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Why reregulation after the crisis is feeble:
Shadow banking, offshore financial centers,
and jurisdictional competition
Thomas Rixen
University of Bamberg, Bamberg, Germany
Abstract
A crucial element in the complex chain of factors that caused the recent financial crisis was the lack
of regulation and oversight in the shadow banking sector, which is largely incorporated in offshore
financial centers (OFCs), but instead of swift and radical regulatory reform in that sector after the
crisis, we observe only incremental and ineffective measures. Why? This paper develops an expla-
nation based on a two-level game. On the international level, governments are engaged in compe-
tition for financial activity. On the domestic level, governments are prone to capture by financial
interest groups, but also susceptible to demands for stricter regulation by the electorate. Govern-
ments try to square the circle between the conflicting demands by adopting incremental and
symbolic, but largely ineffective, reforms. The explanation is put to empirical scrutiny by tracing the
regulatory initiatives on shadow banks and OFCs at the international level and within the United
States and the European Union, where I focus on France, Germany, and the United Kingdom.
Keywords: financial crisis, institutional change, offshore financial centers, shadow banking, state
competition.
1. Introduction
The creation of credit bubbles that precede financial crises is often facilitated by regulatory
gaps that enable market participants to realize greater profits. In the process, financial
actors take on ever more risk, which they manage to hide from regulatory agencies, or to
which regulators, if they are aware of the risks, turn a blind eye. Eventually the bubble
bursts and regulators ex post try to close the particular regulatory gap that has fuelled the
boom. In the current crisis the main regulatory gap identified is the existence of a largely
off-balance-sheet non-bank financial system, the so-called shadow banking system.Banks
sponsored special purpose vehicles (SPV) in which credits were securitized and sold on
the market. While securitization in itself could lead to a more efficient allocation of risks,
this business was, to a large extent, driven by regulatory arbitrage. By using off-balance
sheet vehicles, banks circumvented minimum capital requirements to hand out more
credit. One element of this regulatory gap is offshore financial centers (OFC). Most
shadow bank entities are incorporated offshore and enjoy the tax and regulatory privileges
offered by these places. It was,therefore, warranted to target OFCs after the crisis – one of
the most immediate and publicly discussed policy reactions of the G20.
Correspondence: Thomas Rixen, University of Bamberg, Feldkirchenstr. 21, 96052 Bamberg,
Germany. mail: rixen@wzb.eu
Accepted for publication 15 March 2013.
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Regulation & Governance (2013) 7, 435–459 doi:10.1111/rego.12024
© 2013 Wiley Publishing Asia Pty Ltd
However, the regulatory response toward OFCs and shadow banking falls short of
what would be needed. For one, we see only incremental rather than radical regulatory
reform, which many experts consider necessary given the severity of financial market
failure (see e.g. OECD 2009). The initiatives are, at best, minor improvements over the
status quo. In addition, in many instances there is a remarkable misfit between causes of
the crisis and the content of policies. For example, the policies adopted toward OFCs
hardly touch on the shadow banking strategy and financial instability. I submit that the
regulatory reaction largely serves a symbolic purpose to acquiesce popular sentiments
without having actual effect. In other words, the case of shadow banking is not only one
of incremental, but also of insufficient reform. While incrementalism, as pointed out by
Moschella and Tsingou (2013), clearly has its virtues, they do not bear out in this case.
How can we explain the incremental and feeble regulatory response against shadow
banking and OFCs?
I argue that it can be explained by focusing on the preferences of national govern-
ments and their strategic interaction. I model the situation as a two-level game and
incorporate insights on the theory of regulation (e.g. Stigler 1971; Wilson 1980). In a
nutshell, my explanation is as follows. Reregulation is hampered by intensive jurisdic-
tional competition. Governments fear losing internationally mobile financial activity to
competitor states. They are not able to solve the collective action problem to curb or ease
competition among each other because they are influenced, or even captured, by domes-
tic financial interest groups, which lobby governments to refrain from effective regula-
tion. Combined with the structural constraint of jurisdictional competition, these
interests make up an effective veto player. At the same time, governments are susceptible
to popular and electoral demands for stronger regulation. The electorate in big onshore
states can be seen as change agents. This can explain why the outcome is not the absence
of reform. Subject to these different pressures, governments can only agree on incremen-
tal and ineffective reforms, which are symbolically potent enough to soothe popular
demands. While there is a broad consensus among policymakers and academics that
fundamental regulatory reforms are needed (e.g. Warwick Commission 2009; G20
2009a), the basic mechanisms of jurisdictional competition and financial interest group
pressure that drove policy before the crisis still hold after the crisis.
As Helleiner and Pagliari (2011) have shown in their recent review, the literature on
the regulation of global financial markets has usually focused on any of three arenas –
interstate, domestic, and transnational. The argument put forward here relies on linking
the interstate and domestic arenas and, thus, aims at being able to better explain the
empirical record of feeble regulation. In particular, I focus on an aspect that has so far
been under-analyzed in the post-crisis literature – state or jurisdictional competition for
financial activity as a serious obstacle to regulatory reform. While the existence of such
competition is, of course, well known to international political economists working on
financial markets, it has not been discussed as the main factor in the literature on
regulatory reform after the crisis (see e.g. the contributions in Helleiner et al. 2010;
Mayntz 2012). By focusing on state competition I emphasize the importance of a struc-
tural constraint for successful governmental action on financial regulation. International
capital mobility, which is the precondition for such competition, is a serious constraint
for national governments that cannot even be overcome by the most powerful states.
Thus, while my explanation is rationalist itself, it provides a corrective to both rational
functionalism and approaches focusing on state power.
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The rest of the article is structured as follows. In section 2, I explain what OFCs and
shadow banks are and how they have contributed to the financial crisis. Section 3 presents
a simple two-level game of jurisdictional competition and domestic interest group poli-
tics from which implications for both the expected outcome and the process of regulatory
reform are derived. In section 4, I trace regulatory initiatives after the crisis and evaluate
this record against the theoretical conjectures. Section 5 considers three alternative expla-
nations for the outcome. The conclusion summarizes the main findings and briefly
discusses their implications for global financial reregulation in general.
2. What is the problem?
The financial crisis was a bank run on so-called shadow banks (Krugman 2009). The
shadow banking system consists of non-depositary banks, for example, investment
banks, hedge funds, special purpose vehicles (SPV), structured investment vehicles
(SIVs), and asset-backed commercial paper (ABCP) conduits, and certain activities like
securitization, securities lending, and repo. It essentially provides the same functions as
the traditional banking system, that is, shadow banks engage in credit intermediation
and maturity transformation – funding longer-term financial assets with short-term
liabilities. But, rather than relying on the money deposits of their customers as tradi-
tional banks do, shadow banks fund their investments with money market instruments,
such as mutual funds, short-term commercial paper, and repos.1Traditional banks enjoy
the privilege of a publicly provided safety net to prevent their collapse in bank runs. In
return for this privilege, they are under tight regulatory control. Shadow banks,
however, are not under the same regulatory obligations as traditional banks and, in
theory, should not enjoy the privileges of a publicly provided safety net either (Ricks
2010).
The lack of regulatory oversight is an important incentive for creating shadow banks.
Significant parts of the shadow banking system emerged through various techniques of
regulatory arbitrage to realize greater rates of return than in the traditional banking
sector (European Commission 2012, p. 5). Driven by the desire for ever higher rates of
return, the shadow banking sector increased in size from $11.7 trillion to $26.8 trillion
between 2002 and 2009 (IMF 2010). In the US, its size outgrew the regular banking sector
(Pozsar et al. 2010,p. 5).The Financial Stability Board (FSB 2012a, pp.8–9) estimated the
shadow banking sector at around $67 trillion at the end of 2011, which is about 25
percent of the global financial system.
