policymakers demonstrate

Financial Regulation in Europe: Foundations and Challenges 499
number of affiliates and the share of nonbank activity are positively correlated
with the size of the parent bank, measures of business and geographic complexity
are not. Complexity is thus a bank characteristic, which is not completely
correlated with size; in addition to the challenge of too-big-to-fail, there is thus
the challenge of too-complex-to-resolve.
Not just financial institutions, but also the regulatory framework has grown
in complexity over the past decade, with the Basel II capital regime being a
watershed. Hakenes and Schnabel (2014) use a theoretical model to show that
it is in banks’ interest to push complex regulation, in what they refer to as ‘regulatory
capture by sophistication’. Specifically, in a world where regulators are
less well paid than bankers and with a variation in skills across regulators, regulators
might be swayed to rubber-stamp banks’ risk models in order not to
have to admit that they do not understand these risk models. This allows banks
to hold less capital than required. This trend towards sophistication and the
resultant capture have been exacerbated by the Basel II regulatory framework,
which allowed the use of banks’ internal risk model to compute risk weights
for different asset classes. However, this phenomenon becomes more critical
if the regulator has discretionary power, such as under pillar II of Basel II.
It is important to note that this type of regulatory capture by sophistication
is somewhat different from the regulatory capture due to conflict of interest,
social connection (rotating door), political interference or lobbying activity by
banks.
Related to the trend towards complexity is the increasing globalization of
banks, with leading global banks active across a large number of regions and
countries. In addition, over the past decade there has been a trend towards
regional banks, that is, Latin American and African banks reaching out across
their respective regions. This poses additional challenges for supervisors in
terms of cooperation across borders. While this topic is somewhat outside the
current survey, it is important to be flagged.
Overall, the financial sector and, with it, the financial regulation are becoming
more and more complex over time. The two phenomena are related, as
greater the complexity of the financial sector calls for the greater complexity
of regulation, but are also driven by additional separate factors. There is also a
vicious circle in that complexity of regulation leads to complexity of financial
services, which leads to more complexity of regulation, and so on. This trend is
not conducive for effective regulation and efficient financial systems and needs
to be considered by policy-makers when going forward.
11.5 Special Issues in Europe and How they Affect Future Regulation
Many of the regulatory issues discussed in this paper concern all advanced
countries if not the emerging/developing world as well. However, some of the