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While the role of laws and regulations in structuring markets is well established, it is less understood how rule evasion affects the evolution ofmarkets or howthe interaction between regulators and the regulated about the meaning of compliance influences this effect. The authors study this issue by looking at the development of the asset-backed commercial paper (ABCP) market in France, Germany, and the Netherlands from 1999 to 2009. In all three countries, this market involved financial innovations designed to evade regulations. The authors identify diverging trends in the ABCP market that are a result of whether and how regulators were embedded in the different interpretive communities that defined regulatory compliance, such embeddedness being dependent on their discretionary and sanctioning power as well as their expertise. Focusing on these regulatory networks that embed institutions in markets, they propose a synthesis of relational and institutional accounts of the embeddedness of markets.
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Stitched on the Edge: Rule Evasion,
Embedded Regulators, and the
Evolution of Markets
1
Matthias Thiemann
Goethe-Universität Frankfurt am Main
Jan Lepoutre
ESSEC Business School
While the role of laws and regulations in structuring markets is well
established, it is less understood how rule evasion affects the evolution
of markets orhow the interaction between regulators and the regulated
about the meaning of compliance inuences this effect. The authors
study this issue by looking at the development of the asset-backed com-
mercial paper (ABCP) market in France, Germany, and the Nether-
lands from 1999 to 2009. In all three countries, this market involved
nancial innovations designed to evade regulations. The authors iden-
tify diverging trends in the ABCP market that are a result of whether
and how regulators were embedded in the different interpretive com-
munities that dened regulatory compliance, such embeddedness be-
ing dependent on their discretionary and sanctioning power as well
as their expertise. Focusing on these regulatory networks that embed
institutions in markets, they propose a synthesis of relational and in-
stitutional accounts of the embeddedness of markets.
INTRODUCTION
How do interactions between the regulator and the regulated about the na-
ture of compliance with regulations shape the evolution of nancial markets?
1
We are grateful for insightful comments from Tom DiPrete, David Stark, Fabien
Accominotti, Leonard Seabrooke, Andreas Noelke, Daniel Mertens, Yuval Millo, Stoyan
© 2017 by The University of Chicago. All rights reserved.
0002-9602/2017/12206-0004$10.00
AJS Volume 122 Number 6 (May 2017): 17751821 1775
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Regulation and regulatory compliance are key factors in shaping nancial
markets, because the nancial products being traded are synthetic bundles
of law and measurement(Black 2013, p. 34; Pistor 2013). While institu-
tionalist studies in the sociology of markets identify laws and regulation
as central constitutive factors in the functioning and stability of nancial
markets (Carruthers 1996, 2013; Block 2001, p. xxvi; Krippner 2001; Block
and Evans 2005; Krippner and Alvarez 2007; Abolaa 2010; Fligstein and
Goldstein 2010, 2012; Swedberg 2010, 2012), they say little about how the
regulated creatively interact with these rules in order to evade their behav-
ioral constraints or how the regulators react to these attempts. Institution-
alists mostly consider regulators and regulation to operate in a steering role
outsideof the markets. Researchers in the sociology of law, however, have
warned that viewing regulation as exogenous to markets overlooks impor-
tant dynamics within them (Edelman and Stryker 2005; see also Streeck
and Thelen 2005; Mahoney and Thelen 2010).
To understand the role of regulation in markets one must know both how
rules are written and how they are interpreted and enacted by regulators and
the regulated (Edelman 1992; Black 2002; Mahoney and Thelen 2010; Edel-
man and Talesh 2011; Gray and Silbey 2014). Much as market actors ap-
proach nancial market devices and their outputs reexively and adapt
them to local use (Muniesa et al. 2007; Beunza and Stark 2012; Turco and
Zuckerman 2014), they also reexively interact with and enact rules and reg-
ulations. In a similar way, however, regulators will also reect on market actor
activities and change regulations accordingly. This often adversarial interac-
tive and iterative process, known as the regulatory dialectic(Kane 1988), is
a perpetual cat and mouse cycle of regulationrule avoidancereregulation,
where market actors innovate with nancial instruments to evade regulatory
control and regulators then seek to expand regulation to recapture control
(Halliday and Carruthers 2007; Funk and Hirschmann 2014). Despite the ex-
istence of a rich body of literature on nancial market regulation, we know
very little about the factors that facilitate or vitiate this iterative process.
A stark example of such rule circumvention by nancial market actors is
the development of the shadow banking systembefore the 2008 nancial
Sgourev, Frederic Godart, Eve Chiapello, and Kim Murphy, as well as the many inter-
viewees who were so kind to offer us their time and expertise. We appreciate the com-
ments we received from attentive audiences at the 2013 session on the sociology of law
at the American Sociological Association, the 2014 Normative Orders conference at Goe-
the University Frankfurt, the 2014 Accounting, Organization, and Society conference at
the London School of Economics, the 2014 Society for the Advancement of Socio-Economics,
conference, the MaxPo Graduate Student Conference on Economic Moralities, the Centre
de Sociologie des Organisations workshop at Sciences Po, and the Management Depart-
ment at ESSEC Business School. Direct correspondence to Matthias Thiemann, Goethe-
Universität Frankfurt am Main, Department of Sociology, Gruneburgweg 1, Hesse 60487,
Germany. E-mail: thiemann@soz.uni-frankfurt.de or lepoutre@essec.edu
American Journal of Sociology
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crisis. Shadow banking emerged as a mechanism for banks to creatively use
nancial markets to conduct business in a way that avoided banking regu-
lation (Acharya and Schnabl 2010; Thiemann 2014). Once the nancial cri-
sis unfolded from 2007 onward, large parts of the shadow banking system
collapsed and caused signicant harm, especially to those national banking
systems in which banks had engaged in shadow banking(Hardie et al. 2013a)
and, as we will show, especially those forms of shadow banking especially
designed to circumvent banking regulation. However, analyzing the differ-
ences in exposure of national banking systems to the shadow banking ac-
tivities of their banks revealed different national regulations (Hardie et al.
2013b), suggesting a capacity of some regulators to adapt regulations to limit
rule circumvention.
To study this regulatory dialectic of rule avoidance and reregulation, we
employ a relational perspective on markets, which suggests that we can bet-
ter understand how institutions are enacted and how markets function by
looking at the embeddedness of actors in networks (Granovetter 1985).
2
As
Baker (1984) and Abolaa (2001) documented for nancial markets, the
structural embeddedness of market actors in social networksthat is, the
patterns of ongoing interpersonal relations that contextualize economic ac-
tion (Granovetter 1990; Zukin and DiMaggio 1990)can constrain the op-
portunistic evasion of cultural norms. We extend this relational analysis to
the networks regulators and the regulated form in the process of determin-
ing compliance and study how market actorsattempts at bending the rules
are embedded in their ongoing relations with regulators and semiprivate
gatekeepers(Coffee 2006), authorized to supervise their compliance. By con-
centrating on the dialogues that these three different groups (market actors,
regulators, and gatekeepers) use to negotiate the meaning of compliance, we
uncover some mechanisms that encourage or hinder rule avoidance behav-
ior by the regulated.
In this study, we investigate these interactions by looking at the regula-
tion of a nancial market at the heart of shadow banking, the asset-backed
commercial paper (ABCP) market, in three different countries: France, Ger-
many, and the Netherlands. Whereas the ABCP market in Germany and
the Netherlands expanded rapidly between 1999 and 2007 and fell precip-
itously afterward, activities in the French ABCP market grew more steadily
and avoided a sudden plunge in 2007. Closer examination revealed that this
was due to the different growth of segments in the ABCP market that were
most characterized by rule circumvention. Given the same transnational
rules and nancial techniques, we nd that the ABCP markets developed
2
The impact of social relations on the enactment of institutions, while often overlooked,
is an important component of Granovetters contribution (cf. Granovetter 1985, pp. 481,
499ff ). Work by Abolaa and Baker expanded on this notion and applied it to markets as
social institutions.
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differently as a result of the interactions between national banking regula-
tors on the one hand and banks and their auditors on the other hand. We
show that when the regulator is both central in the network of actors that
determine the meaning of compliance and linked to both the regulated and
semiprivate gatekeepers, creative compliance will less likely go undetected
and provide regulators with the capabilities to constrain such behavior. In
contrast, the more peripheral regulators are to these networks, or the more
they lack diversity of perspectives in their network by being connected only
to the regulated, the more markets will evolve in ways that reect creative
compliance of the regulated.
Our ndings enable us to develop propositions related to both the impact
of regulation on the evolution of markets and the mechanisms of regulation.
First, we propose that the variance in structural embeddedness of the reg-
ulator within the network of actors that determines the meaning of compli-
ance is of crucial importance for the dynamic of regulationrule avoidance
reregulation in markets. Second, we nd that structural embeddedness is a
function of the institutionalized powers and competences of the regulator.
More specically, it is a function of the regulatorsdiscretion, expertise, and
sanctioning power, which determine who is approaching whom and when
in order to determine the meaning of compliance. Finally, we propose a syn-
thesis of relational and institutional accounts of the embeddedness of mar-
kets, which relates the structuring impact of laws and regulations to the re-
lational context of their enforcement, jointly determining how markets are
embedded in regulation.
THE INDETERMINACY OF RULES AND THE REACTIVITY
OF MARKET AGENTS
Economic sociologists of law and sociolegal scholars insist that in order to
understand the effect of regulation on the behavior of market agents, it is
necessary to investigate not only the rules but also how they are locally in-
terpreted when rms seek to comply with them (Edelman 1992; Black 2002;
Halliday and Carruthers 2007; Ford 2008; Edelman et al. 2011; Gray and
Silbey 2014). Rules and regulations seeking to impose societal control on or-
ganizational behavior are by denition over- or underinclusive and thus
indeterminate and subject to interpretation(Black 1997, p. 10), which ex-
plains why their implementation becomes a site for overt contestation
(Edelman and Stryker 2005, p. 537). The regulated do not simply implement
the rules, but seek to revise them in the process of implementation, making
use of their inherent openness(Streeck and Thelen 2005, p. 15; see also
Mahoney and Thelen 2010; Edelman and Talesh 2011).
Several studies have shown how market actors exploit the indeterminacy
of regulation through creative interpretation. Edelman (1992) and Dobbin
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(2011) demonstrate how organizations and the compliance professionals
within them developed new organizational forms and practices to respond
to labor legislation and shape its interpretation in their favor (Edelman
1992; Edelman et al. 2011). Some scholars have even argued that such rule-
bending behavior is ubiquitous: the typical rule taker . . . is a rule bender:
She reads rules entrepreneurially, untiringly looking for ways of twisting
them in her favor(Streeck 2011, p. 146; italics in the original).