Traditional banks entered the market and sponsored SPVs and SIVs, thus, creating
interdependencies between the traditional and the shadow banking sector (IMF 2010,
pp. 16–19).Importantly,shadow banks are not subject to the capital reserve requirements
that traditional banks are under and, therefore, enjoy unrestricted possibilities for lever-
aged investments. Additionally, because SPVs are kept off banks’ balance sheets, neither
do the latter have to increase their core capital buffers if they sponsor SPVs.2Thus,
traditional banks can indirectly engage in unrestricted leverage. This way, the shadow
banking system has exacerbated the creation of the credit bubble (Adrian & Shin 2009).
In order to maximize regulatory and tax arbitrage, most shadow banks are incor-
porated in offshore financial centers (OFC). While there is no generally accepted defini-
tion of an OFC, in this paper the term refers to states or dependent territories which
intentionally create regulations and tax rules for the primary benefit and use of those
Why reregulation after the crisis is feeble T. Rixen
© 2013 Wiley Publishing Asia Pty Ltd 437
not resident in their geographical domain. Regulation and taxation are designed to
circumvent the legislation of other jurisdictions. Often, OFCs create a deliberate, legally
backed veil of secrecy that ensures that those making use of the regulation cannot be
identified to be doing so (Palan et al. 2010, pp. 33–35).3
Analytically, two functions of OFCs can be distinguished – financial regulatory
havens and tax havens. Tax havens offer very low or zero taxes and strict bank secrecy
rules. They do not exchange tax relevant information with other countries or only under
very restrictive conditions. A financial regulatory haven offers light financial regulation
and supervision, less stringent reporting requirements, and no trading restrictions. This
often includes no or modest minimum capital requirements and opacity on the beneficial
owners of the businesses incorporated there. While the analytical distinction is valid, in
reality, most OFCs offer both tax and regulatory loopholes to the benefit of owners of
businesses incorporated there. For example, jurisdictions, such as the Cayman Islands or
the British Virgin Islands, aim to attract business through both low tax and light regu-
lation. On the other hand, Switzerland is a tax haven, but not a financial regulatory haven.
For the purposes of this paper, a jurisdiction will be considered an OFC if it offers at least
one of the two functions.4
In order to benefit from regulatory and tax advantages, non-residents register off-
shore corporations, of which the infamous SPVs and SIVs are examples.5While tradi-
tional banks sponsor shadow banks and will often manage them from onshore states, for
legal purposes they are largely located in OFCs. For example, around 60 percent of all
hedge funds are located offshore, with the Cayman Islands being the most prominent
location (TheCityUK 2011).6Also, many of the SPVs that failed in the crisis were incor-
porated offshore. Well-known and publicized examples are the German IKB Bank and
Sachsen LB, which had managed their deals with mortgage-backed securities through
SIVs in Ireland and Delaware. HSH Nordbank has about 150 off-balance-sheet subsid-
iaries in OFCs (Troost & Liebert 2009). The Cayman Islands were the largest foreign
holder of US mortgage-backed securities (Lane & Milesi-Ferretti 2010).
Though OFCs are often very small states, data on aggregate financial flows shows that
they are major players in the global financial system and tightly interconnected with
onshore jurisdictions. In 2007, the Cayman Islands (6th), Switzerland (7th), Luxembourg
(9th), and Jersey (16th) ranked among the biggest financial centers as measured by their
assets and liabilities (Palan et al. 2010, pp. 25–27). Fifty-one percent of the world’s
cross-border assets and liabilities were held in OFCs (Palan et al. 2010, p. 51). In order to
reveal some of the linkages between important economies and offshore centers, one can
focus on bilateral data. For example, in 2007, foreign assets and liabilities of the US
against offshore centers amounted to a sum that is about 45 percent of US gross domestic
product (GDP) (in comparison: 56 percent against European area countries, and 19
percent against Japan). The European area had assets and liabilities against offshore
centers of about 52 percent of its GDP, compared to 72 percent against the US
(Milesi-Ferretti et al. 2010). Importantly, the funds only get channeled through OFCs. An
analysis of financial flows shows that OFCs are used as intermediaries between large
financial institutions in onshore financial centers (IMF 2010).
OFCs increase financial risk in at least five ways. First, given their lax incorporation
rules, they make it easier to register SPVs. Second, as a result of lax oversight and lack of
cooperation with onshore jurisdictions they enable onshore financial institutions to hide
the risks involved in their offshore subsidiaries from regulators. Third, the low or zero
Why reregulation after the crisis is feebleT. Rixen
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taxes lead to higher profit margins and, thus, increase the incentive for risky behavior.
Fourth, and related, by using SPVs in tax havens certain quality requirements on credit to
be securitized could be avoided (OECD 2009, p. 48). Fifth, the tax advantages offered by
OFCs foster the debt bias of investments. As interest payments can be deducted as costs,
whereas dividend payments cannot, most tax systems advantage debt over equity financ-
ing. This effect is exacerbated by the low or zero tax rates in OFCs; the interest payments
lower onshore tax burdens, and the profit can be accumulated tax-free offshore.7Overall,
this increases the propensity to take on credit and to work with ever higher leverage ratios
in investments.8The tax bias toward debt conflicts directly with financial regulation,
which tries to lean against debt (cf. IMF 2009). Taken together, these features of offshore
finance increase investment profit margins and make the shadow bank strategy more
attractive. To some extent, OFCs feed the shadow banking system.
When the market for mortgage-backed securities collapsed, the instability of shadow
banking became apparent. Almost the entire emergency policy response was aimed at
preventing the default of shadow banks and their sponsoring traditional banks (Ricks
2010). While off-balance-sheet shadow banking and OFCs were certainly not the sole
cause of the crisis, they have played a significant role in the complex interaction of several
factors that caused the credit bubble and its bursting.9
This description of the OFC–shadow banking complex shows that we are dealing with
a phenomenon of supply and demand. On the demand side, firms, investors, and other
financial market participants (usually from onshore states), search for ways to minimize
their regulatory and tax obligations in order to increase their profit margins. On the
supply side, sovereign jurisdictions are free to design their rules in ways that meet the
demand. All states have joined the competition and tried to supply the demanded rules.
While OFCs are notable for pursuing such policies in extreme ways, onshore states also
try to attract financial activity and foreign tax base. The US state of Delaware and the
Netherlands are examples, which enable the registration of shell companies to profit from
very low tax rates. Other important financial centers with light regulation are Singapore
and, most prominently, London and New York.10 Accordingly, many observers include
these jurisdictions on their list of OFCs (Palan et al. 2010, pp. 41–44). Apart from
installing regulatory gaps themselves, onshore jurisdictions have often allowed – or at
least abstained from disallowing – their firms to access light regulations and taxes off-
shore. At the least, large, developed, presumably onshore economies want to make sure
that they do not lose the headquarters and well-paid jobs of multinational companies.
They have often followed Margaret Thatcher’s advice:“If you can’t beat them, join them!”
(Cited in Eden 1998, p. 659).
Thus, I am not claiming that OFCs are individually responsible for causing financial
instability. Under conditions of liberalized capital flows, jurisdictional competition, in
which both OFCs and onshore states are involved, is a systemic condition. It is this
condition that can be seen as a major cause of globally deregulated financial capitalism
and the ensuing instability. OFCs are merely an extreme manifestation of jurisdictional
competition.
