1. Comparative Legal Traditions University of Trieste 20 April 2016 The power of Soft Law How to regulate global financial markets with non-binding legal standards Luca Amorello (ESRB Secretariat) Disclaimer: The views here expressed are mine and do not necessarily represent the views of the ESRB

2. 2 Outline Soft Law and Financial Markets A possible definition of Soft Law The Global Financial System as a construction of Formal and Informal Rules The use of Soft Law in International Financial Regulation Why is Soft Law prevalent in Finance? Global bodies and International Institutions for Financial Stability The ‘European Systemic Risk Board’ as a case study The Hierarchical Structure of Financial Supervisors in Europe; Systemic Risk and Regulatory Framework; The Mandate of the ESRB: Macroprudential Policy & Financial Stability Oversight Legal instruments: Recommendations and Early Warnings The ‘Comply or explain mechanism’ ‘The Power of Soft Law’ explained. EFC Financial Stability

3. The generic term soft law covers a wide range of instruments of different nature and functions that make it very difficult to contain it within a single formula. It constitutes an infinite variety. (T. Faiardo) In general, one can argue that Soft Law refers to rules that are neither strictly binding in nature nor completely lacking legal significance. (Black’s law Dictionary) In the context of international law, soft law refers to guidelines, policy declarations or codes of conduct which set standards of conduct. However, they are not directly enforceable. One can also understand soft law as a composite network of policy statements couched in the normative mood, where the expectations of international authorities and bodies are publicly disclosed and communicated to market actors. Market actors are incentivized to comply with this informal legal layer as the policy statements represent the new standards of the international economic order. A possible definition of Soft Law 3

4. National regulators and private market participants have developed an array of informal global networks aimed at the creation of common cross-border formal and informal rules for disciplining the global financial system. These networks ranged from private bodies, like ISDA and ICMA to more procedurally complex, government-affiliated bodies staffed by national regulators, such as the BCBS, IOSCO and IAIS. For example, networks like BCBS, IOSCO, and IAIS are hybrid bodies that assembled central bank, securities, and insurance regulators, respectively, to develop industry standards on a global, cross-border basis. These bodies reflect the persistent and dominant role of national authorities in directing financial rulemaking, while permitting the informal development of common regulatory approaches, standards, and principles on a transnational level. These bodies are ‘soft-law bodies’ as they lack legal personality, issue largely nonbinding standards, and permit significant variations in implementation across jurisdictions. However, because these bodies bear the imprimatur of national authority, there is at least some expectation that member nations will implement some version of the standards they promulgate. See: Barr (2014) The Global Financial System as a construction of Formal and Informal Rules 4

5. Best practices in contemporary global finance have not emerged through positive, prescriptive lawmaking within a single, hegemonic nation-state and the de facto export of that nation’s regulatory standards to the rest of the world. International financial standards are even less likely to be developed through a rigid process of formal lawmaking within a treaty-based international organization. Instead, the decentralized network of global financial actors with diverse, broadly distributed responsibilities engages in cycles of reciprocity and retaliation as a cooperative method of developing international financial law. Over the long run, uncooperative, self-interested regulators can expect to lose the assistance of other actors within the international financial system. The enforcement mechanisms of international financial law closely resemble the reputational tools that financiers, traders, and other private actors routinely use to patrol self-dealing and enforce socially beneficial norms within their own communities. The thin shell of hard formality in international financial law adds the threat of institutional sanctions, such as the denial or withdrawal of membership in an international organization.. See: Chen (2011) The use of Soft Law in International Financial Regulation 5

6. To sum up :  “International financial regulation is mainly a system of “soft law” – meaning standards, guidelines, interpretations and other statements that are not directly binding and enforceable in accordance with formal techniques of international law but nevertheless capable of exerting powerful influence over the behaviour of countries, public entities and private parties”. There are several reasons for that: International organisations, in particular the IMF and World Bank, can exert pressure on countries to adopt internationally-recognised standards and codes by using them as benchmarks in international assessments and reporting on the extent to which countries observe them. A state’s compliance with “best practice” international standards can result in lower funding costs for its sovereign debt and more favourable financing terms for its financial institutions. Market incentive-related reasons may lead banks and other regulated firms to adopt soft international standards, even when the country in which they are based has not implemented them, because they will want to signal to the global market that they adhere to the latest, most sophisticated models that have received the approval of the FSB and other international bodies. Why is Soft Law prevalent in Finance? 6

7. Soft law expands the international regulatory toolkit. Hard law ordinarily gives rise to enforceable obligations and therefore has to be reasonably certain and predictable so that people can determine what is expected of them. Soft law, not being directly enforceable, can be more open-textured. This means that some international standards may be articulated at too high a level of generality to be immediately operational and will need to be supplemented by more detailed rules enacted at national or supranational level to make the position more concrete and to ensure practical effectiveness. Soft institutions are often praised for their flexible decision-making structures. Often comprised of a limited number of participants, they are seen to be able to react quickly to changing circumstances, which, in a field as dynamic as international financial market regulation, can be a particularly valuable characteristic. These institutional features lead into a further perceived advantage of the soft law concept, namely, that it is a mechanism that can be superior to hard law-making processes in meeting the need for regulation that can be changed and adapted in response to the ever-evolving, highly complex interactions of the modern world. The capacity for soft law to be changed more easily than hard law may foster willingness to “try out” regulatory innovations in circumstances of uncertainty; if the experiment “works”, this can, in turn, lead to a stabilisation of expectations in that area. 7