The qualication of market actors as rule benders particularly holds in
nancial markets, which are uniquely sensitive to regulatory conditions,
since for the most part the things they trade are themselves regulatory crea-
tions: nancial instruments(Moran 2002, p. 268; Knorr-Cetina 2012; Black
2013; Lang 2013; Pistor 2013). These regulatory conditions, which take the
form of rules of categorization, classication, and commensuration that reg-
ulators use to monitor and steer the behavior of market actors (Moran 2002;
Knorr-Cetina 2012; Black 2013; Lang 2013; Pistor 2013), result in regula-
tory costs that market actors subsequently try to avoid. Professional advi-
sors and legal counsels creatively interact with these rules and classications
to exploit the malleability of legal constructs (Black 2002, p. 243; Fleischer
2010) and structure their clientsactivities so that they fall outside of undesir-
able regulatory classications. They can use law, in the form of legal instru-
ments, to avoid law, in the form of legal restrictions(Black 2013, p. 21), often
intentionally creating a gap between the economic substance of a transac-
tion and its legal or regulatory treatment(Fleischer 2010, p. 3). In other
words, rules trigger reactions (Espeland and Sauder 2007): regulatory classi-
cation of an activity causes market actors to modify the activitys legal form
such that classication is technically avoided, while the economic substance
remains fundamentally unchanged (Borio and Tsatsaronis 2005). This is the
driving force behind nancial innovations that evade costly accounting reg-
ulations (McBarnett and Whelan 1991; Shah 1996), taxation (MacKenzie
2009, p. 71; Fleischer 2010), and nancial regulation (Awrey 2013; Funk
and Hirschmann 2014). Yet, if the regulated can effectively bend rules in
their favor and evade regulatory control, then the question becomes whether,
when, and how regulators can enforce the spirit of the law.
Regulator-Regulated Networks and Reregulation
The literature has identied several explanations for how and why regula-
tors adapt the content and meaning of regulations to the behavior of the reg-
ulated, including regulatory capture, cognitive capture, and the complexity
of systems to be regulated. Regulatory capture, when the regulator pursues
only the interests of the regulated (Stigler 1971, 1974), is a rst mechanism
identied in the failure to reregulate nancial innovations (Campbell 2010;
Guillen and Suarez 2010). Regulatory capture may take the form of regula-
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tory forbearance, the acceptance by the regulator of deviant behavior by the
regulated (Edelman and Stryker 2005), and has often been associated with
practices of lobbying or regulator reliance on the regulated for external ex-
pertise, information, and personnel (Seabrooke and Tsingou 2009; Barth,
Caprio, and Levine 2012; Moschella and Tsingou 2013). It also occurs when
organized interests are consulted very early in the regulatory cycle (Mos-
chella and Tsingou 2013) and when revolving doors(Seabrooke and Tsi-
ngou 2009) cause the regulator to share the views of the regulated.
The regulatory capture mechanism involved in the failure to (re)regulate
has recently been complemented by a second mechanism: intellectual or
cognitive capture, that is, the adoption by the regulator of the worldview of
the regulated and the ideologies they support (Buiter 2008; Abolaa 2010;
Baker 2010; Fligstein and Goldstein 2010, 2012; Johnson and Kwak 2010).
Cognitive capture is said to come about through the frequent interaction be-
tween regulators and the regulated (Kwak 2013). As a result of these inter-
actions, regulators come to see nancial innovation in the market in the same
way the regulated do, which may prevent reregulation. The current litera-
ture, however, does not specify when and how the regulators internalize
the perceptions of the regulated. While regulators, by the nature of their pro-
fession, may have to interact closely with the regulated (Black 2003), it has
been shown that cognitive capture does not necessarily result from such in-
teractions (Riles 2011).
A third possible hindrance to reregulation is the increasing complexity of
the systems regulators have to supervise (Guillen and Suarez 2010). This
complexity appears not only in the myriad products and activities being reg-
ulated but also when several competing regulators arguably have simulta-
neous jurisdictions over any given product or activity. In the example of the
markets we study, there are international (in the form of the Basel commit-
tee), European, national, and even regional banking and accounting regu-
latory bodies that may or may not combine rule making, standard setting,
oversight, coordination, and so forth. As a result, regulatory responsibilities
may be unclear and nancial innovations fall between the cracks of regu-
latory jurisdictions(Funk and Hirschmann 2014, p. 674), or different reg-
ulatory agencies may govern diverse aspects of a single activity and may
thereby be prevented from gaining a complete picture to regulate effectively.
In addition, the longer innovations go uncontested by regulators, the more
the markets trading them develop, and the more difcult it becomes to rereg-
ulate such activities, as generated incomes will develop a substantial lobby
favoring regulatory exemption (Braithwaite 2008; Funk and Hirschmann
2014).
Another level of complexity is introduced by the various levels of actors
intervening in the regulatory process; in most cases, regulators do not super-
vise directly, but are forced to rely on various compliance documents pro-
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duced by the regulated and their advisors (Robson 1992; Vollmer, Men-
nicken, and Preda 2009; Gray and Silbey 2014). In nancial markets, regu-
latory action is essentially based on supervision by professional gatekeepers
(Coffee 2006), such as lawyers or auditors. This both hinders the regulators
capacity to implement regulations and inhibits the development of exper-
tise within their own ranks.
3
Furthermore, this dependency of regulatory
oversight on gatekeepers also opens the door for the regulated to exert pres-
sure on their auditors to apply favorable accounting treatments. Because
accounting is an inherently ambiguous exercise of classication and mea-
surement, the terms used in accounting regulation do not predetermine ac-
countantsclassication decisions and so are open to interpretation (Hath-
erly, Leung, and MacKenzie 2008; MacKenzie 2008; Gill 2009; Power
2012). In essence, this network conguration evokes a regulatory drama
in a Goffmanian sense (Vollmer 2007, p. 590) between the audience (the reg-
ulators) and the performers (the regulated), where the regulated strategically
engineer data and information backstage. The regulated may engage certain
audiences (such as auditors) in cross-party cooperation to calibrate numer-
ical displays of regulatory drama for inspection by third parties(p. 590).
4
We are building on this insight and acknowledge the role that semipri-
vate gatekeepers and the regulated play in shaping the effects of regulation.
Because of the multiple layers of nancial products, regulatory actors, semi-
private gatekeepers, and regulated interests, we agree with Millo (2007,
p. 211) that the responsibility for the regulatory process does not lie with
a single agent, or a group of agents, but is rather transferred to the relations
among different actors. It is within these regulatory networks (McCaffrey,
Smith, and Martinez-Moyano 2007)the network of connections through
which regulatory activities take place(Millo 2007, p. 212)that the mean-
ing of compliance is established in regulatory conversations (Black 2002,
2008): these regulatory networks (McCaffrey et al. 2007) create the dialogic,
iterative, and reexive communications between the regulator, the regulated,
and the professional gatekeepers, such as auditors or lawyers, that ultimately
produce the meaning of compliance. These actors form the interpretive com-
munities where the battle for interpretive controloccurs (Black 2010). Us-
ing this relational lens, we can now turn to the ABCP market, our empirical
context.
3
As Edelman et al. have shown, when the nal arbiters of compliance are distant from
actual compliance processes, they tend to rely on industry expertise to judge compliance
procedures, completing a process that Edelman et al. (1999) call the endogeneity of law
(see also Dobbin 2011).
4
As Vollmer (2007) suggests, if regulators were able to observe such backstage activity,
they would no longer believe the regulatory drama performed onstage, suggesting the im-
portance of interactions between regulators, gatekeepers, and the regulated to control the
production of information in nancial markets.
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THE EMPIRICAL CONTEXT
We selected the ABCP market as our empirical context to study how regu-
latory networks affect enforcement, interpretation, and rule evasion for two
reasons. First, rule evasion has been identied as a key driver in the dev-
elopment of these markets (Acharya and Schnabl 2010; Thiemann 2014).
Second, these markets also evolved differently in different countries, despite
similar transnational regulation (Gorton and Souleles 2007; Pozsar et al. 2010;
Acharya, Schnabl, and Suarez 2013; Fligstein and Habinek 2014). The ABCP
market experienced strong growth from the early 1980s until the nancial
crisis of 2007, as parts of it became central components in the shadow bank-
ing system (Pozsar et al. 2010), where banks engaged in banking activities
while evading banking regulation (Gorton and Souleles 2007; Pozsar et al.
2010; Acharya et al. 2013). This shadow banking system collapsed during
the recent nancial crisis and with it much of the ABCP market. Importantly
for this article, however, the collapse was unevenly distributed across nations
and across segments of that market.
Asset-Backed Commercial Paper
Asset-backed commercial papers are short-term loans that are issued by spe-
cial purpose entities (SPEs) called conduits.
5
In the bank-based shadow
banking system, these SPEs were in economic substance subsidiaries of
banking conglomerates, yet they were not classied as such in legal terms.
SPEs issue ABCPs as short-term debt to nance the purchase of nancial as-
sets such as loans, lease payments, credit card receivables, or other cash ows
that banks typically pool together as the conduitssponsor. These assets may
be originated by retailers, nance companies, other banks, or the sponsor
bank itself. The pooled cash ows from these assets are then used to repay
the ABCP investors with interest. ABCPs are purchased by investors in the
money market, such as pension funds, mutual funds, and investment banks,
who are interested in ABCPs as a means of placing large sums of cash in
highly liquid and risk-free investments (Stigum and Crescenzi 2007; Gorton
2010; Pozsar et al. 2010; Pozsar and Singh 2011; Acharya et al. 2013). Banks
ensured the risk-freenature of ABCP through typical techniques of secu-
ritization, that is, bankruptcy remoteness of assets from their originator,
overcollateralization by clients (more collateral is provided than what is re-
nanced), and statutory special purpose obligations, which make the bank-
ruptcy of the SPE virtually impossible (Gorton and Souleles 2007). Finally,
important for the rule evasion described below and uncommon for other
forms of securitization, the sponsors of SPEs (most often banks) provided li-
5
Often also referred to as special purpose vehicles(SPVs).
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quidity lines to assure ABCP purchasers that, in the deemed unlikely event
that no buyers for newly issued ABCPs could be found, the sponsor would
step in and provide the necessary liquidity.
The benecial features of the ABCP market in terms of regulatory costs
and rule evasion for banks become apparent in the construction of the link-
age between the sponsoring bank and the ABCP conduit. Banks used myr-
iad accounting, economic, and regulatory arguments to prevent theirSPEs
from being consolidated onto their balance sheets either for nancial report-
ing purposes or for bank regulatory purposes. First, because banks create
and manage the SPEs, they were in economic substance their subsidiaries;
yet as a result of creative use and interpretation of accounting rules, they were
not classied as subsidiaries of the sponsoring bank in legal, regulatory, and
accounting terms. Depending on the jurisdiction, these rule-avoiding struc-
tures then generally helped SPEs to be qualied for offbalance sheet treat-
ment. As they were hence not consolidated into the banksnancial state-
ments, their sponsoring banks were able to signicantly optimize the perceived
risk prole of their balance sheets toward investors. Evasion of accounting
rules, however, was just one part of the regulatory benets: the second and
majority of benets lay with the avoidance of capital requirements in bank-
ing regulation.
Capital requirements are intended to impose an external limit on the risk
taking of banks by limiting bank leverage (the ratio of equity to loan assets).
Core capital requirements, however, have the effect of lowering the return
that banks generate on a given level of equity. The possibility of excluding a
risk-based asset from the core capital calculation is precisely what makes the
SPE structure attractive to the sponsoring bank: it provides access to reve-
nues without capital requirements for the bank. Depending on the jurisdic-
tions, offbalance sheet treatment, under applicable accounting standards,
may have a greater or lesser impact on the level of reserve capital that the
sponsoring bank is required by its banking supervisor to retain. Yet most
often, classifying an asset for offbalance sheet treatment strengthens (or
even wholly determines) whether that asset will be included in risk-based
capital calculations.
