The Domestic Politics of Financial Regulation: Informal Ratification Games and the EU
The Domestic Politics of Financial Regulation: Informal Ratification Games and the EU Capital Requirement Negotiations
Dr Scott James
Department of Political Economy
King’s College London
Abstract
This paper contributes to our understanding of post-crisis financial regulation by reasserting the centrality of domestic politics in defining government preferences and explaining regulatory outcomes. It draws on Robert Putnam’s two-level game approach and Foreign Policy Analysis to develop a model of a three-level informal ratification game. This adds value to existing approaches by capturing the contested nature of government preferences and delineating the causal mechanisms through which domestic groups shape international negotiations. The model is used to explain the UK’s pivotal role in the reform of bank capital requirements in the European Union (EU). It demonstrates that governments are able to take advantage of a narrowing domestic ‘win-set’ by marginalising the influence of industry and building political momentum for regulatory reform. In particular, the paper shows how UK negotiators were able to exploit the increased domestic costs of agreement and synergistic strategies between negotiations to successfully oppose the maximum harmonisation of capital rules across the EU.
Introduction
Since the financial crisis there has been a surge of regulatory reform initiatives aimed at strengthening financial stability. This has given rise to a variety of theoretical perspectives which seek to understand the role of regulators and industry in these negotiations. The paper contributes to this literature by reasserting the centrality of domestic politics in defining government preferences and explaining regulatory outcomes. It does so by addressing three questions. How do domestic groups influence government preferences on financial regulation? What domestic constraints do government negotiators face? How does domestic politics impact on the bargaining power of governments?
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These are examined by analysing the UK’s role in the negotiation of the EU Capital Requirements Directive IV (CRD IV). Following international agreement on bank capital rules in the Basel 3 accord in 2010, the European Commission published legislation establishing a Single Rulebook for capital definitions and capital levels. This was eventually agreed in the EU Council of Ministers in May 2012 and endorsed by the European Parliament in February 2013.[i] In parallel the UK established the Independent Commission on Banking (ICB) to explore options for wider structural reform. Throughout the UK championed much tougher definitions of capital and the higher capital requirements. But the outcome of the CRD IV negotiations was mixed. On capital definitions the UK encountered significant resistance from France and Germany whom successfully diluted the capital definitions by allowing state support (‘silent participation’) and insurance subsidiaries (‘double counting’) to be excluded in the calculation of regulatory capital. On capital levels, UK regulators were highly critical of the Commission’s proposal for maximum harmonisation: this broke with Basel 3 by legislating for both a minimum and maximum level of capital, thereby prohibiting national regulators from unilaterally imposing higher requirements on their own banks. Eventually however the UK successfully negotiated a legal carve out providing the flexibility to vary capital levels without prior approval from the EU. This paper explains how the UK secured this notable victory in the face of concerted opposition from the Commission, most EU Member States and the financial services industry.
The UK offers a valuable case study in four respects. First, as host to one of the world’s leading international financial centres, the UK offers an important test case of how and why powerful domestic financial interests shape government preferences and regulatory outcomes. Second, since the financial crisis UK government preferences on regulation have undergone a significant shift, with the UK adopting one of the world’s toughest stances on bank capital. It therefore allows us to assess the claim that negotiating positions reflect the balance of power between different domestic groups. Third, in addition to being at the forefront of international regulatory reform efforts, the UK has unilaterally embarked on its own banking reform process. This provides an ideal opportunity to analyse how domestic reform processes impact upon multi-level negotiations by reshaping government preferences, negotiating strategies and/or bargaining power. Finally, the role of the UK was pivotal in leading opposition to maximum harmonisation and decisive in forging the final agreement on CRD IV despite being isolated. The case study therefore sheds new light on why some countries risk becoming ‘outliers’ by opting to go beyond international regulatory commitments.
The paper draws upon two frameworks to embed domestic politics at the centre of our theoretical approach. First, the paper uses Robert Putnam’s two-level game approach to model the negotiations on capital requirements as a three-level informal ratification game (Putnam 1988). Second, the process of government preference formation is conceptualised using Foreign Policy Analysis (Allison and Halperin 1972, Welch 1992). The value of the model is then tested by explaining the UK’s role in reforming EU capital requirements (the dependent variable) through the structure of the political process and the configuration of domestic group preferences (the independent variable).[ii] The paper concludes by reflecting on the value added of the theoretical approach presented here.
Theoretical approaches
A variety of theoretical perspectives have been used to explain post-crisis financial regulation. Comparative political economy (CPE) approaches emphasise the institutional configuration of national economic systems. The Varieties of Financial Capitalism (VoFC) framework suggests that governments will seek regulatory agreements that protect the comparative institutional advantage of industry (Zysman 1983). Applied to the EU level, government preferences on CRD IV derive from the institutionally-embedded features of national banking systems and the distributive implications of the Basel 3 reforms. According to Howarth and Quaglia, UK regulators had an economic incentive to upload tough capital rules to create a level playing field at the EU level because UK banks were better capitalised than their French and German counterparts by 2010 (Howarth and Quaglia 2013: 337). This would give the UK a potential competitive advantage because the adaptational cost of compliance would be low.