3. Jurisdictional competition and domestic politics
Given these undesirable results, we can expect a collective interest in curbing such
jurisdictional competition. However, in regulatory competition, countries can benefit
Why reregulation after the crisis is feeble T. Rixen
© 2013 Wiley Publishing Asia Pty Ltd 439
individually from undercutting each other’s regulatory standards to attract financial
activity. The result is inefficiently low regulatory standards (race to the bottom). Large
and small countries are differently affected by this outcome and, thus, have diverging
interests in such asymmetric competition (see e.g. Genschel & Schwarz 2011, pp. 341–
342). Large developed countries cannot sustain their economies on the basis of the
activities of the financial sector alone, but also have to guard the financial sector’s
interactions with the real economy. The domestic economic base, which would be sub-
jected to inefficiently low taxes and may suffer from very low financial regulatory stan-
dards, is too big relative to the size of foreign financial activity that could be attracted.11
For them, it should be collectively preferable to come to a cooperative agreement to
curb regulatory competition. For small offshore states, the situation is different.
Because their domestic economic base is small compared to the size of foreign financial
activity that they can attract, they can overcompensate the potential welfare loss of
lower regulatory standards. They oppose collective agreements to curb jurisdictional
competition.12
Overall, this makes the strategic structure an asymmetric prisoner’s dilemma. Large
countries have classic prisoner’s dilemma preferences, and small countries have deadlock
preferences. Overcoming an asymmetric dilemma is demanding, but possible. If the large,
developed countries collectively disallowed their resident financial actors to use the
offshore and shadow banking device, then it would no longer be profitable for OFCs to
offer those services. Large countries could, as a group, pressure small states into compli-
ance.13 Based on this insight, we can, in the following, concentrate on the large country
governments alone.
What would be needed at the international level to achieve this is an institution that
can define binding regulatory standards for all countries. Because the standards are not
self-enforcing under this particular strategic structure, this institution would also have to
provide monitoring and enforcement. Moreover, the regime needs to encompass all large
countries to make it impossible to free ride and exploit those adhering to the standards;
that is, a broad agreement is needed.
In the previous paragraphs, I have intentionally used “countries” to describe the
general workings and incentive structure of state competition. I now expand this model
by focusing on (large country) governments and their preferences in two-level games. In
line with Singer (2004) I assume that governments or regulators maximize a combination
of electoral support and campaign contributions or other rents from interest groups.
Extending on Singer,they also have to mediate domestic and international pressures; they
aim to stay within the win set that satisfies both domestic and international demands
(Putnam 1988). Thus, collective action and effective regulation will hinge on two con-
straints at the international and one at the domestic level.
On the international level, there is, first, the competitiveness constraint described
above. While making it impossible for their banks and businesses to use the shadow
banking and offshore device would lead to better regulated markets and prevent tax
revenue losses, large country governments would also run the danger of losing financial
activity (and with it, well-paying jobs). To avoid these adverse effects they need to make
sure that the other large country governments also implement such policies. To achieve
this, they have to manage and overcome the credible commitment problem posed by their
conflicting individual incentives to continue undercutting one another. Second, govern-
ments also need to manage a distributive conflict amongst each other. Some of the large
Why reregulation after the crisis is feebleT. Rixen
© 2013 Wiley Publishing Asia Pty Ltd440
countries, notably the UK and the US, have larger financial sectors than other industri-
alized countries. The countries with big financial sectors have less to gain from strict
regulation and may, thus, be more hesitant to support it, or at least can be expected to
hold out longer to extract side payments.
The domestic constraint consists of societal interests, which influence governmental
preferences on financial regulation.We can distinguish between two conflicting pressures.
On the one hand, domestic business and financial interests profit from regulatory and tax
arbitrage possibilities offered by shadow banking and the offshore device. They lobby
onshore governments to refrain from reform efforts and promise campaign contribu-
tions or other rents in return. On the other hand, politicians in onshore states can be
hypothesized to be under electoral pressure to push for reform. Given that the general
public in onshore states suffers welfare losses, there should be majorities favoring effective
reform. The logic of collective action (Olson 1965) suggests that the small group of
business and financial interests, which enjoys significant and concentrated benefits, is able
to exert more influence on governments than the general electorate.14 This seems all the
more likely in the field of finance. As it is a very complex matter, it will be difficult for the
electorate to fully grasp the issues involved. Likewise, political decisionmakers will
depend, to some extent, on the expertise of financial market actors. There is an informa-
tion asymmetry on top of the collective action problem of interest mobilization. All in all,
this makes it likely that financial interests can successfully influence or even capture
governments to refrain from effective international collaboration and stricter regulation.
Nevertheless, we also have to account for the desire of elected politicians to accommodate
popular sentiments in favor of stricter regulation. Note that governments cannot accom-
modate both domestic demands in substance, but they may try to square the circle
symbolically, for example, by passing regulations that seemingly address the problems,
but, in reality, leave loopholes for financial actors that are invisible to the public. This way,
they would be able to realize both rents and reelection.
Based on these theoretical considerations, we can derive conjectures on the reform
process after the financial crisis. Broadly speaking, the scenario is one of feeble and
ineffective reform. While they feel pressured by their electorates to come up with stricter
rules, governments are unlikely to agree on and implement effective regulation and
supervision if the international situation corresponds to a collective dilemma and if, at
the domestic level, they are strongly influenced by interests opposed to reform (Putnam
1988; Zangl 1994). In such a situation, the international and domestic forces against
reform reinforce each other: the competitive pressures at the international level make
governments more susceptible to the arguments of business interests; and these argu-
ments are more credible because of the existence of jurisdictional competition. Under
these conditions, the regulatory response should (at best) remain feeble – at both the
domestic and international levels.15 In addition to this general and broad expectation we
can specify the following observable implications:
•Considerations of jurisdictional competition should play an important role in the
reform process. We should find evidence at both the international and domestic
levels that governments are aware of the competitive situation they are in.
•We should see big country governments as agenda setters for regulation, pushing
for collective agreements on stricter regulatory standards. But we can also expect
failure of these initiatives.
Why reregulation after the crisis is feeble T. Rixen
© 2013 Wiley Publishing Asia Pty Ltd 441
•We should see countries with large financial sectors opposing strict and effective
regulation or at least holding out.
•At the domestic level, in particular, we should find that countries justify the
absence or feebleness of domestic reform with concerns for their countries’
competitiveness.
•We should see significant efforts of lobbying by financial interests making exten-
sive use of the argument that stricter regulation endangers a country’s competitive
position.
•Nevertheless, it is likely that governments wish to respond to the demands for
reform by the electorate. In order to square the circle between this need on the one
hand and concerns for competitiveness and business pressures on the other, they
will adopt tough rhetoric and symbolic policies. Overall, there will, at best, be
incremental reform.
4. Reforms after the crisis
To see if the conjectures are borne out I describe and evaluate the regulatory and
supervisory activity related to shadow banking after the crisis. There are, in principle,
three approaches to the regulation of shadow banking (FSB 2011a, p. 8). The first
considers shadow banking to be part of the banking sector and would simply subject it to
the very same regulations in terms of capital requirements, supervision, and so on, as
regular banks (broad direct regulation). This would, of course, only be effective if they
were also implemented by OFCs, otherwise direct regulation could be circumvented. The
second develops specific direct regulations for each type of shadow bank entity or activity.
Special regulations for hedge funds or money market funds, or certain restrictions on
securitization, serve as examples. Again, in order to be effective, OFCs would have to go
along. The third approach eliminates the banks’ vulnerability in relation to the shadow
banking sector by indirect regulation of the links between traditional banks and shadow
banks. This would include measures such as risk weights and additional capital buffers for
banks dealing with the shadow banks they sponsor. Indirect regulation could be done by
the home states of banks, that is, large developed countries, without OFCs’ cooperation.