The avoidance of regulatory costs structured the evolution of the ABCP
market right from the introduction of core capital requirements. Core cap-
ital requirements were initially introduced in the United States in 1983 (Ka-
vanagh, Boemio, and Edwards 1992; Wall and Peterson 1996), making it
more expensive for banks to provide short-term credit to their commercial
clients (Ahern 2008). In reaction, banks set up SPEs to offer their commer-
cial clients access to the money market through ABCP instruments, where
interest rates were lower than those for credit provided directly by the bank
(Kavanagh et al. 1992). These conduits, directly serving bank clients, were
called multiseller conduits. Clients would pay a service fee to the bank for
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facilitating access to the money market, which provided fee income to the
bank without increasing the core capital requirements, as extending straight
loans would have required. Importantly, during this period the short-term
liquidity lines that banks provided were exempted from core capital, on the
justication that they were purely contingent loans.
In the 1988 Basel Accord, Japanese, European, and U.S. banking super-
visors, united under the auspices of the Bank for International Settlements,
agreed to harmonize and increase core capital requirements simultaneously
and create a level playing eld in terms of core capital requirements for banks
across the world (Kapstein 1991). These new core capital requirements are
higher and forced several banks to reduce their leverage by either selling
assets or issuing more equity. In their attempt to avoid these costly efforts,
U.S. banks began to move some of their own existing assets into offbalance
sheet ABCP conduits. Although legally complying with the new core capi-
tal requirements, this construction maintained exposure to the offbalance
sheet assets in economic substance as a result of the liquidity line (Ehrlich
et al. 2009). These securities arbitrage conduits(SAC) became a widespread
self-serving tool for banks worldwide to play the yield curve by nancing
long-term assets (which generally carry a higher interest rate) with short-
term commercial paper (which generally pays very low interest rates; Flig-
stein and Habinek 2014), while avoiding core capital charges.
Whereas the economic reason for banks to set up a multiseller conduit was
essentially to offer their clients access to money markets and to earn a fee for
this service, the economic advantages in the securities arbitrage segment of
the market were completely driven by rule evasion: a reduction in core cap-
ital requirements for the banks sponsoring these conduits (Hellwig, Hoef-
ling, and Zimmer 2010). In contrast, multiseller conduits also generated di-
rect service fees for the originating bank, making them protable even if
some core capital charges applied. Figures 1 and 2 provide a visual depiction
of multiseller and securities arbitrage conduits.
The business models of the two other segments of ABCP markets (single-
seller and hybrids) are a mixture of the two models explained above: single-
seller conduits provide capital market access to a single client (often banks),
and hybrid conduits engage in both securities arbitrage and facilitating cap-
ital market access for clients.
While initially the assets in the SPEs consisted of loans, banks gradually
started to place other securitization products, such as asset-backed securi-
ties (ABS) and collateralized debt obligations (CDOs), off balance sheet,
warehousing and proting from them (Pozsar et al. 2010). The starkest ex-
ample consisted of offbalance sheet proprietary trading(interview, Ger-
man banker, 6/15/2011), when bankstrading desks started using securities ar-
bitrage conduits to buy highly rated long-term ABSs and CDOs for the banks
own trading portfolio. In this way, banks were engaging in securitization
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FIG.1.The structure of a multiseller conduit
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FIG.2.The structure of a securities arbitrage conduit
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without risk transfer(Acharya et al. 2013), because banksliquidity lines main-
tained their risk exposure to securitized assets.
Variations in the Development of the ABCP Market and Case Selection
While the global ABCP market experienced strong overall growth of about
270% from 1999 to the summer of 2007 (Moodys 1999, 2007), this growth
varied substantially between segments and countries. While the largest seg-
ment, the multiseller segment, doubled, SAC, hybrid, and single-seller con-
duits experienced more than a fourfold expansion. The nancial crisis of
20078 ended the exponential growth of these conduits for the sole purpose
of rule circumvention, as investors started to mistrust the securities that
banks had placed into offbalance sheet ABCP conduits. Essentially, inves-
tors reevaluated their risk exposure in the ABCP market and refused to roll
overtheir ABCPs to nance the SPEs. The global market for ABCPs
dropped by about 50% between 2007 and 2009, with most of the underlying
assets returning to the banking system as the liquidity lines were drawn on
(Milne 2009). The decline was most pronounced in the SAC segment of the
market (where banks had placed ABSs and CDOs): by June 2008 it had fallen
about 60% from its June 2007 peak. Single-seller conduits were close behind,
declining by 53% by June 2008. The hybrid segment declined by 43% by June
2008 (authorscalculation, Moodys Program Index; cf. Standard & Poors
2010). The multiseller conduit segment of the market, which renanced clients
credits, remained stable, however, shrinking only 1% by June 2008 and drop-
ping (down 24.5% by June 2009) only after the collapse of Lehman Brothers.
Figure 3 depicts these divergent developments before and after the crisis by
comparing the evolution of the multiseller segment with those segments in
which banks engaged in shadow banking.
Because the exposure of banks to the ABCP market in general, and the
segments engaging in shadow banking in particular, differed across coun-
tries, the national impact of the collapse of this market varied as well. Table 1
shows the size of the largest engagements of sponsoring banks in the global
ABCP market in 2007 according to nationality, the growth of the market from
1999 onward, and the decline from 2007 to 2009. We also compared the vol-
ume of ABCP assets with total bank assets per country in 2007 to get a bet-
ter understanding of the importance of ABCP conduits for banks in each
jurisdiction.
In terms of total ABCP volume, the United States had the largest precrisis
ABCP market in 2007 followed by Germany, the United Kingdom, and the
Netherlands. As a percentage of the relevant national banking systems, how-
ever, ABCP conduits represented a signicantly larger portion of banking
assets in Germany and the Netherlands than they did in the United States
or France. All countries, except France, show a steep decline in ABCP vol-
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ume from 2007 to 2009. In contrast, the French ABCP market stabilized in
2009 at approximately its 2007 size. A comparison of banksrelative expo-
sure to the ABCP market by country indicates that the ABCP market ac-
counted for relatively smaller proportions of U.S. and U.K. bank assets. By
contrast, the ABCP markets accounted for approximately 4.6% of Dutch
bank assets and 3.2% of the German banking system, which shows an ag-
gressive engagement with the ABCP sector. The outlier in this analysis re-
TABLE 1
Asset Volume of ABCP Conduits by Nationality of Sponsoring Bank
and Evolution between 1999,2007, and 2009
Asset
Volume of
ABCP Conduits
(2007, Billion $)
%of
National
Banking
System
Growth
(19992007)
(%)
Asset
Volume of
ABCP conduits
(2009, Billion $)
Growth
(20079)
(%)
Netherlands . . . . . . 153.85 4.64 200 54.98 264.3
Germany . . . . . . . . . 204.01 3.15 397 60.56 273.5
Belgium. . . . . . . . . . 35.98 2.88 1,014 15.72 256.4
United States. . . . . . 256.86 1.86 75 173.24 246.5
United Kingdom . . . 153.94 2.20 662 73.78 252.1
France . . . . . . . . . . . 61.00 1.06 183 62.14 2.5
NOTE.Data are from Moody Program Index and the OECD Banking Database, and out-
comes are the authorsown calculations.
FIG.3.Evolution of different ABCP market segments pre-and postcrisis. Data are
from Moody Program Index and authorsown calculations.
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mains the French banking system, which conned the ABCP market to a
relatively low percentage of total banking assets and avoided the precipi-
tous decline suffered in other countries.
Given the sensitivity of the ABCP market to regulation, we explored the
differing national regulatory requirements regarding ABCP programs, in
order to discover how the structure of the regulatory networks and inter-
actions played a role in shaping these requirements. We analyzed the Dutch
and German caseswhere we saw strong precrises engagement by banks
in this market, followed by substantial declines of 65% and 74%, respec-
tivelyand contrasted them to the French case, where there was no reduc-
tion in market size from 2007 to 2009. These different developments occurred
even though banks in all three countries began engaging in the ABCP mar-
ket around the same time (France 1991, Germany 1992, and the Netherlands
1990) and were initially bound by much of the same nancial regulation. The
Netherlands, France, and Germany therefore function as comparable case
studies with highly developed nancial systems.
What strengthened our choice is that the divergent developments in Ger-
many, France, and the Netherlands can largely be accounted for by the vary-
ing engagement of banks in those segments of the ABCP market used solely
for rule circumvention (SAC, hybrid, and single-seller segments), which were
unprotable without circumventing banking regulation. Table 2 shows the
different engagement of banks from these three countries in the different
segments of the market, while gure 4 shows the combined evolution of the
rule-circumventing segments in France, Germany, and the Netherlands be-
tween 1999 and 2009, including important steps in the regulatory dialectic.
The volume of ABCPs issued by multiseller conduits sponsored by French
banks was 93% of the market in 2007, with no issuance by SAC or hybrid
conduits and only 1% by single-seller conduits. In contrast, the ABCPs issued
by multiseller conduits in Germany and the Netherlands made up only about
one-third of the exposure at that time, the rest stemming from SAC and
TABLE 2
Exposure to the Different Segments of the Market by Banks
from the Three Cases in 2007
Multiseller
Conduits (%)
Single-Seller
Conduits (%)
Hybrid
Conduits (%)
Securities
Arbitrage
Conduits (%) Others
Germany . . . . . . . . . . . . . . 38.5 1 26.5 22 12
Netherlands . . . . . . . . . . . 29 37 8 21 5
France . . . . . . . . . . . . . . . . 93 1 0 0 6
Global . . . . . . . . . . . . . . . . 43.8 16 13.2 13.8 13.3
NOTE.Data are from Moody Program Index and the OECD Banking Database, and the
outcomes are the authorsown calculations.
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FIG.4.Securities arbitrage, hybrid, and single-seller segments of the ABCP market in France, Germany, and the Netherlands. Data are from
Moody Program Index and authorsown calculations.
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hybrid conduits as well as single-seller conduits. As shown in gure 4, Ger-
man and Dutch banks were increasing their engagement in these segments
of the market up until 2007, while French banks, which were initially also
involved in these segments of the market, started reversing their engage-
ment in 2001. The reason for these deviating trends, we submit, is the di-
verging national evolution of regulation concerning banksengagement in
the ABCP market, operating on the level of national interpretations of trans-
national regulations, such as Standard Interpretation Committee (SIC) 12
and the Basel I requirements for liquidity lines.
Data Sources and Methodology
In order to study and understand the regulatory interactions in the ABCP
regulatory network and its implications for ABCP market developments,
we collected data from multiple sources from France, Germany, and the
Netherlands from the mid-1990s until the nancial crisis in 2008. We rst
used documentary analysis and short surveys with experts to understand
the importance of rule evasion for the ABCP market (e.g., Moodys 1997;
PwC 2006). Subsequently, we conducted in-depth interviews with experts
who could inform us about the general developments in the banking in-
dustry and the regulatory developments with regard to the ABCP market.
These experts included public and private professionals involved in na-
tional and international accounting standard setting and several academic
and political domain experts, bank analysts, and members of rating agencies.
