Why G20 should plug regulatory arbitrage

Regulatory arbitrage can undermine the effectiveness of regulatory frameworks, create competitive imbalances, and increase the risk of financial instability

Regulatory arbitrage has long been a concern for global financial regulators, and for good reason. The practice of financial institutions in exploiting differences in regulatory frameworks across different jurisdictions to gain a competitive advantage has the potential to destabilise the global financial system, and undermine the efforts of regulators to protect consumers and ensure market stability. Ultimately, the risks posed by regulatory arbitrage can only be addressed through a collaborative effort by regulators, financial firms, and other stakeholders.

As leaders of the world's largest economies, the G20 has a critical role to play in addressing the issue of regulatory arbitrage. This practice of exploiting differences in regulatory frameworks across different jurisdictions to gain a competitive advantage poses significant risks to the global financial system, and undermines the efforts of regulators to protect consumers and ensure market stability.

The G20 finance track is an important component of the G20 summit process, which brings together finance ministers and central bank governors from the world's largest economies. However, there is no formal working group on the financial sector issues under the aegis of the G20 Finance Track. The key areas discussed by the central bankers under the financial sector issues include strengthening global financial system resilience, prudential oversight, improving risk management.

At its core, regulatory arbitrage involves taking advantage of gaps, loopholes, or inconsistencies in regulatory frameworks across different jurisdictions. By doing so, financial firms can reduce their regulatory costs, avoid compliance requirements, or engage in activities that may be prohibited in their home jurisdiction. The result is often a race to the bottom, with regulators in different jurisdictions competing to attract business by offering more favourable regulatory frameworks. Regulatory arbitrage is a complex and multifaceted issue that requires a more granular analysis to understand its implications for the global financial system. This can take many forms, including:

1. Capital Requirements: Financial firms may engage in regulatory arbitrage by moving their operations to jurisdictions with lower capital requirements. This allows them to reduce their capital costs and increase their leverage, which can lead to greater profitability but also increases the risk of financial instability, both for the firm and the economy at large.

2. Taxation: Regulatory arbitrage can also be used to reduce tax liabilities. Financial firms may establish subsidiaries in jurisdictions with lower tax rates or engage in transfer pricing to shift profits to jurisdictions with more favourable tax regimes.

3. Regulatory Compliance: Financial firms may engage in regulatory arbitrage by avoiding compliance with certain regulatory requirements. This can include avoiding disclosure requirements or engaging in activities that are prohibited in their home jurisdiction.

4. Supervision: Regulatory arbitrage can be used to evade regulatory supervision. Financial firms may move their operations to jurisdictions with less stringent regulatory oversight or engage in regulatory arbitrage by using complex legal structures that make it difficult for regulators to track their activities.

The consequences of regulatory arbitrage can be significant. It can undermine the effectiveness of regulatory frameworks, create competitive imbalances, and increase the risk of financial instability. In addition, it can erode public trust in the financial system, and lead to calls for greater regulation and oversight.

The G20 must take a proactive and co-ordinated approach to address regulatory arbitrage. This includes developing common standards for regulatory frameworks across different jurisdictions, enhancing regulatory co-ordination and information-sharing, and strengthening oversight and enforcement mechanisms. In addition, the G20 must promote greater transparency and accountability among financial firms, and encourage responsible business practices that promote long-term sustainability and stability.

Ultimately, the G20 must work collaboratively with financial firms, regulators, and other stakeholders to address the risks associated with regulatory arbitrage. By taking a proactive and co-ordinated approach, the G20 can help to promote a more stable and sustainable global financial system, one that serves the needs of consumers and businesses alike.

(Srinath Sridharan is an author, policy researcher, and corporate adviser. Twitter: @ssmumbai)

Disclaimer: The views expressed above are the author's own. They do not necessarily reflect the views of DH.