With the distinction between these three approaches in mind,I now turn to the actual
policy initiatives after the crisis. I first focus on the international level and then turn to the
domestic level in the US and the European Union (EU), where I look at Germany, the UK,
and France. These countries are major players in the international reform debate and
were all affected, albeit to different degrees, by the breakdown of the shadow banking
system. Also, the size of their financial sectors varies. It makes up a more significant part
of the economy in the US (around eight percent of gross value added) and the UK
(around nine percent), than in Germany and France (around four percent and
4.7 percent, respectively) (Broughton and Maer 2012, p. 5). Accordingly, we expect the
former to be more hesitant in reregulation. Throughout, I will draw out the links between
theory and empirical evidence.
4.1. The international level
After the crisis, arguably the most visible institutional change is the fact that the G20,
rather than the G8, has taken the lead in crisis response. The enlarged club has held
several summits since the peak of the crisis and has set the reform agenda. The G20
Why reregulation after the crisis is feebleT. Rixen
© 2013 Wiley Publishing Asia Pty Ltd442
pledged “to extend regulation and oversight to all systemically important financial insti-
tutions, instruments and markets” (G20 2009a, p. 4). It also set (and continues to do so)
more specific tasks for the international financial institutions to pursue. With respect to
OFCs, it set out “to take action against non-cooperative jurisdictions, including tax
havens. We stand ready to deploy sanctions to protect our public finances and financial
systems. The era of banking secrecy is over” (G20 2009a, p. 4). The fact that the initial
steps have been taken by a group of large and developed countries shows that my
expectation that those countries should have an interest in stricter regulation is borne
out. Likewise, the enlargement of the group to 20 is evidence of the fact that actors
understand the need to create a broad multilateral initiative.
In the following, I provide an overview of the regulatory activity that has followed
these strong and ambitious statements of the G20. I start with taxation and move on to
financial regulatory aspects.
4.1.1. Taxation
One of the immediate political reactions to the crisis that received a lot of public attention
was the attempt to exert pressure on OFCs to refrain from harmful tax practices. As
instructed by the G20, the Organisation for Economic Co-operation and Development
(OECD) reinvigorated its ongoing project on harmful tax practices. The project had been
launched in 1998 and had so far made little progress. While it was initially envisaged as a
broad effort to address (legal) tax avoidance and (illegal) tax evasion, it ultimately ended
up targeting only tax evasion. The major reason for the curtailment of the project was
successful domestic lobbying by business interests in the US arguing that if US firms
could no longer use the offshore device they would have a competitive disadvantage
against European firms whose foreign profits were exempt from home country taxation
(Rixen 2008, pp. 132–142). In response to US demands, the OECD settled for an inef-
fective standard of information exchange on request between national tax authorities.16
This episode is an example of business lobbying and concerns for national competiveness
reinforcing each other, as expected in my explanation. The required bilateral tax infor-
mation exchange agreements (TIEA) were, however, only forthcoming at a very slow
speed, even though tax havens had quickly agreed to the rather soft standard of the OECD
and were, thus, removed from a black list the organization had drawn up (Rixen 2011a,
pp. 215–220).
After the crisis, the OECD began to regularly report to the G20 on progress achieved.
The OECD-sponsored “Global Forum on Transparency and Exchange of Information for
Tax Purposes” – with 110 member countries the expected broad multilateral forum –
continues its peer reviews of the legal and regulatory frameworks for transparency and
exchange of information in member jurisdictions. In April 2009, the OECD issued a new
black list. The 46 listed countries were asked to reinforce their efforts at negotiating
bilateral TIEAs. By the end of May 2012, the number of TIEAs had increased to 518
(OECD 2012). One of the reasons identified jurisdictions are so willing to enter into
TIEAs is that the OECD has stated that once a country has signed at least 12 TIEAs, it will
be taken off the list. Many tax havens, therefore, conclude TIEAs among each other in
order to get such a stamp of approval. Because all jurisdictions are considered coopera-
tive, the G20 never had to prove that its threat of sanctions was credible.
While the willingness of OFCs to enter into TIEAs represents progress over the
previous situation, this does nothing to ameliorate the major shortcoming, that is, the
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limits of the OECD standard of information exchange on request. More important in the
context of this paper, all of the efforts to rein in evasion do not address any of the tax
distortions that cause financial instability. While the crisis provided the impetus for
action, the policies pursued do not address the tax loopholes that contributed to the
crisis. This shows that, as predicted, large country governments engaged in symbolic
policies to accommodate popular sentiments by continuing to pursue a project that they
had agreed on earlier for different reasons and that had already been curtailed to meet the
needs of business interests and competitiveness concerns.
4.1.2. Financial regulation
From 1998 on, OFCs had been under the scrutiny of the Bank for International Settle-
ments (BIS), the International Monetary Fund (IMF), and the Financial Stability
Forum (FSF). After the Asian financial crisis, developed countries launched an initiative
to promote standards of financial regulation to be adopted by middle- and low-income
countries and OFCs. The standards that were promoted were presumably already in
place in high-income countries. Thus, as predicted, the initiative for stricter regulation
came from the governments of large and wealthy countries. Often the standards had
been developed by private actors from these countries, which also had a significant say
in their development (Mosley 2010, p. 725). In 2000, the FSF had drawn up a black list
of 42 OFCs (FSF 2000) and delegated the task of assessing their regulatory systems to
the IMF, which launched an OFC assessment program alongside its general Financial
Sector Assessment Program (FSAP) and repeatedly reported on the progress of both
programs. In the formulation of their policies, large country governments were very
much aware of the competitive situation they were in. All reports and statements by
state representatives stress the need to act collectively as individual initiatives would
only lead to the diversion of financial activity to lesser regulated areas (Drezner 2007,
p. 142).
The IMF reports found that most countries, including OFCs, adhere to the regulatory
standards. Often, OFCs had even stricter standards than so-called onshore jurisdictions
(IMF 2005, pp.4–6). In 2008, it was,therefore,decided to integrate the OFC program into
the FSAP carried out jointly by the IMF and the World Bank and, thus, to prepare the
same Reports on the Observance of Standards and Codes (ROSC) that all countries are
subject to. The main shortcoming in the FSAP framework is that the IMF and World Bank
do not have the authority to enforce the standards and codes. They can merely hope that
the publication of regulatory gaps and the implied moral suasion lead to improvements
in the respective countries. Further, even in the case of positive ROSCs, there are often
large, but hidden, gaps between the formal adoption of international standards and real
compliance (Walter 2010, p. 33). Also, the assessment by the IMF does not pay sufficient
attention to the fact that regulators often simply assume that they are only responsible for
regulating their domestic banks – a task that they often fulfill very well and in line with
the standards – and do not assume responsibility over foreign branches or subsidiaries
(Troost & Liebert 2009).
The lack of enforcement capacity is a result of a lack of political will on the part of
large country governments to act vigorously against countries violating financial stability
standards. Whereas in the FATF initiative against money laundering, the US, shaken up by
9/11, put its political clout and credible threats of sanctions behind the policies and,
consequently, substantial progress was achieved (Drezner 2007, pp. 142–145; Tsingou
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2010), there was far less resolve in the IMF/FSF case (cf. e.g. Palan et al. 2010,
pp. 209–210). As expected, concerns for the competitiveness of the financial industries,
which are irrelevant in the case of money laundering, can explain this difference. With
respect to financial stability, large countries could not agree on effective measures, but
wanted to present regulatory activity to their audiences.