We sought to understand how the different actors involved in the ABCP
market made sense of regulatory developments, in particular with regard
to the regulatory interactions between the banking supervisor, the banks,
and the auditors. We interviewed important players in regulatory networks
in France, Germany, and the Netherlands: actors from central banks, -
nancial supervisory bodies, auditing associations, and banking associations;
bankers and internal compliance ofcers concerned with accounting deci-
sions; and, most importantly, external auditors; as well as regulatory service
providers for the big auditing networks involved in the actual auditing deci-
sions for ABCP conduits. Of the 72 interviews in total, 64 took place between
August 2010 and March 2012, with a second round of eight interviews in
March and April 2015. The interviews lasted between 45 minutes and
2.5 hours. Table 3 provides an overview of the various stakeholders inter-
viewed by country.
We also collected multiple independent observations in the specialist
press, public documents such as nancial statements and legislation, indus-
try reports, academic articles, and background interviews to verify statements
from our primary interviews. The triangulation of multiple data sources as-
sisted us in maximizing the reliability of our ndings (Yin 2003).
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With this multitude of data sources as our starting point, our data anal-
ysis consisted of looking for qualitative and quantitative patterns in the in-
teractions between regulators and market actors about key elements in the
ABCP market. More specically, during the iterative process of data anal-
ysis, coding, and cross-case comparison, we became particularly sensitive to
interpretations of and discussions about the risk and rewards these markets
offered to participating banks in the light of important transnational regu-
latory initiatives, such as SIC 12 and Basel II. Such discussions occurred
both between banks and their auditors and between banks and the regula-
tor.
Rule Evasion in the ABCP Market and the International
Regulatory Dialectic
Before examining the specic regulatory actions taken in each country un-
der study, it is important to understand the supranational regulatory con-
text. It is important to bear in mind the distinction between accounting rules,
which determine whether given assets or liabilities are consolidated within
the banksnancial statements, and banking regulations, which tally all the
risks inherent in a banks activities and determine the level of core capital a
bank must raise.
6
Such regulations are often set by different regulatory bod-
ies and are intended to serve different ends. In all three countries, core cap-
ital requirements had a decisive impact on whether banks engaged in ABCP
6
Core capital requirements specify the proportion of a banks assets that must be -
nanced with equity or equity-like capital to allow for the absorption of potential losses
by the bank (Morris and Shin 2008; Admati and Hellwig 2014).
TABLE 3
Categories and Number of Interviewees
Function of Interviewee Germany Netherlands France Total
Central banks/banking supervisor . . . . . . . . . . . . . . . 4 6 10 20
Financial market regulators . . . . . . . . . . . . . . . . . . . . 2 2 1 5
Auditing association . . . . . . . . . . . . . . . . . . . . . . . . . . 3 2 2 7
Banking association . . . . . . . . . . . . . . . . . . . . . . . . . . 0 0 1 1
Senior bank managers concerned with accounting
decisions regarding SPEs . . . . . . . . . . . . . . . . . . . . 5 3 5 13
Accounting and law professors involved in
accounting standard setting . . . . . . . . . . . . . . . . . . 3 3 4 10
Accounting standard setters and state ofcials
concerned with accounting standard setting . . . . . 3 2 5 10
External auditors from the big four auditing
networks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 2 3 7
Regulatory services big auditing networks . . . . . . . . 1 1 0 2
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 21 31 75
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programs (interview, German bank manager, 7/12/2011; interview, French
banking manager, 3/25/2011; interview, Dutch banker, 12/6/2011). To min-
imize regulatory costs, bankers engaged in creative framing behaviors to op-
timize the classication of both the liquidity line and the status of SPEs as
outside the perimeter of banking regulation and therefore exempted from
core capital charges. The techniques used to exempt these instruments from
capital charges consisted of pushing the limits of existing rules (senior audi-
tor, 2/2011). As one board member of a large auditor network said of rele-
vant accounting practices, Special purpose entities are a construct invented
by lawyers to optimize the existing system of rules. . . . Special purpose en-
tities are always stitched on the edge: knitted in such a way as to fall outside
the perimeter of consolidation(interview, 5/3/2011).
While the quote refers to the practice of including or excluding a subsid-
iary in the balance sheet of a banking conglomerate, we found that this prac-
tice of stitching on the edgeoccurred in all realms of accounting and bank-
ing regulation: the regulated sought to push the constructs involved in the
ABCP conduit to the precise limits of compliance to ensure the optimal reg-
ulatory classication for the purpose of maximizing prot.
This optimizing behavior did not remain hidden from international reg-
ulatory bodies. As early as 1988, regulators reacted to offbalance sheet clas-
sications of asset-backed instruments by including them in the core capital
regime of the Basel I Accord (Basle Committee on Banking Supervision
1988, p. 12f). But banks found a loophole they could exploit: Basel I ex-
empted liquidity facilities of no more than 364 days from all capital charges
(p. 24). As a result, banks set up 364-day liquidity lines and simply renewed
them the day they expired. By 1999, the Basel Committee had noticed this
widespread rule circumvention and suggested that core capital requirements
be adjusted ( Jackson et al. 1999). This became part of the negotiations for
Basel II, which started in the same year and sought to adjust capital stan-
dards on liquidity lines and close the loophole. The rst proposal for a revi-
sion of the Basel treaty included a core capital charge on liquidity lines for
ABCP conduits (Basel Committee for Banking Supervision 2001). This charge
was implemented in the nal version of the treaty in 2004, with a few amend-
ments. However, until 2008, when Basel II came into force for large Euro-
pean banks, national regulators had to deal with the rule evasion regarding
liquidity lines for nearly a decade.
In parallel to the discussions around core capital charges, which are part
of banking regulation, accounting regulations were also being adjusted to
confront offbalance sheet rule evasion. Originally, because of the overly le-
galistic interpretation of the concept of controlin the accounting regula-
tions of almost every jurisdiction, banking conglomerates consolidated only
entities in which the bank held shares. Conveniently, SPEs were structured
such that the bank held no shares or not enough to consider the entities to be
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controlledby the bank and therefore consolidated. Given that bank reg-
ulatory compliance was mostly monitored through the International Finan-
cial Reporting Standards (IFRS) or local Generally Accepted Accounting
Principles (GAAP) nancial statements, this had the fortuitous effect of re-
ducing capital charges. A senior French accounting standard setter recalls,
I remember when I was consulted in 1995 by people asking whether it [an
SPE] would have to be consolidated into the French GAAP, and I said, well,
as long as you dont have any shares in it, you dont have to consolidate any-
thing, youre free . . . which was of course horrible, but I mean . . . It was the
law(interview, 1/21/2011).
Such rigid rules-based accounting standards made the work of creative
compliance easier for market actors, since legal engineers could easily avoid
binding criteria. Auditors on the technical committees of large accounting
rms informed the International Accounting Standard Committees (IASC)
SIC of the exploitation of this rigidity in offbalance sheet rules for SPEs.
During its deliberations, the SIC concluded that it was impossible to provide
clear, detailed regulation on what needed to be consolidated, since there was
no single fact pattern regarding SPEs (interview, SIC member, 2/2011). The
members of the SIC believed that clear rules would just trigger the develop-
ment of new contractual structures falling outside the criteria, which would
again qualify SPEs as off balance sheet. In 1998, the IASC published a new
interpretation of the IAS 27 consolidation standard, called SIC 12. SIC 12
stipulated that consolidation would no longer be based on detailed rules,
but rather on principles; specically, if the majority of risks or rewards of
an SPE were seen to lie with oneentity, that entity needed to be consolidated
(PwC 2004). Importantly, this consideration now also included the liquidity
line, which both exposed the bank to risks and led to signicant rewards.
SIC 12 made the consolidation of an SPE an issue of ownership in eco-
nomic substancewho benets most from the SPE and who is most exposed
to the risksrather than ownership in legal form. Evaluating compliance
now required the judgment of accountants and auditors on the basis of a
principle and avoided the mechanistic rule-based check boxes that had pre-
viously bound auditorsdecisions. As a result, auditors and banks needed to
form common interpretations of the distribution of risks and rewards of an
SPE to decide whether to include it in the balance sheet (interview, French
auditor, 1/21/2011). Although SIC 12 was issued in 1998, it was not binding
in any jurisdiction until it was introduced at the European level as part of
IFRS (European Commission 2000). Prior to its adoption as part of IFRS,
national accounting standard setters were allowed to choose whether or
not to require compliance on the one hand, and national banking regulators
had the discretion to use this information to increase core capital charges or
not on the other. This decision was what mattered most for banking con-
glomerates: the offbalance sheet status of conduits for the purposes of
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banking regulation and thus core capital requirements rather than in terms
of nancial accounting (PwC 2006, p. 3).
Ambiguity in transnational rules and the transient nature of these regula-
tions created a space for national regulators to exercise their discretion and
choose how and when to engage regulated banks and intermediate gatekeep-
ers in the rule-making and rule-enforcement process. Owing to the trans-
national nature of the market, such regulatory action also initiated immedi-
ate international competitiveness concerns by banks (Thiemann 2014). How
national regulators and local accounting standard-setting bodies came to
choose divergent approaches to address rule evasion in Germany, the Neth-
erlands, and France is then the question we turn to next.
THE REGULATORY DIALECTIC IN GERMANY,
THE NETHERLANDS, AND FRANCE
GermanyIgnorance Caused by Distance
The Regulatory Network
In Germany, banking supervision is implemented by a highly fragmented
and decentralized regulatory network. The Bundesanstalt für Finanzdienst-
leistungsaufsicht (BaFin,the Federal Financial Supervisory Authority)
holds the nal legal responsibility for German banking supervision (DIW
2006; Hartmann-Wendels, Hellwig, and Jäger 2009, p. 104) as an adminis-
trative agency operating under the mandate of the Federal Ministry of Fi-
nance (BMF).
7
Despite its key regulatory role, BaFins banking supervision
unit has very limited staff (mainly lawyers), which allows only for off-site su-
pervision: the unit veries bankscompliance with existing rules on the basis
of documents produced by the banks themselves and their auditors, which
are veried by the Bundesbank (the German Central Bank). Accounting
standards for banks are drafted by the Federal Ministry of Justice and Con-
sumer Protection, assisted by a private German Accounting Standards Com-
mittee, the DRSC.
The decentralized nature of the German banking regulatory network is
further reinforced by the limited discretion that administrative agencies have
in Germany in interpreting the law, leading to few inquiries or supervision
across divisions and little coordination between the various actors. The reg-
ulatory focus on the letter of the law originated in postwar Germany, when
strict limits on the regulatory discretion of administrative agencies were in-
7
The BaFin was created when the Bundesaufsichtsamt für das Kreditwesen (BaKred)
banking supervisory agency was merged with the securities and insurance supervisory
agencies in 2002.
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cluded in the constitution as checks on excessive executive power (Hellwig
et al. 2010). This constitutional framework emphasizes the liberty of legal en-
tities to take economic risks and subjects federal administrative intervention
to extensive legal scrutiny. The BMF and BaFin share this strong focus on fa-
cilitating private enterprise and limiting regulatory supervision (Hartmann-
Wendels et al. 2009). Since the BMF can revoke any BaFin administrative or-
dinance or circular, innovative regulatory actions have always been strongly
discouraged in Germany (interview, BaFin, 7/1/2011). As a regulatory advi-
sor explained, BaFin always has one theme: we are a constitutional state,
we have the law for banking supervision, we have a basic framework that
is to be applied. . . . Every bank in Germany could have sued if BaFin had
asked for something that went beyond the laws and the decrees(6/14/2011;
also banking expert, 5/24/2011).
