable, even comforting, for regulators to focus on increasing the safety and soundness of financial institutions.  However, that approach can be disastrous for capital markets if it goes too far.  And if this flawed regulatory approach is applied not only in the U.S., but also globally as a result of coercive regulatory harmonization, then I worry that we will be left with capital markets – and economies – that are inefficient and that operate at far less than their full potential.  I think we can all agree that such a state of affairs would not be in anyone’s best interest.


Thank you again for inviting me to speak to you this evening, and for your gracious attention.  I would be happy to answer a few questions.



[1] Ladies and Gentlemen: Good evening. I want to read my entire speech in German, but my German is not very good. So much for seven years of German language study!


[2] In contrast, the Jumpstart Our Business Startups Act was passed with overwhelming bipartisan support in both Houses of Congress.  See Bill Summary & Status, Major Congressional Actions, Jumpstart Our Business Startups Act, H.R. 3606, 112th Congress (2012), available at (Senate vote 73-26; House of Representatives vote 380-41).


[3] European Commission Implementing Decision 2012/628/EU, October 5, 2012, OJ L 274/32 (9 Oct. 2012).


[4] Letter from Hon. George Osborne, Hon. Michel Barnier, Hon. Ikko Nakatsuka, and Hon. Pierre Moscovici to Hon. Gary S. Gensler (Oct. 17, 2012), available at .


[5] See Daniel M. Gallagher, Commissioner, Sec. & Exch. Comm’n, Dissenting Statement Concerning Re-Proposal of Rules Implementing the Credit Risk Retention Provisions of the Dodd-Frank Act (Aug. 28, 2013), available at


[6] See Fin. Stability Bd. Charter art. 1, available at .


[7] Fin. Stability Bd., Overview of Progress in the Implementation of the G20 Recommendations for Strengthening Financial Stability, Report of the Financial Stability Board to G20 Leaders, at 16 (Sept. 5, 2013), available at .


[8] See id. at 24.


[9] See Benton Ives and Phil Mattingly, Geithner Outlines Regulatory Overhaul, CQ Weekly, Mar. 28, 2009, available at 2009 WLNR 6351182 (discussing Senator Dodd’s call for “a council of regulators” that could “watch for systemic risks” with the help of “a professional staff that could analyze systemic risk”); see also Industry Backs Multi-Agency Approach on Risk, Compliance Reporter, May 22, 2009, available at 2009 WLNR 26668110 (noting that certain ex-SEC officials and senior industry professionals “backed a council of regulators approach for overseeing risk”) (noting one idea for “a framework in which a council of agencies could act more as an oversight body than as a regulator”).


[10] See Dodd-Frank Wall Street Reform and Consumer Protection Act § 120, Pub. L. 111-203, 124 Stat. 1376 (2010); Financial Stability Oversight Council, Proposed Recommendations Regarding Money Market Mutual Fund Reform, 77 Fed. Reg. 69,455 (Nov. 13, 2012).


[11] See Dodd-Frank Wall Street Reform and Consumer Protection Act § 120(c)(2), 124 Stat. at 1409.


[12] The example of money market mutual funds is a useful illustration.  These funds were created in the early 1970’s as a response to the prohibition on paying interest on demand deposit accounts at U.S. banks and have been regulated by the SEC ever since.  Over time, these funds grew to the point where they represented a significant alternative to banking products.  I have no doubt that many bank executives – and perhaps some of the regulators who oversee their firms -- would be perfectly happy to see the end of money market mutual funds and reap the benefits of having trillions of dollars of assets flowing from those funds into banks.


[13] Troy A. Paredes, Commissioner, Sec. & Exch. Comm’n, Statement at Open Meeting to Adopt the Joint Final Rule, Joint Interim Final Rule, and Final Interpretations Regarding the Further Definition of “Swap Dealer,” “Security-Based Swap Dealer,” etc. (April 18, 2012), available at


[14] See Roberta Romano, Against Financial Regulatory Harmonization:  A Comment 16 & n.23, available at .


[15] See id. at 16.


[16] Id. at 16-17.


[17] See Financial Stability Oversight Council, Proposed Recommendations Regarding Money Market Mutual Fund Reform, 77 Fed. Reg at 69456, 69469-78.


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