VoFC accounts present a structurally-deterministic explanation of government preference formation for two reasons. First, they conflate the UK’s support for tougher EU capital rules with its opposition to maximum harmonisation. It is not clear from a CPE perspective why the UK insisted on the right to unilaterally impose higher capital standards on its own banks once it became apparent that the EU’s proposals would be significantly weaker. In opposing the creation of a level playing field, UK regulators signalled their determination to prioritise financial stability over international competitiveness (Howarth and Quaglia, forthcoming). Second, the assumption that policy makers seek to preserve the competitiveness of domestic industry leads it to assume that the preferences of government and industry must be aligned and relatively fixed. In reality preferences are constantly in flux and contested due to disagreement or uncertainty about the impact of proposed regulations. VoFC accounts are therefore inadequate as an explanation of why the UK successfully opposed maximum harmonisation in CRD4 in defiance of the preferences of its own banking industry.[iii]
International political economy (IPE) perspectives provide a valuable qualification by underlining that economic interests do not predetermine regulatory stances. In negotiating financial regulation, governments face a dilemma between domestic stability and international competitiveness, the resolution of which will not only reflect economic interests but also the beliefs and values of policy makers (Kapstein 1989). Similarly Young (2012: 663) argues that the variability of regulatory outcomes often reflects the heterogeneity of industry preferences, divisions amongst interest groups, and the discretion, autonomy and resources wielded by national regulators.
The business power literature helps to further clarify the sources and limits of industry influence in the policy process. Culpepper (2012) argues that political salience is a key determinant of business power: under low salience, industry can rely on the ‘quiet politics’ of access, networks and knowledge to influence government; but under high salience, industry is weakened as governments seek wider sources of public legitimacy for their policy stances. Applied to financial regulation, Woll (2012) finds that salience can enhance the negotiating autonomy of national regulators because governments are able to build broader domestic coalitions of support which accord with their wider geopolitical objectives. Despite this, Bell and Hindmoor (2014 forthcoming) argue that these accounts give insufficient attention to governmental actors in mediating the structural power of big business.
In short, there remains a gap in the literature explaining when, why and how domestic politics matters. Specifically, a systematic framework is needed for disaggregating competing political and bureaucratic interests at the domestic level and specifying the causal process through which they shape government preferences and bargaining power in multi-level regulatory negotiations. The paper seeks to add value by drawing upon international relations (IR) approaches to complement existing CPE, IPE and business power perspectives by reasserting the importance of domestic politics in international financial regulation.
The importance of domestic politics
To embed explanations of financial regulation in an account of domestic politics, the paper revises the two-level game model. Putnam’s main insight is that at the international level, governments seek to maximise their ability to satisfy domestic pressures, while minimising the adverse impact of international agreements (Putnam 1988: 434). The influence of domestic groups rests on the extent to which their support is needed in order to implement the agreement at the national level. This support includes both formal parliamentary ratification as well as informal consent from powerful interest groups (Putnam 1988: 436).
Two-level game analysis has been widely applied to intergovernmental bargaining on treaty revisions and trade negotiations (for example, see Milner 1997). But the theory is less developed in its application to parliamentary systems and divided government where domestic constraints are less clearly defined (Mo 1994, Pahre 2006). Analysis of EU decision making poses a further challenge because national governments lack formal veto power: at both the decision-making stage because of the use of qualified majority voting (QMV) in the Council of Ministers; and at the ratification stage as most EU legislation is legally binding (Johannson 2013, Pakull 2013). The main mechanism through which domestic constraints impact upon international negotiations – the right of governments to defect – is therefore absent. Yet it is clear that domestic constraints do matter. Recent research has shown that member states use the communication of domestic constraints as a tactical device to signal commitment and credibility, to transmit information about issue salience, to extract concessions through implicit threats, or as an exercise is suasion to influence negotiations (Bailer 2011). Moreover, the recurrent nature of Council negotiations means that the overwhelming majority of decisions are still reached by consensus (Heisenberg 2005). The EU therefore forces us to identify different mechanisms through which domestic constraints shape government preferences and negotiating strategies in the Council.
Informal ratification games
Recent studies have refined the two-level game approach in the absence of formal ratification. Pahre (2004) argues that we can add rigour to the analysis of ‘informal ratification games’ by modelling the domestic constraints on international negotiations. Governments must remain attentive to the views of domestic groups as dissatisfaction with agreements can impose significant costs (Fearon 1994). The paper contributes to this theoretical development by proposing that costs derive from three sources. The first originates from groups outside government (‘audience costs’). In opposition to an agreement powerful domestic interest groups may mobilise by lobbying government, withdrawing political funds and/or hampering implementation, thereby undermining governing competence or popularity. More broadly public disapproval can impact directly on government stability if it leads to anticipated or actual electoral losses, internal party disunity and political paralysis. The desire of political leaders to retain power will therefore force them to anticipate the reaction of interest groups during negotiations and avoid agreements that will get them into electoral trouble (Milner 1997: 61).
