David Andrew Singer writes a very interesting account of the history of efforts to build an international framework for securities regulation in his book Regulating Capital: Setting Standards for the International Financial System. The International Organization of Securities Commissions (IOSCO) was tasked with the goal of setting minimum standards for the prudent supervision of securities dealers world wide. The IOSCO failed to reach an agreement and efforts were abandoned by 1992.

However, regulators started to realize that international standards needed to be in place in the mid-80s with the dramatic increase in the operations of brokerage houses across national borders. In 1979 annual international securities transactions amounted to $73 billion; by 1990 that amount had risen to $1.5 trillion. An interesting motivating factor for the increase was the demise of the Bretton Woods (fixed exchange rate regime) and the increased desire of institutional investors to take advantage of international market movements. The task was facilitated by the rapid development of computers and telecommunications. It was the market crash of 1987 that the regulators realized the consequences of these massive international flows.

The UK was particularly hard hit by the 1987 crash which was due to the decision by the British government to privatize their stake in British Petroleum, worth approximately 7.25 billion pounds. The market crash caused many of the underwriters in the transaction to take substantial losses. The UK pushed hard for greater oversight but brokerage firms in the City faced ever increasing competition from US brokerage houses that were better capitalized and faced a different regulatory regime. The rules introduced in Europe and the UK focused on consolidated entities – much like in Canada – whereas in the US securities dealers had to comply with the Net Capital Rule, but this was not applied on a consolidated basis.

This regulatory difference gave the US dealers a comparative advantage. Derivatives became increasingly important in the financial world and US brokerage houses were able to set up subsidiaries that dealt in derivatives that were essentially unregulated, meaning they didn’t have to set aside any regulatory capital. The collapse of Drexel Burnham Lambert and the junk bond market made the US reevaluate the oversight of brokerage firms – as Drexel moved much of their regulatory capital out of the regulated section of their firm and into the unregulated holding company – however it resulted only in increased disclosure requirements for securities firms.

The issue of consolidated reporting between the US and Europe emerged as an issue and the European Union passed a rule in 2004 allowing European regulators to oversee the risk of both investment banks and holding companies. The SEC, in response, allowed investment banks with $5 billion in capital or more to be regulated using internal models as consolidated entities – thus gaining an exemption from the EU regulatory requirements. An interesting result for firms electing to join the alternative regime was that under the new program investment banks would no longer be subject to the Net Capital Rule (a leverage of 12 to 1). The five banks that elected to switch: Bear Stearns, Lehman Brothers, Merrill Lynch, Goldman Sachs, and Morgan Stanley. Do you wonder why we now have a worldwide Banking and Stock Market Crisis!