The history of finance, and the recent history in particular, shows that in periods of political and economic stress financial authorities are particularly prone to sacrifice the benefits of international cooperation for the lure of short-term national gains, often to the detriment of global financial stability. A question therefore arises as to why financial nationalism is so appealing and which risks it poses for the global financial system. In my recent book, The Logic of Financial Nationalism, I aimed to analyse this phenomenon from the perspectives of political economy and international law.
If we look at financial nationalism through the lenses of law and economics, the weaknesses of current international financial law are immediately clear, especially when it comes to reducing the risks of cross-border crises and incentivizing globally optimal solutions. In order to understand why, it is useful to make a comparison with the role of regulation in national financial systems. Modern financial systems are structured as networks made by a constellation of diverse entities that, for a variety of reasons, are highly interdependent. This means that a problem in one node of the financial network can easily transmit instability to others and therefore endanger the entire financial system. Regulation plays a fundamental role in containing systemic risks. In order to participate in a common and interconnected financial system, financial institutions must indeed comply with rules that force them to internalize the social costs of their actions, thereby modifying their behaviour towards the socially optimal.
When we move to the role of international law in the international financial system, however, the situation is very different. Since the 1970s, financial systems have progressively internationalized and become interdependent to the point that a problem in one country can now easily be transmitted across borders and affect other states. The push for deeper integration was not, however, always accompanied by a parallel push for real international policy coordination. From a political economy perspective, financial authorities are bound by a principal-agent relationship with their domestic stakeholders that forces them to put domestic interests above everything else. Given the costs that come with global cooperation, for instance during cross-border banking crises or in the process of regulatory harmonization, it is clear that there are few incentives for international coordination. In an interconnected global financial system, one would expect international law to require states to take into account the global implications of their policies, and internalize the social costs of their actions. Surprisingly, however, this logic does not fully apply to states.
The status quo in international financial law is full financial sovereignty. For instance, despite the evidence of dangerous loops between banks and sovereigns, outside the European Union there are no international rules on fiscal sustainability. Despite the recent reforms on bank resolution frameworks, there is little evidence that resolution authorities will forget their national interests to cooperate during a crisis. Even when states have agreed to reduce their sovereignty in favour of a more coordinated approach, they are, nonetheless, protected by various legal doctrines that have the ultimate goal of protecting the strict bond between the regulators and their citizens. For instance, most of the international rules on regulatory cooperation are in the form of soft laws. This means that, ultimately, states can renounce them at any time if they consider it necessary to protect their own political interests. Regulators cannot resort to international law to challenge another regulator’s failure or refusal to cooperate, thus leaving the solution of regulatory disputes to pure power politics. In the few cases in which rules are binding, international law sometimes dispenses states with their obedience whenever doing so would impair an essential state interest. In sum, despite the rhetoric of regulatory cooperation, in the international law of finance what really matters is not the protection of social goals, but rather the safeguarding of national interests. In other words, in international finance, the logic of stability often gives way to its opposite: the logic of financial nationalism.
Most of the solutions proposed by the literature to the challenges of global financial stability focus either on a reduction in the level of financial integration, or on the entire dismantling of financial sovereignty in favour of a centralized international regulator. In contradistinction to these solutions, the strategy that I discuss in my book focuses on the role of (binding) international law and international courts. First, I argue that international agreements should increase the power of foreign stakeholders in driving international financial policymaking – for instance, by giving them rights and standing in international courts, similar to what international law does already in international trade or investment agreements. Second, I propose to change the political economy bargain at the basis of financial integration in favour of a system that grants market access to foreign firms only when their home states agree to a binding code of conduct that guarantees regulatory and policy cooperation. I call this approach ‘Regulatory Passporting’. By leveraging on the desire of nation states to access foreign markets, this strategy forces states to adopt a binding regulatory framework that reduces regulatory frictions and, therefore, global instability.