A second group of costs derive from the fixed costs of the domestic governing coalition (‘coalition costs’). Foreign Policy Analysis alerts us to the fact that government is composed of distinct political interests which compete to influence government preference formation (Welch 1992). This paper differentiates between three groups – government (ministers), parliament (parties), and bureaucrats (regulators) – which have their own preferences, wield autonomous sources of power (executive authority, electoral legitimacy and administrative resources) (Allison and Halperin 1972), and impose different constraints on negotiators. Hence negotiators are unlikely to sign any agreement that threatens government unity (by undermining multi-party coalition agreements), its broader parliamentary position (for example, if it leads to calls for no-confidence votes) or important sources of bureaucratic support (such as administrative resources and legitimacy).
The final set of domestic constraints are rooted in the costs of having to undo, amend or abandon existing domestic reforms to which governments have embarked (‘sunk costs’). In Putnam’s model the causal mechanism of domestic constraints rests on the ability of negotiators to block international agreements. Less is known however about the reverse: international agreements that threaten to block or delay domestic reforms. In this instance domestic constraints do not derive from the risk of defection, but rather from the need to secure domestic agreement on changes to existing reforms in order to fit with international level commitments (Milner 1997: 73). Any domestic reform process that ‘locks in’ a particular policy trajectory prior to international agreement being reached will potentially constrain negotiators’ room for manoeuvre. By reversing Putnam’s model, this offers the potential to shed new light on how governments utilise political momentum at home to shape international negotiations.[iv]
Having identified three causal mechanisms through which domestic constraints impact on negotiations in informal ratification games, it is possible to generate a series of theoretical hypotheses. Schelling’s ‘paradox of weakness’ tells us that negotiators can exploit domestic constraints to strengthen their bargaining position and shape the distribution of joint gains in international agreements (Schelling 1960). It follows that:
H1. The bargaining power of international negotiators will be strengthened by increasing
audience costs, coalition costs and sunk costs at home.
The two-level game approach hypothesises that the likelihood of international agreement is determined by domestic ‘win-sets’: the range of possible outcomes that domestic groups are willing to support (Putnam 1988: 437; Moravcsik 1993: 23). Two factors determine the size of domestic win-sets. First, the win-set reflects the costs of no agreement to different groups: as these costs approach zero, so groups are less likely to support any agreement which diverges from their ideal position. The second factor is the distribution of preferences amongst groups. If they have similar preferences, the win-set will be smaller: this makes international agreement less likely but (according to Schelling) strengthens the bargaining power of negotiators. Counter-intuitively, divergent preferences force governments to balance the competing interests of divided domestic groups which will widen the win-set: this facilitates agreement but undermines negotiating influence (Putnam 1988: 444-5).
Negotiators also have their own preferences, defined by the ‘acceptability-set’ of agreements that they are willing to sign up to (Moravcsik 1993: 30-1). If a negotiator’s acceptability-set is within the wider win-set, the negotiator as ‘agent’ simply articulates the preferences of domestic groups with whom they are aligned. Alternatively the preferences of negotiators and domestic groups may be misaligned: a negotiator’s acceptability-set may lie partially outside the domestic win-set and closer to the opposing win-set (negotiator as ‘dove’) or further from the opposing win-set than the set of agreements supported domestically (negotiator as ‘hawk’). In either case negotiators have an incentive to expand the domestic win-set in order to reach an agreement that they themselves are willing to sign up to. Conversely domestic groups with preferences opposed by their own ‘hawkish’ government may forge transnational alliances with counterparts in other states. This is intended to facilitate agreement closer to their ideal position by narrowing the foreign win-set and thus strengthening the government’s opponents (Moravcsik 1993: 32).
H2. In response to domestic divisions, negotiators will seek to expand the domestic win-set by building domestic support.
H3. In response to domestic divisions, interest groups will seek to narrow the foreign win-set by building transnational alliances.
Figure 1
Finally, the Putnam framework considers the interdependency of negotiations at different levels. Foreign Policy Analysis alerts us to the importance of political agency in mediating this ‘reverberation’ effect. In particular, simultaneous negotiations provide scope for political entrepreneurs within government to exploit synergistic strategies to further their party-political or bureaucratic interests. This may involve using issue linkages at different levels in an effort to shape government preferences and alter the bargaining power of negotiators (Schoppa 1993: 354). In doing so political entrepreneurs can manipulate the domestic win-set: to improve the prospects for reaching agreement by deliberately expanding the domestic win-set (‘cutting slack’); or conversely, by strengthening bargaining power by increasing domestic constraints and so narrowing the win-set (‘tying hands’) (Moravcsik 1993: 24-30).
H4. Political entrepreneurs within government will exploit synergistic strategies to further their own interests.
The model developed here (figure 1) is used to conceptualise the negotiations on capital requirements in the Basel Committee on Banking Supervision (BCBS), the EU Council of Ministers, and the UK Independent Commission on Banking (ICB). This requires us to model the process as a three-level informal ratification game at the international (Level 1), European (Level 2) and domestic (Level 3) levels. In order to explain the impact of domestic politics on financial regulation, we examine the UK’s role in regulatory reform at each level.