After the crisis, the picture has hardly changed. The FSAP remains the only interna-
tional instrument to monitor offshore and onshore jurisdictions. The renamed FSB was
tasked to develop an effective peer review program to assess compliance with regulatory
standards that should explicitly include, but not be limited to, uncooperative OFCs (G20
2009b, pp. 1–2). Compared with the FSF, the FSB has a somewhat stronger mandate
(including the task to design supervisory colleges and to set up an early warning system),
to promote financial stability, a wider membership (with all G20 countries joining), more
resources, and a more permanent internal organizational structure (with a full-time
Secretary General), than its predecessor. Nevertheless, just as its predecessor,the FSB does
not possess any formal powers and merely aims at international policy coordination.
While the FSB is now allowed to assess countries’ compliance record and publish its
reports (Helleiner 2010, pp. 8–12), it still does not command any “hard” means of
enforcement. Instead, it will carry out this task by essentially relying on FSAP assess-
ments. “ROSCs have been an ineffective tool for promoting compliance in the past; nor
did they prevent the build-up of financial fragility in the major centres before 2008”
(Walter 2010, p. 35). There is little change in the overall program and the incremental
reforms will not promote financial stability.
In addition to the FSAP program, there are other policy initiatives concerned with
better regulation and supervision of the shadow banking sector. At the November 2010
Seoul Summit, the G20 asked the FSB to develop recommendations for improved
regulation of the shadow banking system. The FSB set up a task force chaired by
Adair Turner of the UK Financial Services Authority and Jaime Caruana, General
Manager at the BIS. The task force shares the view that shadow banking is an important
source of financial instability in the manner described in this article. The FSB high-
lights the importance of a “global approach to monitoring and policy responses”
because of the danger of unhealthy competition for lower standards among jurisdic-
tions (FSB 2011a, p. 5) and, thus, echoes the issue of state competition at the heart of
this paper.
In a second report, prepared for the G20 meeting in Cannes, 11 recommendations
with a work plan to further develop them in the course of 2012 are outlined. They
consist of a mix of indirect regulatory measures: that is, measures that apply to banks
sponsoring shadow banks, most importantly introducing risk weights, stronger capital
requirements, and an improvement of accounting principles to force the consolidation
of SPVs on their balance sheets; and specific direct measures, most importantly stricter
supervision of money market funds, securitization, and hedge funds (FSB 2011b). The
task of devising indirect measures is delegated to the Basel Committee of Banking
Supervisors (BCBS), and that of devising direct measures to the International Organi-
zation of Securities Commissions (IOSCO). In April and November 2012, the FSB
reported on the ongoing work in the relevant five work streams (capital requirements of
banks interacting with shadow banks, money market funds, other shadow bank entities,
securitization and securities lending, and repo) and further specified their recommen-
dations (FSB 2012b,c). In late 2012, the FSB also published its first “Global Shadow
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Banking Monitoring Report,” which provides the most comprehensive collection of
aggregate data on the shadow banking system. Obviously, as emphasized by the FSB,
such data are an important prerequisite of proper regulation and supervision (FSB
2012a).
So what kind of specific regulations have the international bodies that the FSB relies
on proposed so far? First, shortly after the crisis the BCBS agreed on minor amendments
to Basel II, specifically asking for heavier risk weightings for securitization exposure and
off-balance-sheet vehicles so that they cannot be used as easily to circumvent capital
requirements (BCBS 2009).17 These rules will also be part of the new Basel III agreement,
as will be an increased scope of consolidation (FSB 2012b, pp. 5–6). While Basel III leads
to a significant improvement of capital reserve standards (with higher capital require-
ments and the introduction of leverage ratios) in the regular banking sector (Goldbach &
Kerwer 2012),18 most experts, including the FSB, agree that the rules are insufficient to
seriously dampen the risks in the shadow banking sector (see e.g. Turner 2011). Accord-
ingly, there is a real fear that the stricter regulations for regular banks increase the
attractiveness of shadow banking. The FSB writes: “Although Basel III closes a number of
identified shortcomings, both the incentives for, and the risks associated with, regulatory
arbitrage will likely increase as Basel III raises the rigor of bank regulation” (FSB
2011a, p. 5).
Second, the International Accounting Standards Board (IASB) has revised IAS 27, a
standard that determines under what conditions a bank will have to consolidate its SPVs
on the balance sheet. Negotiations at the IASB and FASB, which proved to be controver-
sial, had been ongoing since 2003 and have renewed importance after the crisis. The
revised standard can be expected to be a more detailed specification of the previous
standard (IASB 2012). Importantly, however, the IAS had already been very strict even
before the crisis, requiring the consolidation of off-balance-sheet SPEs on banks’
accounts. However, many national accounting rules, for example, those in the US, the UK,
and Germany, which are binding for banks and are the basis for prudential regulation,did
not include that requirement (Thiemann 2011, pp. 18–30).
As the work within the FSB is still ongoing, it is certainly too early for definite
evaluations of this work, but one important observation can already be made. The
regulatory approach taken by the FSB and the other international bodies has clearly been
a combination of the second and third approaches outlined at the beginning of this
section. This means that the clear-cut solution of subjecting shadow banks to regular
banking regulation is off the table. Instead,the result will be a large number of specialized
and detailed rules for individual cases. Also,delegating different aspects of the problem to
different agencies implies a fragmentation of the regulatory efforts. This is likely to make
it easier for interested parties to water down the rules and create loopholes.
Admittedly, at this point in time, my skeptical evaluation involves some speculation.
What is certain, however, is that any decisions of these organizations – be it the Basel
III capital requirements or accounting rules – will have to be transposed into national
laws to enter into force. As the case of the pre-crisis accounting rules reveals, domestic
implementation and compliance is crucial. As will be shown below, and in line with the
basic argument of this paper, jurisdictional competition and business lobbying are
major factors at the domestic level, which will very likely turn post-crisis domestic
measures into merely incremental reforms that fail to address the shortcomings of the
status quo.
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4.2. Domestic (and European) politics
In this subsection I provide two brief case studies on the reform process in the US and the
EU, where I focus on the positions of Germany, the UK, and France.
4.2.1. USA
In the US, the legislative process of financial reform in response to the crisis culminated
in the Dodd–Frank Act (DFA). Most commentators welcomed the bill, saying that it
represents progress toward safer financial markets. Nevertheless, it is also widely agreed
that the DFA exhibits significant loopholes that were inserted to accommodate business
group pressure (Woolley & Ziegler 2012). Also, the quite fragmented US regulatory
landscape, which has received criticism by many, has not been changed. Most impor-
tantly, the construction of the DFA is such that it sets out regulatory goals that still need
to be implemented by different specific regulators. Many fear that in this process some of
the more strict rules will be watered down further (Woolley & Ziegler 2012, p. 59).
And indeed, so far only 20 percent of the proposed rules have been implemented. The
regulatory agencies are confronted with intense lobbying efforts by the financial sector,
which took out the bite of some of the regulations (see e.g.Narayanswamy 2011). This is
also true for the two measures that are considered to be the most significant to increase
the stability of financial markets. With respect to capital requirements, the DFA does not
specify targets because it was argued by Republican legislators that the US should wait for
the results of the Basel III negotiations – to protect the competitiveness of US financial
markets, capital requirements should stay in tune with other countries’ regulations
(Johnson 2011). Second, while in the legislative process discussions about proper regu-
lations for the shadow banking sector played an important role, the final act did not
contain specific rules on this aspect. Instead, the responsibility to craft those rules lies
with the Federal Reserve and the newly created Financial System Oversight Council
(FSOC). The FSOC is subject to intense lobbying by financial firms arguing against
stricter capital requirements for both the traditional and shadow banking sectors by
pointing to the competitive disadvantage this may imply for US banks vis-à-vis their
foreign competitors (Johnson 2011). In response, the FSOC pronounced that it may be
dangerous to set capital requirements for banks too high because this may drive activity
to the shadow banking sector. Not only does this raise the possibility of capital require-
ments being too low for banks, but it also means that the FSOC does not appear to be
ready to further regulate shadow banking (Cooley 2011). All in all, these ongoing events
nicely illustrate the logic of my explanation, with competitiveness concerns and interest
group influence reinforcing each other.