Until 2009, BaFins banking supervision was predominantly quantita-
tive in style (DIW 2006; Hartmann-Wendels et al. 2009): BaFin conducted
a largely mechanical check of nancial statements to verify whether assets-
to-equity ratios matched the minimum levels xed by law. Because BaFin
did not have the capabilities to conduct on-site audits of bank reporting doc-
uments, accounting standards and auditor verication played a critical role
in banking supervision in Germany. In addition, the minimally staffed BaFin
lacked the structural capability and expertise to verify banking conglomer-
atesreporting decisions or to question compliance decisions by auditors (in-
terview, BaFin, 7/1/2011). Auditor reports, in the form of either special au-
dits or annual nancial statements, became the BaFinsmain information
element of supervisionin Germany (DIW 2006, p. 29).
8
One important con-
sequence of this distribution of expertise was that BaFin never overruled
auditorsaccounting decisions and dialogues with BaFin relating to rule in-
terpretation were very rare (interview, banking managers, 7/12/2011; inter-
view, regulatory advisor, 6/14/2011).
9
While BaFin did, nonetheless, exchange with accounting professionals
concerned with compliance, these dialogues were initiated by regulatory
advisors and auditors of banks and centered on seeking clarication from
BaFin (interview, regulatory advisor, 6/14/2011). Regulators usually did not
proactively reach out to the auditors for news of bankscreative means of
complying with accounting rules. There was almost no informal exchange
on theseissues, and auditors were reluctant to report their concerns and doubts
about banking practices to BaFin in writing for fear it could endanger their
relationships with clients (interview, banking expert, 5/24/2011).
8
Special audits, which could be ordered by the BaFin to investigate particular topics,
were delegated to auditors in about 80% of cases (DIW 2006, p. 68).
9
In line with this nding, the World Bank reports that in the ve years prior to the crisis,
no legal actions were taken by the BaFin against an auditor (World Bank 2008).
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The (Absent) Regulatory Dialectic
The rst broad regulatory clarication with respect to securitization and
ABCPs was published by the BaKred in 1997 (BaKred 1997b). In line with
the BMFs strong advocacy of securitization to strengthen Germany as a
nancial center(BaKred 1997a), this publication specied how banks could
reduce core capital in securitization transactions, providing a checklist of
practical requirements banks had to fulll. Nonetheless, in setting up ABCP
conduits, banks were required to demonstrate the conduits compliance with
banking regulations to BaKred (BaFins predecessor). In practice, however,
BaKred (and later BaFin) always approved ABCP conduits if banks com-
plied with these checklists and auditors certied their compliance (inter-
view, regulatory advisor, 6/14/2011, 4/9/2015). When banks sought to keep
their conduits off balance sheet, they mostly negotiated with their auditors
and lawyers, using BaFins compliance assessment checklists in a legalistic
fashion to game the system; any liquidity lines below one year were ap-
proved by BaFin without opposition (Florstedt 2013). Asked about BaFins
capacity to challenge the offbalance sheet decisions made between banks
and auditors, a regulatory advisor of a large auditor network responded
that [BaFin] can doubt anything. . . . But Im thinking that if an auditor
has looked at the balance sheet part [of the offbalance sheet decision], then
it will be difcult for BaFin to formulate concerns, because the knowledge at
the large auditing networks is at least equivalent to that at BaFin [laughs]
(interview, 6/14/2011).
BaFins focus on compliance with the legal format of regulation, and its
arms-length relationships with auditors, placed it outside of the network
where discussions about compliance with banking regulation and accounting
compliance occurred. In addition, BaFin was not involved in discussions at
the DRSC concerning securitization transactions and was therefore surprised
when the DRSC reacted to the Enron scandal by proposing to harmonize
German accounting rules for SPEs with SIC 12 in December 2001. BaFin
was concerned about the uncertain consequences that an accounting rule
change for SPEs might have for the core capital requirements of German
banks and urged the justice ministry to rethink these rule changes (BaKred
2002). Yet since BaFin lacked aggregate data on the actual extent of securi-
tization activities of German banks, it was impossible for its employees to
know the impact such a rule change could have (interview, BaFin, 7/1/2011).
BaFins concerns with SIC 12 echoed the opposition of banks and leasing
rms to its adoption and delayed the application of SIC 12 to German ac-
counting rules until 2009, after the nancial crisis (interview, auditor in-
volved in the accounting rule reforms, 5/30/2011). This forestalled conver-
gence was signicant, as the core capital requirements for the subsidiaries of
German banks continued to be calculated on the basis of national rather
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than international accounting rules. Although German banks began record-
ing ABCP conduits as subsidiaries under IFRS accounting standards that
were enforced starting in 2005, the conduits could remain off balance sheet
under German GAAP accounting rules, which BaFin used as the basis for
its calculation of core capital charges. Signicantly, German GAAP contin-
ued to use legal ownership to determine the consolidation perimeter.
Because offbalance sheet engagement had become very prevalent in Ger-
many by 2005, however, banks nevertheless started to restructure their SPEs
in such a way that their onbalance sheet status under IFRS could continue
to be avoided. Banks would work out an initial SPE structure, which pre-
served offbalance sheet status, even if risk exposure remained. These struc-
tures were then presented to the auditors, with whom an intense negotiation
on the interpretation of compliance would ensue (German auditor, 5/3/2011;
German legal advisor, 11/6/2011). A legal advisor conrmed the early in-
volvement of auditors in the process: A draft is drawn up and sent to the
auditors. Then you ask the accountants: if we were to do it like this, what
would you say to the question of consolidation? Its a dialogue; the account-
ing professionals are involved very early on, and often also individuals other
than the auditors. ...Soyoucant say that the legal advisor is developing
the structure and the accountants see it later: its coordinated beforehand
(interview, 11/6/2011).
If auditors had compliance concerns, a new round of negotiations and
ne-tuning of contracts would start so that the auditorsspecic requirements
could be satised. In the process, banks would often rely on in-house or out-
side legal opinions to strengthen their position with respect to the auditor.
Importantly, the regulator was not involved in these negotiations, with neg-
ative consequences as the case of the German bank IKB (Ring 2009) makes
clear. After receiving negative auditor assessments regarding the offbalance
sheet status of its conduits in 2004, IKB engaged in negotiations with its au-
ditors and regulatory advisors to restructure contractual relations and main-
tain the offbalance sheet status. In the process, it outsourced credit risks re-
lated to its large liquidity lines in legal form but kept most of these risks in
economic substance (Ring 2009). These contractual changes convinced the
auditor to maintain deconsolidation. Asked why IKB did not consolidate
its hybrid conduit Rhineland before the crisis, a manager of a large auditing
company explained, No, because this SPE was knitted such that it didnt
have to be consolidated. If it is stitched on the edge in that way, you can al-
ways debate whether it belongs inside or not, and then you get the question:
Now tell me how much more risk I need to transfer to somebody else in or-
der for you to accept it, so that I dont have to consolidate it.And then you
continue to reect, and so you develop a model that is exactly on the edge
(interview, 5/3/2011).
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As the quote above shows, auditors may contradict regulatory engineers
and force them into a negotiation regarding the question of who is exposed
to the major risks and rewards of a structure. Yet even this does not end the
creative interaction of the regulated with the accounting standards. Instead,
banks engage in contractual outsourcing of risk to satisfy their auditors
while maintaining sufcient rewards for the banks. These decisions by au-
ditors would prove to be important for the interpretation of rules by the reg-
ulator beginning in 2006, when the Bundesbank and BaFin started prepa-
rations for the 2008 implementation of Basel II, which required banking
supervisors to engage in a more qualitative style of supervision (DIW 2006).
Until that time, the regulatory dialogue was almost entirely mediated by the
banksauditors, which decreased the embeddedness of the bank regulator
andarguablydecreased thequalityof regulatory oversight.When the Bundes-
bank performed a qualitative review of IKB in February 2007, it questioned
the legal constructions IKB had installed to maintain the 0% core capital
charge for its large ABCP conduits (Ring 2009). At the end of the evaluation,
however, BaFin opted against the economic substance analysis that required
the imposition of core capital charges. Instead, it employed a legal form anal-
ysis, granting the core capital exemption on its liquidity lines. A constraining
element in these decisions was that the auditors had repeatedly conrmed
IKBs conduits as independent from IKB itself. Interview sources indicated
that the limited legal mandate of BaFin and thefear of resistance from banks
and the Ministry of Finance prevented BaFin from challenging the structur-
ing activities of banks (interview, banking expert, 5/24/2011). The BMF had
taken a very strong prosecuritization stance in the 2000s, because it be-
lieved that fee income from the securitization business could improve the
protability of German banks (for the BMF, see Asmussen [2006]; interview,
German banking regulator, 7/1/2011). As a result, ABCP markets contin-
ued to grow until 2007, when IKBs SAC conduit Rhineland defaulted and
marked the epic beginning of the nancial crisis.
The NetherlandsCognitive Capture through One-Sided Dialogue
The Regulatory Network
In the Dutch case, the regulatory network concerned with ABCPs is less
fragmented and is centered on the Dutch central bank (DNB). The DNB
is solely responsible for banking supervision, both on-site and off-site, and
enjoys great discretion in the legal interpretation of existing rules (Seerden
and Stroink 2007, p. 194; Jennen and van de Vijver 2010, p. 94). As in Ger-
many, the supervision of compliancewith banking and accounting regulation
was partly outsourced to auditors, who produce yearly statements regarding
bankscompliance with DNB rules in conjunction with annual reports. The
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DNB has no role, however, in accounting supervision or accountingstandard
setting, which is fully outsourcedto auditors and the Dutch Accounting Stan-
dards Board (DASB). This separationresulted from a political battle between
the DASB and the DNB in the early 1990s over appropriate accounting rules
for banks. Whereas the DNB had an extensive, legally backed role in the ac-
counting decisions of Dutch banks prior to 1993, this link was severed when
Directive EC 86/635 on consolidated banking statements was implemented
into Dutch law in 1993 (Thiemann 2013). The DASBseeking to emulate
the IASC, which insisted that banking regulators should play no role in ac-
counting standard setting (interview, DASB former president, 8/16/2011)
successfully pushed the Dutch Ministry of Security and Justice to exclude the
DNB from setting accounting standards. The DNB then decided to detach
itself entirely from overseeing the actual accounting decisions of Dutch banks
(interview, bank accounting manager, 12/6/2011; interview, Dutch auditing
association, 7/6/2011). While the DNB did have an accounting team, its task was
not the auditing itself, but the translation of nancial accounting numbers
into core capital requirements and the denition of core capital (interview,
DNB, 9/9/2011). As a consequence, accounting expertise was largely absent
among DNB regulatory staff (interview, former DNB employee, 4/27/2015).
