The Network Effects of International Financial Regulation

Courtesy of Hadar Yoana Jabotinsky & Barak Yarkoni*

In our globalized financial markets, the actions of a market participant or regulator in one jurisdiction can have a ripple effect in other jurisdictions, thus making international regulatory cooperation a necessity. International harmonization of financial regulation produces three different kinds of network effects, which we identify and detail in our recent paper: “The Network Effects of International Financial Regulation.” We also demonstrate that network effects contribute to further international coordination of financial regulation.

In the context of financial regulation, the influence of network effects is spread across three dimensions: the regulated markets, the regulated firms, and the regulators themselves. The first dimension relates to overall social welfare: the more jurisdictions that adopt an international standard, the greater the benefits to society as a whole. One example of this effect is the prevention of ‘forum shopping’ by regulated firms; whereby firms seek to locate operations in jurisdictions with lax standards. Each reduction in forum shopping enables all other local markets to strengthen their regulatory standards.

The second dimension where network effects play a role is when regulated firms benefit from compatibility with other regulated firms operating under the same standards. Here, network effects create economies of scope and scale for market participants.

The third dimension where network effects come into play is when a financial regulator or a local politician benefits from belonging to a network. An example is when a regulator relies on the accumulated experience of other financial regulators in her network, thus saving her the learning costs of drafting and implementing new regulations.

Not all network effects are positive; the increasing severity of herding – where firms engage in the same activities or hold nearly identical assets in response to regulation – is an example of a negative network effect which can lead to value destruction. Once financial standards are harmonized, and local barriers are lifted, the market becomes more integrated, and herding is no longer restricted to a specific jurisdiction. The rapid and insidious spread of such phenomena makes it a prime example of negative network effects.

A formal model is also useful in describing the conditions needed to induce local jurisdictions (states) to sequentially adopt an international financial regulation (IFR). The significant positive network effects of an IFR compel local states to consider how many other states have already adopted the IFR and how many states will do so in the future. Each new state that decides to adopt the IFR will increase the value of the IFR for all other states. In turn, this will induce additional states to adopt the IFR. Thus, network effects create a sort of a ratchet effect that gradually increases an IFR’s value for adopting states. We therefore present the formal conditions required for the adoption of an international standard by all states.

 

* Tel Aviv University, Israel.

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