In the area of accounting, the relevant US Generally Accepted Accounting Principles
(GAAP) standards on the consolidation of SPVs were tightened. As a result, $1 trillion
was repatriated back onto balance sheets and an estimated equal size of SPE engagements
was sold by banks (Thiemann 2011, pp. 30–32). This can certainly be viewed as a success.
But it remains to be seen whether banks will find new loopholes in the regulations in the
future.
4.2.2. European Union (Germany, France, and the UK)
In Europe, most of the regulatory rules for financial markets are made at the suprana-
tional level of the EU and are then implemented in member states. Supervision, however,
is mostly a national task. Therefore, I will focus on the role that the three governments
played in regulatory efforts at the EU level, but will also refer to domestic reforms.
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Pre-crisis, Germany was a vocal supporter of stricter global regulations for hedge
funds. At the same time, the Sozialdemokratische Partei Deutschlands (SPD)-Green
government liberalized domestic financial markets with the so-called investment mod-
ernization law in 2003, enabling, among other measures,securitization and the introduc-
tion of private equity firms (Vitols 2005). The main reason for these moves was to
improve the competitiveness of the financial sector vis-à-vis other countries (see e.g.
Asmussen 2006). Post-crisis, one can observe continuity in this general pattern. At the
international level, the government is a strong supporter of stricter regulations, arguing
for a financial transaction tax and better regulation of the shadow banking system. France
joins in these efforts. Former French President Sarkozy was probably the most vocal of all
political leaders calling for stricter regulation. Both Germany and France have stated a
strong preference for acting on a European if not a global level rather than at the domestic
(Jabko 2012, p. 97; Handke & Zimmermann 2012). However, it can be shown that the
results at the European level have been meager, and that neither country has been
successful in implementing stricter regulation and supervision domestically, but both
have been concerned with the competitive position of their financial systems.
At the European level, the most visible change is the establishment of a new super-
visory structure. It consists of the European Systemic Risk Board (ESRB), hosted by the
European Central Bank (ECB) in Frankfurt and in charge of monitoring macropruden-
tial risk and three new bodies: the European Banking Authority (EBA) in London, the
European Insurance and Occupational Pension Authority (EIOPA) in Frankfurt, and the
European Securities Markets Authority (ESMA) in Paris. Their task is to coordinate
the national supervisory agencies and promote cooperation among them. France sup-
ported this reform, while Germany was more hesitant, as the Bundesbank feared a loss of
supervisory authority. The UK was even more skeptical. It considered the new agencies a
“French plot” to intervene into its financial markets (Jabko 2012, pp. 103–104). These
fears seem to be wildly overdrawn, however.To the contrary, the new structure is too weak
to be up to the task of cross-border banking supervision. For one, it would be preferable
to have one agency that deals with banking, insurance, and securities in a comprehensive
fashion. Further, and more importantly, it is not enough to coordinate national supervi-
sors. Stringent supervision would need supranational competencies, ensuring that
national supervisors will not turn a blind eye to “their” banks’ cross-border activities,
including shadow bank and OFC engagements.19
With the Capital Requirement Directive (CRD), the EU will implement Basel III in
Europe. The legislative process is still ongoing, but the current Commission draft
(COM[2011] 453 final), like the Basel template, contains few regulations aimed at the
interface of regulated banks and shadow banks. In Germany, regulators have expressed
similar sentiments as those in the US, stating that it was necessary to ensure that the
stricter rules under Basel III would not drive activity into the shadow banking sector. At
the same time, the responsibility for strengthening regulations is pushed to the interna-
tional level with the argument that unilateral action would threaten competitiveness of
the European banking sector (Kuehnen 2011). France has generally shown little enthu-
siasm about strengthening capital requirements, as it did not want to endanger the
competitive position of its large universal banks (cf. Jabko 2012, p. 104).
In terms of accounting rules, the EU had urged the IASB to strengthen its standards
on the valuation of securitization and the consolidation of SPVs. When the IASB deliv-
ered, however, the Commission did not approve the standards. Reportedly, the reason for
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this was resistance by French, German, and Italian policymakers and banks, which would
have been seriously undercapitalized on the basis of the new rules (Quaglia 2011). This
fits the pattern of advocating reform internationally, but not delivering domestically for
fear of losing competitiveness. Likewise, while Germany modernized its law on GAAP
(Bilanzrechtsmodernisierungsgesetz) in 2009, for the purposes of prudential supervision
and determining capital reserve requirements, banks are still not required to put SPVs on
their balance-sheets (Thiemann 2011, p. 20).
The EU has also pursued specific direct regulatory measures aiming at shadow
banking entities. The Alternative Investment Funds Manager (AIFM) directive targets
hedge funds. The legislative process was accompanied by heavy lobbying of the fund
industry. The UK, together with financial interests, opposed the directive. France
(together with Germany) was the most important proponent. After a contested legisla-
tive process, the compromise saw the UK accept the legislation, but France accepting that
offshore funds continue to be granted access the EU market (Woll 2012, pp. 201–208).
The new rules require the managers of AIFM to register with the competent authorities
of the respective EU member country in which the management is located. Thus, the
management will be subject to this requirement, irrespective of where the fund itself is
incorporated. Upon registration, managers will receive a European-wide passport that
allows them to market their services everywhere in the EU. Managers will be subject to
the supervision of their home member state. They will be required to provide the
competent authority with data on their business activities. However, apart from the
requirement that the country in which the fund itself is incorporated has signed a TIEA
(see above), there will not be any restrictions on the AIFM’s business models. Thus, it is
not clear how the directive can help to improve financial stability in the shadow banking
sector.
In addition, the Commission is currently reviewing existing legislation on Undertak-
ings for Collective Investment in Transferable Securities (UCITS) and the Markets in
Financial Instruments Directive (MiFID) with a view to broaden the transparency and
oversight of non-equity instruments and enhance consumer protection in the area of
investment funds (European Commission 2012, pp. 9–12).
While these few paragraphs are too short and superficial to do justice to the com-
plexities of financial regulation in the EU, it is apparent that central predictions of my
explanatory account are borne out: the fact that even those countries that are in favor of
reform at the international level do not come forward with domestic reform exemplifies
the logic of the collective action problem inherent in jurisdictional competition. Only if
large, developed countries move in lockstep can reform be effective. Also, we can see that
those countries with smaller financial sectors are more in favor of reform (Germany and
France), than countries with bigger financial sectors (the UK, and also the US). Likewise,
the influence of business pressure is visible.
5. Alternative explanations
In this section I consider alternative explanations for the outcome of feeble and symbolic
regulation. While I am not aware of fully developed alternative accounts which aim at
explaining the failure to effectively regulate shadow banking, I shall briefly contrast my
explanation with three potential alternatives – the first based on states’ regulatory power,
the second on the influence of societal interests, and the third on ideas and norms. I aim
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to show that such accounts, while they certainly provide important insights into the case
at hand, miss important aspects, which my explanation captures.
5.1. State power
A prominent class of approaches to the political economy of global financial regulation
refers to state power as an important explanatory factor. In those accounts, power is
usually operationalized as market share. The expectation of these accounts is that the
preference(s) of the most powerful state(s) determine(s) the regulatory outcome.