10
The Regulatory Dialectic
In the mid-1990s, the DNB developed regulation for securitization transac-
tions in close dialogue with Dutch banks, rst on a case-by-case basis (DNB
1997; interview, bank manager, 4/8/2015)and then, from 1997 onward, based
on a memorandum stating the supervisory aspirations of the DNB with re-
spect to securitization (DNB 1997). In its assessment of the ABCP market,
the DNB used two primary information sources: regulatory developments in
the Anglo-Saxon context that increasingly relied on the internal risk assess-
ment of banks (Johnson 2000) and the banks themselves. The DNB aimed to
ensure the international competitiveness of its banks and perceived securiti-
zation as an important area in this respect. As a result, the DNB kept abreast
of market developments but was generally supportive of bank engagement in
the ABCP market (interview, bank manager, 12/6/2011) and used the inter-
actions with its banks as a practical classin securitization, seeking to better
understand developments based on industry experience (e-mail, bank man-
ager, 3/16/2015, 3/25/2015; interview, bank manager, 4/8/2015). The securi-
tization framework developed in 1997 essentially formalized the practices
developed in these dialogues (e-mail, bank manager, 3/23/2015). The DNB
10
In line with this distribution of competencies, the World Bank reports that no legal ac-
tion against auditors had been taken by the Dutch supervisor in the ve years before the
crisis (World Bank 2008).
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was aware of many of the advantages and risks of securitization and aimed to
provide clarity to the banking industry on how it would assess securitization
transactions.
One important element of the 1997 securitization framework was that, as
in Germany, Dutch banks had to directly approach the DNB for every con-
duit they set up and inform the DNB of every securitization transaction on a
quarterly basis. The dialogue between banks and the DNB essentially fol-
lowed a two-step process: rst, banks proposed the framework of the ABCP
conduit to be set up, and second, after an informal DNB agreement, banks
submitted a more detailed proposal. The DNB would use this proposal to
determine the core capital charge of the conduits and could ask additional
questions. These discussions were described by bank managers as very con-
structive, content-driven,and based on new mathematical models that the
banks had developed in the late 1990s to argue successfully for core capital
reductions (interview, bank manager, 5/13/2015). Although these discus-
sions included requests by the DNB that banks adjusted conduit structures,
banks and their regulatory advisors always kept a knowledge edgethat
guided the discussion and exchange (e-mail, bank manager, 3/16/2015). In
contrast to the German situation, the DNBs decisions about core capital
treatment of ABCP conduits relied almost exclusively on information from
the banks, ignored accounting treatment of the conduits, and included few in-
dividual assessments by third parties, such as auditors. This purely dyadic re-
lationship would prove to be important for the evolution of regulation, as it pre-
vented the inclusion of critical outside voices reporting on rule circumvention.
A good example of these regulatory dialogues was the prudential treatment
of liquidity lines of less than one year. In the late 1990s, following conver-
sations with industry and in particular with bank asset management divi-
sions and their mathematical modelers (interview, bank manager, 12/6/2011;
e-mail, 3/16/2015), the DNB accepted the industry proposition that the li-
quidity lines for ABCP conduits posed no risk to the banks and agreed to
maintain the 0% core capital charge. The DNBs decision to accept the in-
dustry views that these conduits were only pipes through which money was
owing,without any risks to the bank, was inuenced by discussions with
British regulators (interview, bank manager, 12/6/2011).
Because the decisions regarding core capital requirements were discon-
nected from conduitsaccounting treatment, the achievement of offbalance
sheet status in the nancial accounts was not the predominant goal of large
Dutch banks, so auditors were largely uninvolved in the design of ABCP con-
duits (PwC 2006; interview, bank manager, 12/6/2011). The lack of impor-
tance of auditors in producing data about ABCP conduits for the DNB was
also reected in the way SIC 12 was implementedby Dutch banks in 2001. Re-
actions were mixed when the Dutch accounting standard setter decided to
translate the SIC 12 norms and include them into the Guidelines for Annual
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Reporting of the Dutch Accounting Standards. Some banks simply consoli-
dated these conduits in their annual nancial statements,
11
while others con-
tested the new rule or engaged in restructuring negotiations with their audi-
tors (interview, regulatory advisor, 10/6/2011). This mixed reaction can be
explained in part by the fact that accounting decisions did not make a differ-
ence to core capital charges, as the DNB chose to ignore the accounting infor-
mation and continued to rely on its own securitization framework, which
granteda de facto offbalancesheet status to securitization transactions when-
ever the DNB concluded that a substantial risk transfer had occurred (in-
terview, DNB, 10/5/2011). This disconnect of core capital treatment from
accounting numbers continued when IFRS and SIC 12 were ofcially im-
plemented in 2005 (DNB 2005), because the DNB accepted the banksview
that all elements of risk had already been included in the direct negotiations
(e-mail, bank manager, 11/30/2015).
As the DNB was not involved in accounting standard setting, it was also
unconcerned that the intent of SIC 12 was to push ABCP conduits back on
balance sheet when banks were exposed to the majority of the rewards, not
just the risks. Discussions between the banks and the DNB had focused ex-
clusively on the risks as identied by the DNB and had looked at them
through a banking lens of risk management and assessment. The DNB suf-
fered from cognitive closurewith respect to the ABCP market and its risks
(Aalbers, Engelen, and Glasmacher 2011): it considered this banking activ-
ity only from the banksviewpoint and abstained from questioning banks
business models (IMF 2011, pp. 5960 ).
An important enabler of this cognitive closurewas the DNBs sensitiv-
ity to the global competition Dutch banks were facing (e-mail, bank man-
ager, 3/27/2015) and its attention to banksconcerns regarding a level playing
eld in the context of international and European nancial market integra-
tion (interview, second bank manager, 4/8/2015; e-mail, banking supervisor,
4/14/2015). This became particularly clear in the DNBs handling of the an-
ticipated new core capital charges in Basel II, which stipulated a 20% core
capital charge on liquidity lines. In 2004, the DNB issued a memorandum
on securitization that reserved its right to impose an equivalent core capital
charge before the implementation of Basel II but that also indicated that
the central bank would consider the effect on international competitiveness
(DNB 2005, p. 395). Indeed, because of international competitiveness con-
cerns (e-mail, DNB manager, 4/14/2015), the DNB did not impose such new
core capital requirements on liquidity lines until 2008 (e.g., Rabobank 2009,
p. 28), in line with their predominant reliance on bank perspectives. As a re-
11
This was the case for ABN AMRO.
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sult, the ABCP market continued to grow in the Netherlands until the begin-
ning of the nancial crisis.
FranceEmbedded Regulators
The Regulatory Network
The central player in the French regulatory network during this period was
the Commission Bancaire (CB).
12
The CB was endowed with large regulatory
discretion and was involved in both off-site and on-site banking supervision,
the latter shared with auditors. While the CBs off-site supervision consisted
of collecting and examining the accounting and prudential documents sent
by banks as well as auditors, the CB also conducted generic or specicon-site
qualitative inspections to evaluate whether the information disclosed by each
of these institutions reected the actual situation of the banks. In the case
of nancial innovations, on-site supervision would typically identify poten-
tial issues and report them both to the bank and to CB examiners. Every six
weeks, on-site and off-site supervisors would meet in the CB to share con-
cerns about emerging bank practices (interview, French banking regulator,
1/21/2011). Mutual understanding was helped by the fact that the typical ca-
reer of a CB employee included both off-site and on-site functions, creating
strong practical expertise inside the CB (interview, French banking regulator,
2/3/2011).
In contrast to the Netherlands, the CB also played a large role in account-
ing supervision and standard setting. The well-staffed CB accounting de-
partment supervised the accounting decisions of French banks and their au-
ditors. It had extensive legal rights to question the accounting decisions of
banks and of auditors so as to provide a complementary guarantee of the
independence of the auditors (Commission Bancaire 2002, p. 12). A number
of structural incentives also ensured that the auditors would proactively in-
form the CB about novel rule interpretations. First, auditors were required
to inform the CB of dubious bank practices. Second, the French banking
regulator had extensive powers to contest and overrule accounting classi-
cations if it deemed them to violate the spirit of the law. These powers were
rst instituted in 1996, when the CB was given the authority to hold audi-
tors accountable for signing off on dubious accounting decisions. Further-
more, in June 1999 the CB was empowered to request a change of auditor
12
A part of the Banque de France (French Central Bank), the CB became independent
from the French Ministry for the Economy and Finance in 1993 after a scandal at Credit
Lyonnais bank revealed the dangers of political interference in banking regulation ( Jean-
Pierre 1997; Coleman 2001).The CB is now part of ACPR, the authority that merged the
CB with insurance and nancial supervision authorities ACAM, CEA, and CECEI.
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if that auditors independence was deemed questionable and to reject bank
nancial statements if it found them inaccurate. These legal powers have
been put to frequent use by the CB, and as a result, banks and auditors fre-
quently negotiate accounting decisions with the CB.
13
The CB also plays an extensive role in accounting standard setting for
banks. Before 1996, the CB alone drafted the accounting rules for banks, in
coordination with the banking industry, but since 1996 it has been part of a
National Credit Council (CNC) subcommittee that makes accounting rules
specically for banking conglomerates (Senat de France 1998). This subcom-
mittee includes representation from banks, bank accountants, and auditors.
Members engage in a monthly deliberation and negotiation to formulate
new rules (interview, banking manager on the subcommittee, 3/25/2011; in-
terview, former state ofcial, 4/29/2011).
14
The regulatory discretion of the CB, which went hand in hand with a
strong presence of regulators inside the banks (on-site supervision) and a
continuous dialogue with the external bank auditors and bank accountants
(off-site supervision), fostered the regulators deep understanding of the eco-
nomic substance of business transactions and banksaccounting classica-
tions. This ongoing compliance dialogue between experts regarding ABCP
conduits would prove important for the evolution of the regulation of that
market.
The Regulatory Dialectic
As early as 1988, the French state set up a comprehensive regulatory frame-
work for securitization as part of the comprehensive reforms by the French
administration to foster nancial innovation (OSullivan 2007; Hardie and
Howarth 2013). The framework established clear rules for securitization,
but it did not restrict the CBs capacity to apply its own discretion and judg-
ment to each case. As the CB put it, The general secretary of the Commission
Bancaire reserves to itself the possibility, as in all matters of core capital re-
quirements, to adapt prudential treatment if a securitization operation pres-
ents characteristics which would make such a treatment inappropriate or of a
nature which would lead to a mistake in terms of the objectives of prudential
supervision(Commission Bancaire 2002, p. 12; here and elsewhere, trans-
lations are the authorsown; unless otherwise indicated).
13
In contrast to Germany or the Netherlands, the French regulator used these powers to
take legal action against auditors in the ve years before the crisis (World Bank 2008).
14
The French banking regulators staff in these negotiations has practical experience and
receives a thorough education in accounting matters at the academy of the Banque de
France, widely recognized by accounting professionals and bankers for its expertise (in-
terview, accounting standard setter, 1/27/2011; interview, bank manager responsible for
group accounting, Paris, 3/25/2011).