8. Global bodies and International Institutions for Financial Stability 8

9. The ‘European Systemic Risk Board’ as a case study 9

10. In the aftermath of the financial crisis, steps are being taken to harden some aspects of financial supervision and also to confer legal enforceability on standards developed by supervisors rather than by the EU institutions. The financial crisis has created political momentum for reforming the structure of European financial supervision and regulation. The European Systemic Risk Board is part of the new supervisory structure. The ESRB's role is to monitor and assess systemic risks – individual banks and the whole European financial system. What is systemic risk? ‘Systemic Risk’ means a risk of disruption in the financial system with the potential to have serious negative consequences for the internal market and the real economy. All types of financial intermediaries, markets and infrastructure may be potentially systemically important to some degree. As a soft law body without legally-binding powers, the ESRB structure finds a way around the strict limits on the powers that can be delegated to regulatory agencies in the current Union legal order. These limits are that agencies cannot be empowered to adopt general legislative acts and cannot be granted decision-making power in areas in which they would have to arbitrate between conflicting public interests, exercise political discretion or carry out complex economic assessments. Systemic Risk and Regulatory Framework 10

11. The ESRB is responsible for the so called macro-prudential oversight of the financial system within the Union in order to contribute to the prevention or mitigation of systemic risks to financial stability in the Union that arise from developments within the financial system and taking into account macro- economic developments, so as to avoid periods of widespread financial distress. It shall contribute to the smooth functioning of the internal market and thereby ensure a sustainable contribution of the financial sector to economic growth. The tasks conferred on the ESRB cover: –data collection and analysis; –systemic risk assessment and prioritisation; –issuing systemic risk warnings and recommendations for remedial action and monitoring follow-up –issuing confidential warnings to the Council of impending emergencies; –co-operating closely with the other parties in the ESFS and working with the ESAs in the development of quantitative and qualitative indicators to identify and measure systemic risk; –coordinating with international institutions and relevant bodies in third countries on matters related to macro-prudential oversight; and other related tasks as specified in EU legislation. The Mandate of the ESRB: Macroprudential Policy & Financial Stability Oversight 11

12. The ESRB is empowered to issue general or specific warnings, or recommendations addressed to the Union as a whole, to one or more Member States, to one or more of the ESAs, or to one or more national supervisory authorities. Recommendations may also be addressed to the Commission in respect of EU legislation. The ESRB may not address financial firms directly: that remains the responsibility of Member States, under the oversight of the ESAs. Although ESRB recommendations and warnings are not binding in themselves, there is considerable indirect reinforcement. First, there is a specific “act or explain” obligation on all recipients of ESRB recommendations. If the ESRB is dissatisfied with the action taken or the explanation for inaction, it can refer the matter to the Council, the Chair of the European Parliament’s Economic and Monetary Affairs Committee and, where relevant, the ESA concerned. Legal instruments: Recommendations and Early Warnings 12

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15. The ‘comply or explain mechanism’ 15

16. Do EU countries comply with ESRB Recommendations? 16

17. The power of soft law in finance lies into a “Name and Shame” mechanism. This power has considerable potential force notwithstanding the fact that it is a “soft” sanction. If a country does not comply with a Soft Law measure which is recognized by the financial community as badly needed market-destabilising effects of public announcements can occur. This is particularly true for Sovereigns and National Authorities. And this also explains why International financial law departs from traditional public international law. The informal rules in finance can in fact be ‘harder’ than its soft-law quality suggests. Although non-binding these rules are able to influence market behaviors and discipline financial interactions. This feature helps explain why international financial rules, though technically non-binding, are often relied upon. ‘The Power of Soft Law’ explained 17

18. Michael S. Barr (2014) Who's in Charge of Global Finance? Geo. J. Int'l L. 45, no. 4 (2014): 971-1027. Chris Brummer (2011) Soft Law and the Global Financial System Rule Making in the 21st Century, Cambridge University Press. Rolf H. Weber and Dominic N. Staiger (2014) Financial Stability Board: Mandate and Implementation of Its Systemic Risks Standards. Int. J. Financial Stud. 2014, 2, 82–102 Eilis Ferran & Kern Alexander (2011) Can Soft Law Bodies be Effective? Soft Systemic Risk Oversight Bodies and the Special Case of the European Systemic Risk Board. University of Cambridge Paper No.36/2011. Michaela Posch and Remco Van der Molen (2012) The macro-prudential mandate of national authorities. ESRB Macroprudential Commentaries, Issue No. 2. Relevant Bibliography 18

19. 19 Personal contacts: Email1: lucamorale@gmail.com Email2: lamorello@llm17.law.harvard.edu Skype: luca.amorello Linkedin: https://de.linkedin.com/in/luca-amorello-89182276