Simmons (2001, pp. 597–600), operating under a unitary state assumption, considers the
US to be the hegemon with a preference for liberalized, but well regulated, financial
markets. As described above, the case of shadow banking exhibits a dilemma structure. In
her 2 ¥2 matrix of possible configurations, it fits into the scenario of “significant negative
externalities” for the hegemon and a “low incentive to emulate.” She maintains, in line
with my expectations, that, under these circumstances, reregulation is difficult to achieve
and will have to rely on multilateral institutions and threats of sanctions. However, in her
account the hegemon should be able to push through its desired outcome of stricter
regulation by employing positive and negative sanctions. Even though threats of sanc-
tions were clearly part of the package, such an account fails to correctly predict the
outcome observed in this case, that is, feeble regulation. One plausible reason for this may
be that all states are locked into competition and not even powerful states are strong
enough to pressure their competitors into collaboration.
But this cannot prematurely be taken as evidence corroborating my explanation, as it
may also be the case that powerful states do not have a preference for stricter regulation.
This leads us to a second set of alternative explanations – societal or political interests
which program the preferences of powerful states.
5.2. Adding societal interests
The first competing explanation referring to societal interests can be developed by build-
ing on Drezner (2007). He links the focus on power with societal interests. He argues that
the international regulatory outcome will be determined by the most powerful states, but
that societal interests determine the actual preferences of those states. In his account those
interests facing the highest adjustment costs to the new regulations determine a govern-
ment’s preference. In the case at hand this would mean that the preferences of great power
governments derive from the interests of the financial industry. Therefore, we should see
no efforts at regulatory reform at all. This is not corroborated empirically. Clearly, there
are regulatory initiatives by great power governments.
Alternatively, one might assume that governmental preferences reflect the interests of
the electorate. As the empirical evidence shows, this is not the case. Third, as in my
explanation, governments could see a need to balance the interests of the electorate and
the financial industry (Singer 2004). In Singer’s model, regulators care for the competi-
tiveness of their countries’ financial industries, but at the same time have to satisfy
electoral demand for financial stability (to which they are only indirectly responsive via
the fear of intervention by their principal, the legislative). Accordingly, following a severe
crisis, regulators should react to a drop in the electorate’s confidence in financial stability
by successfully engaging in international regulatory harmonization with their peer regu-
lators from other countries. As has been shown, while there are of course attempts at
international regulation, these did not result in stringent regulation.
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A very plausible reason for the failure of all three versions of a societal interest
explanation lies in state competition that is part of my explanation. While I assume, just
like Singer, that domestic politics is about balancing financial interest groups and elec-
toral pressure, my account extends on his by taking the international competitiveness
constraint seriously, whereas in his account international regulatory harmonization will
be forthcoming.20 Also, as I have argued, governments try to square the circle; they
soothe electoral demand for reregulation, while at the same time not endangering their
industries’ competitive position by relying on symbolically potent (but actually feeble)
policies.
All in all, neither power nor a focus on domestic societal interests (alone) can provide
a better explanation for the outcome of feeble regulation. These accounts underestimate
the constraints that state competition for financial activity present to governments.
5.3. Ideas
While I am not aware of a constructivist account that aims at explaining the failure to
regulate shadow banking, one could construct such an account. A constructivist could
argue that effective reregulation is not forthcoming because the belief into the neoliberal
dogma (“the market will take care of itself efficiently”) among policymakers is still very
strong. On the face of it, such an account seems rather implausible in the current
situation, as a majority of policymakers have called for stricter regulation or even explic-
itly declared the era of neoliberalism to be over.21 But a softer version may nonetheless be
plausible. For example, Sharman (2006) has argued that the OECD project on harmful
tax practices failed because the OECD, whose authority derives from its status as an
impartial expert bureaucracy devoted to the liberal market ideology, could not convinc-
ingly argue against tax competition. An analogous account may be constructed for the
case of shadow banking and the IMF and/or the FSB.
In itself, such a constructivist account is plausible. But are norms of appropriate
behavior the best explanation for feeble regulation? Sharman himself acknowledges that
in order to answer in the affirmative, competing hypotheses have to be rejected. With
respect to rationalist accounts, he argues that the failure to effectively regulate tax havens
can also not be explained by state competition and the influence of business interests on
large country governments. This claim can be refuted. As I have demonstrated elsewhere
(Rixen 2011a), both factors have played an important role in the failure of the OECD
project. The evidence collected in this paper shows that this is also true for the case of
shadow banking and OFCs. Consequently, my rationalist account cannot be rejected by
the norm-based argument.
6. Conclusion
I have shown that shadow banks and OFCs played a significant role in the financial
crisis. Fundamental regulatory change in this area could, thus, be expected, and politi-
cal leaders and policy experts, indeed, made the connection and called for such
reforms. However, overall, the regulatory activity after the crisis can be summarized
under the heading “more of the same.” While some institutions, most importantly the
FSB, are strengthened, their basic workings and formal powers are not enhanced. They
still merely aim at coordination. Also, the institutional landscape remains fragmented.
In consequence, a coherent policy toward shadow banking and OFCs has not been
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formulated. While the international institutions would, thus, be ill-equipped to achieve
significant progress in reining in jurisdictional competition anyway, their crisis
response so far does often not even target the crucial links between shadow banks,
OFCs, and financial instability. The actual content of regulatory efforts after the crisis
can often not be linked to the causes of the crisis. Likewise, the policy recommenda-
tions by the FSB have settled for a mix of indirect regulation and a series of specific
regulations for certain shadow bank entities or activities, and did not further explore
the clear-cut solution of subjecting shadow banks to regular banking regulation.
Instead, the result will be a large number of specialized and detailed rules for individual
cases. This may lead to regulators losing sight of the big picture and systemic risks
involved in shadow banking. In any case, it is still open, whether domestic regulators
will actually pursue the recommended policies. At the domestic level, the case studies
on the US and the EU corroborate the conjecture that responses are feeble and incre-
mental at best.
I have also shown that the reason for this reform trajectory can be found in govern-
ments’ concerns about international competitiveness. There is ample evidence that large
country governments perceive themselves to be in a situation of jurisdictional competi-
tion. In particular, those countries with large financial sectors are hesitant to agree on
strict and binding international standards. While a rationalist approach that adopts a
unitary state assumption would expect governments to be able to overcome this collective
action dilemma, the failure to do so is a result of capture by interest groups, which
becomes visible if we adopt a two-level game perspective.
Competitiveness concerns and interest group influence are even more apparent at
the domestic level. Reforms are feeble in all four countries and are significantly slowed
down by the interference of financial and business interests. Even those countries advo-
cating a strong international reform agenda do not follow through domestically. Thus,
while some have expected the crisis to provide a strong enough stimulus for govern-
ments to solve their collective action problems and free themselves from the grip of
financial interests, the basic political constellations and mechanisms that drove policy
before the crisis still hold after the crisis. Nevertheless, the crisis has spurred regulatory
activity. Policymakers try to square the circle between jurisdictional competition and
financial interest capture on the one hand, and public demands for stricter regulation
on the other, by resorting to incremental, but often ineffective and symbolic, reform
measures.
On a general note, the case of shadow banking and OFCs exemplifies a fundamental
asymmetry in the dynamics of financial market regulation. While governments are in a
position to open up to global financial markets and deregulate their financial sectors
individually, reregulation hinges on collective action. While of course, governments are
formally free to reregulate unilaterally, doing so is self-defeating under conditions of
jurisdictional competition. In contrast, unilateral deregulation and liberalization
promise gains, at least in the short run. This can explain why the processes of deregu-
lation and reregulation are so fundamentally different. While a deregulatory dynamic is
quasi-automatic and market-like because its diffusion across countries is supported by
state competition, reregulation relies on the ability of reformers to craft effective collec-
tive action in the face of a dilemma situation. Accordingly, reregulation is always an
inherently political process, and, typically, a very protracted one. So far, it has not been
forthcoming.