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Given this regulatory discretion and vigilance, it became important for
banks to approach the French regulator with new conduit structures early
on to avoid being hit by core capital charges (interviews, banking regula-
tors, 4/2011). During these institutionalized conversations in the 1990s, the
CB became increasingly concerned with the core capital treatment of ABCP
conduits, as it observed the emergence of more and more complex contractual
structures on the one hand and as it was approached by auditors about their
dubious offbalance sheet treatments on the other hand (interview, CB, 2/3/
2011). This drove the CB to take early action to reduce instances of rule eva-
sion. In 1999, the CB pushed for convergence of French banking standards
with SIC 12 through a nationally implemented rule. The CBs input was
key, as it fought to make the standard for offbalance sheet accounting as
strict as possible (interview, CNC member, auditor, 3/22/2011). As a result,
the standard for banks reached almost complete convergence with SIC 12
(Commission Bancaire 2002), even if the standard for other corporations re-
mained wedded to a legal form approach. This accounting norm for banks
was then used as the basis for banking regulation in September 2000 that ap-
plied core capital charges to consolidated conduits.
15
After the introduction of the new accounting rule, the CB maintained an
ongoing dialogue with the banks andauditors about its effects.In particular,
the CB, the French auditorsassociation, and the Commission des Opéra-
tions de Bourse (COB) engaged in a two-year investigation into the offbalance
sheet vehicles of French banks, with special focus on those offbalance sheet
SPEs in which banks had placed debts in the wake of the Latin American
and East Asian crises of the 1990s (interview, French Banking Association,
5/11/2011; interview, Autorité des Marches Financiers, 4/12/2011). Follow-
ing the investigation, the CB and the COB issued a joint recommendation
in 2002 that SPEs should be consolidated on a banks balance sheet if the ma-
jority of rewards resided with the banking conglomerate (COB 2002). Moving
away from a legal ownership as a basis for consolidation, the CB built on the
principle-based approach in SIC 12 that economically substantial risks and
rewards should fall together and that exposure to risks should be visible on
the balance sheet. In effect, the recommendation shifted the burden of proof
to the banks: when the majority of rewards of a securitization process were
seen to reside with a bank, consolidation would automatically be required
unless the bank could prove that it did not hold the majority of the risks:
If you have most of the advantages, you have most of the risks. The idea be-
hind it was that we are dealing with professionals, and if they have most of the
rewards, it is because they carry most of the risks; otherwise there is a problem.
This was always the case(interview, French auditor, 3/23/2011).
15
The French text (Règlement n7200003) can be found at http://www.banque-france
.fr/fr/supervi/regl3e_ba/textvig/reg6_2003.htm.
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The CB ensured enforcement through a constant dialogue with the au-
ditors and the banks. An auditing partner of a large auditing network ex-
plained how they had to justify their decisions not to consolidate the con-
duits, presenting their reasoning and risk-reward calculations: They [CB
staff] were always very present, absolutely. We auditors would defend our
position, meaning that we would present our opinion as to why we had ac-
cepted the deconsolidation of the large conduits, for example. . . . We had
to justify our position, and then make the calculation. . . . They didnt mon-
itor us every day, but every time the question was asked about these vehi-
cles, they were present(interview, 3/22/2011).
These institutionalized conversations effectively squelched blatant at-
tempts by bankers to evade the rules. The active involvement of the regulated
and the gatekeepers was encouraged by the CBs power, as banking regu-
lator, to reject the nancial reporting statement of a bank, which was feared
for its reputational effects on banks and auditing teams alike (interview, for-
mer representative of French banking federation, 5/11/2011). Although the
2002 CB/COB recommendation did not have the force of law, it was imme-
diately implemented, since the sanctioning capacity of the CB made non-
compliance totallyunthinkable(interview, former auditor,5/11/2011). Fur-
thermore, the banking regulator reserved the right to reverse decisions to
nancially deconsolidate andcould treat the conduits prudentially as on bal-
ance sheet (Commission Bancaire 2003, p. 20; interview, banking regulator,
2/3/2011).
This constant institutional dialogue enabled the CB to also detect rule cir-
cumvention related to liquidity lines in 2002 (interview, banking regulator,
2/3/2011). When off-site supervisors noticed that liquidity lines were consis-
tently being renewed on their expiration date in order to secure a 0% core cap-
ital charge (interview, French banking regulator, 1/2011), the CB was able to
react swiftly. It did not need to change the law to tighten the criteria on core
capital charges, however; it merely published changed criteria in 2003 in an
annual communication on core capital charge rules (CB 2003, p. 20), thereby
circumventing a long and possibly contentious legislative process. The 2002
recommendations by the regulator, in tandem with the 2003 ofcial inter-
pretation on liquidity lines, forced banks to restructure their contractual re-
lations with ABCP conduits, which initially led to a substantial reduction in
their margins (interview, bank group accounting manager, 3/25/2011) and,
consequently, to a virtual discontinuation of issuance of ABCP by all single-
seller, hybrid, and securities arbitrage programs in 2006 (g. 4).
Importantly, however, regulatory action was never directed against the
ABCP market itself, which was perceived as legitimate. Instead, in accor-
dance with its administrative mandate, the regulator wanted banks only to
account for the risksthey were taking in this market (interview, French
banking regulator, 2/2011), defending this stance against the banks as well as
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the Ministry of Finance (Amis and Rospars 2005). As a result, French bank-
ing activity persisted only in multiseller conduits, which the French regula-
tors considered more legitimate.
REGULATORY SUPERVISION AND THE PREVENTION
OF RULE EVASION
Comparing the three different cases, we gain a better understanding of how
regulator-regulated interactions inuence rule evasion, the factors that ex-
plain regulatory control, and the impact of such interactions on market evo-
lution.
Our ndings show that the respective regulatorsability to control rule
evasion in the ABCP market arose in part in the different relational cong-
urations among the actors in the regulatory network. More specically, the
regulatory dialectic was inuenced by the regulatorspositioning in the in-
terpretive community(Black 2008; Ford 2010), that is, the regulatory net-
work in which actors engage in conversations to interpret the meaning of
regulation and compliance. As ABCP-related regulatory costs were deter-
mined by both accounting and banking regulation, we nd that when regu-
lators were embedded in the interpretive communities of both these regula-
tory spheres, they were more aware of rule-bending behavior and therefore
were better equipped to reregulate. Figure 5 provides a schematic overview
of the differences in the regulatory network and interpretive communities in
France, Germany, and the Netherlands.
In Germany, BaFin was a peripheral actor in the regulatory network and
was completely disembedded from the interpretive community and there-
fore lacked an awareness of specic rule-bending practices that could have
triggered regulatory steps to control them. Its actions were furthermore in-
hibited by the Ministry of Finances regulatory capture by bankersinterest.
In the Netherlands, by contrast, the DNB was central and rmly embedded
in the interpretive community for banking regulation yet disembedded from
the interpretive community for accounting regulations. The data used to as-
sess and debate rule compliance were produced entirely in the DNB-bank
dyad, cut off from accounting discussions about how to best assess the risk
exposure of ABCP conduits. Finally, in France, the CB not only was central
and embedded in the interpretive communities for both accounting and
banking regulation but also made sure there was a well-organized ow of
information among the CB employees involved with the respective inter-
pretive communities.
Our ndings also provide indications about the factors that facilitate or
hinder the regulators embeddedness in the regulatory dialogues that occur
in the interpretive communities: regulatory discretion, expertise, and sanc-
tioning power. We found that embeddedness emerged when the regulator
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FIG.5.The regulatory networks governing ABCP conduits in Germany, the Netherlands, and France
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had the sanctioning power and regulatory discretion to interpret and sanc-
tion, which was the case when regulators could rely more on principle-based
rather than rule-based regulation. In addition, embeddedness in an inter-
pretive community was more likely when the regulator had the technical ca-
pabilities and expertise to engage in and contribute to the rule interpreta-
tion. For example, the German BaFin and Bundesbank were limited by
legal and cultural norms to adhere to narrow rule-based interpretation of
the law and were hindered by their limited resources, accounting capabili-
ties, and expertise. Conversely, in the Netherlands and France, bank super-
vision was centralized in the DNB and CB, respectively, both of which used
their signicant regulatory discretion and power to force banks into a dia-
logue about ABCP conduits. However, since the DNB had no regulatory or
stafng capacity in the accounting realm, it effectively disembedded itself
from the accounting interpretive community. The French banking regulator,
by contrast, relied heavily on a diversity of inputs from a variety of sources,
based on the incentives for local gatekeepers and banks to provide data on
new nancial innovations. The capacity of the CB to interpret and sanction
bank behavior, as well as its legal mandate to challenge auditor decisions,
made it in the auditorsinterest to preemptively seek dialogue with regulatory
authorities. The legal capacities and expertise of the French banking regula-
tor, and the obligation of auditor and audited to justify their decisions, al-
lowed the regulator to be central in both spheres of the interpretive commu-
nity and be deeply involved in regulatory conversations.
In sum, legal discretion, sanctioning power, and technical expertise inu-
enced how regulators were structurally embedded in the regulatory network
determining the appropriate interpretation of accounting standards for ABCP
conduits and core capital charges for liquidity lines. These aspects secured
or prevented regulatorstimely representation and participation in negotia-
tions. In contrast to the German and Dutch examples, the French regulator
appears to have avoided cognitive capture that occurred in the Netherlands.
Being embedded in two interpretive communities allowed the CB to avoid
the one-sided view presented by nancial engineers, go backstage in the reg-
ulatory drama that regulatory action at a distanceentails (Vollmer 2007),
and maintain skepticism of the nal numbers provided by the regulated (Por-
ter 1995), as well as the product itself. Equipped with this knowledge and le-
gal discretion, they could maintain interpretive control and close regulatory
loopholes before the practices became so widespread that the political oppo-
sition to change became insurmountable.
REGULATORY DRAMA AND THE EMBEDDEDNESS OF MARKETS
Attempts by the regulated to avoid regulatory control by bending the mean-
ing of compliance can inuence the evolution of markets, as we have shown
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with our case study of the ABCP market. We also found, however, that rule-
bending behavior affects market evolution in different ways depending both
on the structural embeddedness of the regulator within the network of ac-
tors engaging in regulatory conversations around compliance and on the reg-
ulators ability to respond to such behaviors after these discussions. For a
more complete understanding of the sociology of markets, economic sociolo-
gists should therefore focus their attention on the network of interactions be-
tween market actors and regulators that structures the cycle of regulation
rule avoidancereregulation and, in turn, steers the behavior of market actors.
As such, our article contributes to the sociology of markets on the one hand
and to the sociology of law on the other.
First, our ndings suggest that for a more complete understanding of the
sociology of markets and nancial markets in particular, economic sociolo-
gists should consider work on the effects of both the endogeneity of law and
the regulatory dialectic on shaping markets. While recent explanations of so-
cially undesirable market evolutions have been mostly concerned with de-
regulation (Guillen and Suarez 2010; Funk and Hirschmann 2014) or fraud
(Calavita, Tillman, and Pontell1997; Vaughan 1999; Martinez-Moyano, Mc-
Caffrey, and Oliva 2014), the impact of creative compliance has received
much less attention. As we have shown, exchange on the ABCP market is
to a large extent structured by the rules of classication and commensuration
that regulators use as input to steer the behavior of market actors. To avoid
the intended behavioral constraints that come with these classications, mar-
ket actors will engage in the creative compliance procedures described as
stitching on the edge.This nding shows that regulation does not directly
structure markets by steering behavior as intended by regulators. Instead,
their inuence is mediated by how compliance is interpreted. By being sen-
sitive to the processes by which the regulated shape the effects of regulation
in their favor, our study integrates insights from the sociology of law, most
notably the endogeneity of law(Edelman, Uggen, and Erlanger 1999), into
the sociology of markets.