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Acknowledgments
Previous versions of this paper were presented at the Max Planck Institute for the Study of
Societies in Cologne in February 2011, the ECPR General Conference in Reykjavik in
August 2011, the meeting of the International Politics Section of the German Political
Science Association (DVPW) in Munich in October 2011, a workshop at Copenhagen
Business School in December 2011, and a seminar at the Institute for Intercultural and
International Studies (InIIS), University of Bremen, in January 2012. Participants at these
events and, in particular, Jakob Ache, John Biggins, Reinhart Blomert, Sebastian Botzem,
Peter Dietsch, Jan Fichtner, Philipp Genschel, Martin Höpner, Sonja Juko, Roy Karadag,
Andreas Kruck, Peter Mayer, Manuela Moschella, Daniel Mügge, Lena Rethel, Peter
Schwarz,Leonard Seabrooke, Matthias Thiemann, Eleni Tsingou, Cornelia Woll, and Kevin
Young provided helpful comments and discussions; as did three anonymous reviewers and
the editors of this journal. Xaver Keller provided research assistance. I thank all of them.
Notes
1 A typical chain of credit intermediation in the shadow banking system is the following: A bank
that provides loans sells them to an SPV, which slices and bundles the loans and transforms
them into tradable bonds (securitization). SIVs, investment banks or hedge funds invest in
these long-term bonds. They do this with short-term funds that they raise by issuing money
market instruments like ABCP. Other shadow banking entities with deposit-like features, such
as money market funds (MMF), invest in these instruments.
2 In order to make sure that the SPVs could be kept off their balance sheets, banks had to play
a “legal game, which relied strongly on an interpretation of the law according to the letter of
the law rather than its spirit” (Thiemann 2011, p. 13).
3 There are, depending on the classificatory scheme used, between 40 and 72 states or dependent
territories which have positioned themselves as OFCs. For a list of countries that are OFCs
according to the “Tax Justice Network” (TJN), the OECD, and the IMF, see Palan et al. (2010,
pp. 41–44).
4 A third function, for which OFCs have come under scrutiny, money laundering, will not be
discussed. On this see, for example, Tsingou (2010).
5 In fact, most financial institutions in regulatory and tax havens are under the control of
non-residents using them to channel funds to other non-residents. This means that the
financial sector in regulatory havens by far exceeds the size necessary to finance the local
economy (cf. IMF 2000).
6 Importantly, while hedge funds are incorporated offshore, the location of management is
typically onshore, with New York and London being the most important locations by far
(TheCityUK 2011).
7 Given the focus on financial stability, I leave aside the adverse effects in terms of tax revenue
foregone. On this, see Rixen (2011b).
8 The sophisticated version of such thin capitalization is the construction of hybrid instruments
with many features of equity, but enough features of debt to attract interest deductibility. It has
been argued that the tax advantages offered by these instruments have been one of the major
drivers of securitization. In particular, Eddins (2009) has shown that, in theory, a trader can
realize risk-free profits, which consist entirely in tax revenues foregone, by structuring his
investments into credit default swaps (CDS) in certain ways.
9 For an excellent overview of the causes of the crisis, see Helleiner (2011).
10 The only difference between offshore and these onshore states is that the latter will try to
ring-fence the tax and regulatory privileges, whereas full-fledged OFCs can offer low taxes and
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regulation to everybody and still support their states and economies. The reason for this is that
they are always small countries, in terms of population, that can make a living off an oversized
financial sector,even if it creates only few jobs and taxes.See also the discussion of the strategic
interaction in section 3.
11 This, plus electoral pressure (see below), can explain why large countries do not turn into
full-blown regulatory and tax havens themselves.
12 Note that, as opposed to large countries, for small countries this consideration is not changed
by incorporating governments that mediate between the domestic and international levels. In
OFCs, there should be no strong domestic opposition to maintain such a policy stance.As the
entire economy is geared toward the offshore sector and profits from it, both economic interest
groups and a majority of the electorate can be hypothesized to defend their country’s status as
an OFC. One may consider that such a condition – general support for deregulated finance
even from the broad public – may also hold in countries such as the US or the UK, where the
financial sector contributes a high share to value added. But empirical estimates show that the
economic benefits from finance are concentrated (Johal et al. 2012). Thus, it is theoretically
implausible from a rationalist and materialist conception of interest that the general public
should favor deregulated finance.
13 Technically speaking, the k group, that is, those countries that can sustain cooperation on
regulation without hurting themselves, comprises the large, developed countries. Together,
their market power is strong enough to not suffer losses if they enact stricter regulation.
However, in line with other works (e.g. Genschel & Plümper 1997), unilateral action even of
the country with the biggest market share would be self-defeating. While financial institutions
rely on access to the markets of large, developed countries, no single one, or even a minority
group of them, is important enough to be able to regulate unilaterally.
14 One may think that other domestic interests, most importantly organized labor, may
counterbalance business influence on governmental policy. However, it is in theory not clear
that organized labor will be in favor of regulating offshore finance (cf. Rixen 2011a).
Empirically, while they have expressed preferences for regulation, trade unions have rarely
campaigned or lobbied on the issue.
15 Note that one could also argue for the following alternative hypothesis: Given that
governments are in danger of capture by financial interests domestically, they should have an
incentive to gang up at the international level. Acting collectively, they would not be
susceptible to capture by small interest groups, but could rather serve the interest of the broad
electorate. This is actually the logic of Singer’s (2004) theory. However, this only works in a
perspective that is focused solely on the domestic level and treats the international level as
derivative of domestic politics. In contrast, in the two-level perspective adopted here, the
international competitiveness constraint is important in its own right, and there are
reinforcing tendencies of politics on the two levels. Last but not least, there are the additional
distributive conflict on the international level, and the fact that the electorate will be satisfied
with symbolic politics (being largely ignorant of the important regulatory details). Overall,
this leads me to not pursue this alternative hypothesis (but see the discussion of alternative
explanations in section 5).
16 Information exchange upon request is insufficient to effectively curb tax evasion because the
requesting state needs initial evidence of evasion to post a request. Because of the secrecy
offered by OFCs, it is usually impossible to get such initial evidence (see e.g. Sullivan 2007).
17 Even in its pre-crisis formulation, Basel II had already required banks to adjust their capital
reserves for SPV exposure. But during the phase-in stage of Basel II, this requirement was not
obligatory. Interestingly, some countries, such as France, had implemented it into national
legislation already, whereas others, among them Germany, had not, and were, thus, hit harder
by the collapse of the shadow banking system (Thiemann 2011).
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18 Despite these improvements, many experts consider the Basel III capital requirements for
traditional banks to be too low to guarantee stability (see e.g. Admati et al. 2011).
19 The ongoing sovereign debt or euro crisis seems to have led policymakers to the same
conclusion. At least for large, systemically important banks, there are now serious plans for a
“banking union”, that is, truly supranational supervision.
20 The decisive difference is that in my explanation, national policymakers have to mediate
between both international and domestic politics, whereas Singer considers state competition
to be an endogenous variable of the dynamics of domestic politics. Thus, he implicitly assumes
that the dilemma on the international level can be successfully solved. This assumption may be
warranted if the relevant group of countries that can successfully engage in regulation, that is,
Schelling’s k group, is small.This is given in his Basel case (Genschel & Plümper 1997).But this
assumption does not hold in the case of the regulation of shadow banking – where the relevant
k group is bigger.
21 While (as a rationalist) one may think that such announcements are merely cheap talk, such
a view would not be in line with the constructivist notion of the civilizing force of hypocrisy
(Elster 1998).
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