Our ndings extend this endogeneity of law perspective, however, by
showing that the endogenous shaping of the law is not a privilege for market
actors only: regulators and the regulated engage in a regulatory dialectic that
is inuenced by the structural relations that regulators entertain with the reg-
ulated. Through intensive exchange with the regulated and the gatekeepers,
regulators can gain an understanding of how the regulated interpret and in-
novate around these rules, allowing regulators to detect and potentially limit
the rule-circumventing behavior of the regulated. Their capacity to do so de-
pends on the way they are structurally embedded within the interpretive
communities that determine compliance. We found that this structural em-
beddedness of regulators is a function of the regulatory discretion regulators
have in judging compliance, as well as the sanctioning power, competencies,
American Journal of Sociology
1810
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All use subject to University of Chicago Press Terms and Conditions (http://www.journals.uchicago.edu/t-and-c).
and expertise the regulator has when engaging the different interpretive com-
munities involved in determining compliance. These aspects are mutually
reinforcing and are grounded in the type of regulation employed. If regula-
tion is rule based, it locates the power of interpretation with the regulated,
which disembeds the regulator from the interpretive community and hin-
ders the regulator in developing the expertise needed to stay abreast of new
developments. Principles-based regulation, on the other hand, is conducive
to fostering structural embeddedness as it provides only limited ex ante cer-
tainty about the regulatory classication of certain constructs, encouraging
the inclusion of regulators in the community of actors who determine what
is and is not compliant with the rules. In other words, the type of regulation
inuences the regulatory network and the interpretive community involved
in the endogenous production of regulation.
Principles-based regulation alone, however, is insufcient to ward off the
rule-bending behavior of the regulated. As leading sociolegal scholars on
principle-based regulation noted after the crisis, prenancial crisis views
on the effects of principles-based regulation suffered from overcondence
in the capacity of regulators and regulated to come to a mutually agreed un-
derstanding. Such condence was not justied when mechanisms were lack-
ing to bring about a shared understanding (Ford 2010; Black 2012). Our re-
search shows that principle-based regulation can work when regulators have
both the expertise to substantively engage the interpretive communities and
the regulatory discretion to develop their own interpretations of rules and
sanction accordingly. The combination of these institutional powers, regula-
tory discretion, and expertise of the regulator brings about the need for the
regulated and gatekeepersto closely exchange with the regulator on the mean-
ing of compliance, allowing the regulator to maintain interpretive control.
Together, these ndings show that the endogenous effect of laws and reg-
ulations on markets works not only through how they are interpreted by mar-
ket actors but also through how the indeterminacy of rules is resolved in the
regulatory dialectic between the regulator and the regulated. Conicts about
efcient regulation do not take place at the rule-making level alone, but play
out in the interpretation of regulation as well (Hallidayand Carruthers 2007).
For sociologists of law, it is therefore important to look at where regulators,
engaged in regulatory action at a distance (Robson 1992), are situated in the
regulatory drama (Goffman 1959; Vollmer et al. 2009), and ask whether the
regulator can move backstage to observe how the numerical representations
shown to them are produced.
Regulatory Embeddedness
The reexive behavior of both the regulated and the regulator with regard
to regulatory rules of classication has important implications for the con-
Evolution of Markets
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All use subject to University of Chicago Press Terms and Conditions (http://www.journals.uchicago.edu/t-and-c).
cept of the embeddedness of markets (Granovetter 1985; Krippner and Al-
varez 2007). Institutional scholarship focusing on the institutional embed-
dedness of markets in society has long emphasized the constitutive role of
the state and the law for the functioning of markets, going so far as to locate
the impact of the state in every act of market exchange (Krippner 2001,
p. 785). To date, however, these works have mostly operated at the meso-
or macrolevel (Krippner and Alvarez 2007) and do not connect with the
microlevel relational perspective of embeddedness that explains markets
as a result of how networks of market actors shape the conditions for market
exchange (Granovetter 1985; Uzzi 1997). As Fligstein and Dauter (2007)
point out, network scholars, on the other hand, have tended to ignore the
political economy in which markets are embedded. In particular, they ig-
nore the regulatory frameworks, their constraining effects, and market ac-
torsefforts to engage or circumvent these constraints through creative com-
pliance. In both these perspectives, however, regulators are conceptualized
as disembedded from the market, with market actors either interacting with
each other inside of the legal frame set by the regulator, but not with the reg-
ulator itself, or interacting with regulators, but only in the rule-making pro-
cess outside of markets.
Our attention to regulator-regulated interactions about the meaning of
rules and compliance within markets helps to bridge institutional and net-
work perspectives of embeddedness. We show that the macroinstitutional
role of regulation is the product of the relational conguration between mar-
ket actors, regulatory actors, and gatekeepers and how they interact with
each other in shaping the local effect of macrolevel institutions. We there-
fore propose that for a sociological understanding of the evolution of mar-
kets, we need to understand not only how market action is embedded within
institutions (such as state laws and regulations) but also how these (state) in-
stitutions are embedded within the networks that shape the interpretations
of compliance with them. This means that we need to study the embedded-
ness of laws and regulation in their relational context of interpretation, en-
forcement, and compliance, which in turn is structured by the institutional-
ized powers and competences of the regulator. It is this dialectic relationship
between institutions and its context of enforcement that determines the reg-
ulatory embeddedness of markets.
Connecting the institutional and relational notions of embeddedness then
has important implications for the role of interactions between regulators
and the regulated in explaining the effectiveness of regulation. Extant the-
ories of regulator-regulated relations in political science and economics as-
sign unequivocally negative impacts to intensive links between regulators
and the regulated (Stigler 1971, 1974; Buiter 2008; Seabrooke and Tsingou
2009; Baker 2010; Johnson and Kwak 2010; Barth et al. 2012; Kwak 2013;
Moschella and Tsingou 2013), as it would lead to regulatory capture
American Journal of Sociology
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(Stigler 1971, 1974) or cognitive capture (Buiter 2008; Johnson and Kwak
2010; Kwak 2013), as regulators come to approach the problems through
the eyes of the regulated. Our analysis of the Dutch case would indeed suggest
that maintaining arms-length ties between regulators and regulated is the
preferred mechanism to avoid such undue inuence. However, consistent
with sociologists of law (Edelman et al. 1999), our analysis of the German case
shows that such conclusions are overly simplistic and that arms-length ties
between the regulator and the regulated are even more likely to allow rule
circumvention. When regulators maintain relationships with the regulated
that keep them distant from the processes of determining compliance, they
are excluded from the interpretive community and therefore are less capa-
ble of detecting and inuencing rule evasion. Between these two contra-
dicting theories, our analysis of the French case shows that there is a form of
regulatory networks that reconciles these perspectives. We nd that struc-
tural embeddedness of the regulator in a network that engages with the reg-
ulated might be able to prevent rule circumvention, when the regulator relies
on a diverse set of actors in the interpretive community that are empowered
to detect and inuence rule evasion. It appears that cognitive capture occurs
when perspectives in the regulatory network seeking compliance are not or-
ganized in a sufciently diverse way and there is not enough dissonance to
prevent lock-in (Beunza and Stark 2012). Direct interaction about inno-
vation with market actors alone risks allowing industry views to eclipse reg-
ulatory concerns. Gatekeepers, such as auditors, involved in the process of
compliance, when pressured to provide an independent perspective, can chal-
lenge the industry narratives. Our relational perspective on the endogeneity
of law then raises new questions about the relationship between institutions
and the associated regulatory networks. Which relational factors, other than
the sanctioning power of regulators, might induce market actors and gate-
keepers to be forthcoming about creative compliance activities of the regu-
lated? What factors other than social interaction patterns affect the critical
outlook of regulators on the regulated? For example, under which condi-
tions are competitiveness concerns between countries inuencing this crit-
ical outlook? Furthermore, if staying abreast of regulatory developments
in a principles-based regulatory system likely requires proactive and qual-
itative research methods that are grounded in human interaction skills and
a critical inquisitive mind-set, then which organizational and social settings
are conducive to training, maintaining, and rewarding such behaviors? An-
swering these questions is fertile ground for further research.
Anal set of questions leads us to the scope conditions of our ndings. Be-
cause of the constitutive role of law in nance (Black 2013; Pistor 2013) and
the sensitivity of nancial instruments to regulatory conditions (Vollmer
et al. 2009; Carruthers and Kim 2011), nancial markets present a particu-
larly ideal context to study market actorscreative interaction with regula-
Evolution of Markets
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tion and the regulatory dialectic. But creative compliance is a pervasive phe-
nomenon in many markets, which means that the scope of our theory is likely
applicable elsewhere. Other examples of such markets in which creative com-
pliance and corresponding regulatory dialectics prevail are labor markets,
where employers change the legal form of employment contracts, turning their
employees into dependent (false) self-employed to evade regulatory costs
associated with the social security system (Roman, Congregado, and Millan
2011; Lee et al. 2014), or the market for tax avoidance schemes, where tax
lawyers invent tax compliance schemes that exploit loopholes in tax regula-
tion (Picciotto 2007; Fleischer 2010; Seabrooke and Wigan 2017). Common
across these markets is that, as a result of asymmetries in expertise and the
difculty of observing rule compliance directly, compliance behavior that
deviates from the spirit of the law can go undetected more easily. In such cases,
the structural embeddedness of the regulator within the interpretive commu-
nities that determine the meaning of compliance will determine how far rule-
circumventing practices will shape the evolution of markets.
Conclusion
In sum, the way a market responds to regulation depends on the network of
actors involved in rule interpretation. Market evolution in the spirit of regu-
lation requires more, not less, interaction between regulators, the regulated,
and the gatekeepers, but also that regulation is such that the regulated de-
pend on the regulators for rule interpretation and not the reverse. A sociol-
ogy of markets that seeks to provide a coherent sociological view of mar-
kets, market participants and what actors around markets are doingand
that takes social relations, power and meaning as its core elements(Flig-
stein 2001, p. xiii) must therefore take into account the power struggles that
occur when market actors and regulators discuss the meaning of compli-
ance and the capacity of the regulated to circumvent onerous rules. This ex-
panded focus should provide an enriched perspective on the evolution of
markets and their externalities. It is our hope that it will also introduce a
new sensitivity to the role of regulators in stabilizing markets.
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... This has led to new challenges, for example when national actors advocate the protection of their "national banking champions, " thereby counteracting the new regulatory imperative of stronger regulation of too-big-to-fail organizations (Epstein and Rhodes, 2016b;Hardie and Macartney, 2016). In principle, like Thiemann and Lepoutre (2017) show, to better grasp financial compliance or avoidance, it is not sufficient to focus on market actors alone, but one also needs to look at their relationships with regulators. ...
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... Drawing on recent studies about the regulatory dialectic (Thiemann & Lepoutre 2017;Wansleben 2018), and the sociology of law (Edelman et al. 2011;Gray & Silbey 2014), I show that these two problems correspond to capture mechanisms with different temporal trajectories. While information problems tend to be based on shortterm dynamics of deception and secrecy (Gibson 2014;Rilinger 2019), worldview problems tend to result from more gradual influences on the legal (Carruthers 2013) and the institutional structure (Wansleben 2021) that undergird the regulatory dialectic. ...
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