Why reregulation after the crisis is feeble: Shadow banking, offshore financial centers, and jurisdictional competition

Why reregulation after the crisis is feeble:Shadow banking, offshore financial centers,and jurisdictional competition

Thomas RixenUniversity of Bamberg, Bamberg, Germany

AbstractA crucial element in the complex chain of factors that caused the recent financial crisis was the lack

of regulation and oversight in the shadow banking sector, which is largely incorporated in offshore

financial centers (OFCs), but instead of swift and radical regulatory reform in that sector after the

crisis, we observe only incremental and ineffective measures. Why? This paper develops an expla-

nation based on a two-level game. On the international level, governments are engaged in compe-

tition for financial activity. On the domestic level, governments are prone to capture by financial

interest groups, but also susceptible to demands for stricter regulation by the electorate. Govern-

ments try to square the circle between the conflicting demands by adopting incremental and

symbolic, but largely ineffective, reforms. The explanation is put to empirical scrutiny by tracing the

regulatory initiatives on shadow banks and OFCs at the international level and within the United

States and the European Union, where I focus on France, Germany, and the United Kingdom.

Keywords: financial crisis, institutional change, offshore financial centers, shadow banking, state

competition.

1. Introduction

The creation of credit bubbles that precede financial crises is often facilitated by regulatorygaps that enable market participants to realize greater profits. In the process, financialactors take on ever more risk, which they manage to hide from regulatory agencies, or towhich regulators, if they are aware of the risks, turn a blind eye. Eventually the bubblebursts and regulators ex post try to close the particular regulatory gap that has fuelled theboom. In the current crisis the main regulatory gap identified is the existence of a largelyoff-balance-sheet non-bank financial system, the so-called shadow banking system. Bankssponsored special purpose vehicles (SPV) in which credits were securitized and sold onthe market. While securitization in itself could lead to a more efficient allocation of risks,this business was, to a large extent, driven by regulatory arbitrage. By using off-balancesheet vehicles, banks circumvented minimum capital requirements to hand out morecredit. One element of this regulatory gap is offshore financial centers (OFC). Mostshadow bank entities are incorporated offshore and enjoy the tax and regulatory privilegesoffered by these places. It was, therefore, warranted to target OFCs after the crisis – one ofthe most immediate and publicly discussed policy reactions of the G20.

Correspondence: Thomas Rixen, University of Bamberg, Feldkirchenstr. 21, 96052 Bamberg,Germany. mail: [email protected]

Accepted for publication 15 March 2013.

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Regulation & Governance (2013) 7, 435–459 doi:10.1111/rego.12024

© 2013 Wiley Publishing Asia Pty Ltd

However, the regulatory response toward OFCs and shadow banking falls short ofwhat would be needed. For one, we see only incremental rather than radical regulatoryreform, which many experts consider necessary given the severity of financial marketfailure (see e.g. OECD 2009). The initiatives are, at best, minor improvements over thestatus quo. In addition, in many instances there is a remarkable misfit between causes ofthe crisis and the content of policies. For example, the policies adopted toward OFCshardly touch on the shadow banking strategy and financial instability. I submit that theregulatory reaction largely serves a symbolic purpose to acquiesce popular sentimentswithout having actual effect. In other words, the case of shadow banking is not only oneof incremental, but also of insufficient reform. While incrementalism, as pointed out byMoschella and Tsingou (2013), clearly has its virtues, they do not bear out in this case.How can we explain the incremental and feeble regulatory response against shadowbanking and OFCs?

I argue that it can be explained by focusing on the preferences of national govern-ments and their strategic interaction. I model the situation as a two-level game andincorporate insights on the theory of regulation (e.g. Stigler 1971; Wilson 1980). In anutshell, my explanation is as follows. Reregulation is hampered by intensive jurisdic-tional competition. Governments fear losing internationally mobile financial activity tocompetitor states. They are not able to solve the collective action problem to curb or easecompetition among each other because they are influenced, or even captured, by domes-tic financial interest groups, which lobby governments to refrain from effective regula-tion. Combined with the structural constraint of jurisdictional competition, theseinterests make up an effective veto player. At the same time, governments are susceptibleto popular and electoral demands for stronger regulation. The electorate in big onshorestates can be seen as change agents. This can explain why the outcome is not the absenceof reform. Subject to these different pressures, governments can only agree on incremen-tal and ineffective reforms, which are symbolically potent enough to soothe populardemands. While there is a broad consensus among policymakers and academics thatfundamental regulatory reforms are needed (e.g. Warwick Commission 2009; G202009a), the basic mechanisms of jurisdictional competition and financial interest grouppressure that drove policy before the crisis still hold after the crisis.

As Helleiner and Pagliari (2011) have shown in their recent review, the literature onthe regulation of global financial markets has usually focused on any of three arenas –interstate, domestic, and transnational. The argument put forward here relies on linkingthe interstate and domestic arenas and, thus, aims at being able to better explain theempirical record of feeble regulation. In particular, I focus on an aspect that has so farbeen under-analyzed in the post-crisis literature – state or jurisdictional competition forfinancial activity as a serious obstacle to regulatory reform. While the existence of suchcompetition is, of course, well known to international political economists working onfinancial markets, it has not been discussed as the main factor in the literature onregulatory reform after the crisis (see e.g. the contributions in Helleiner et al. 2010;Mayntz 2012). By focusing on state competition I emphasize the importance of a struc-tural constraint for successful governmental action on financial regulation. Internationalcapital mobility, which is the precondition for such competition, is a serious constraintfor national governments that cannot even be overcome by the most powerful states.Thus, while my explanation is rationalist itself, it provides a corrective to both rationalfunctionalism and approaches focusing on state power.

Why reregulation after the crisis is feebleT. Rixen

© 2013 Wiley Publishing Asia Pty Ltd436

The rest of the article is structured as follows. In section 2, I explain what OFCs andshadow banks are and how they have contributed to the financial crisis. Section 3 presentsa simple two-level game of jurisdictional competition and domestic interest group poli-tics from which implications for both the expected outcome and the process of regulatoryreform are derived. In section 4, I trace regulatory initiatives after the crisis and evaluatethis record against the theoretical conjectures. Section 5 considers three alternative expla-nations for the outcome. The conclusion summarizes the main findings and brieflydiscusses their implications for global financial reregulation in general.

2. What is the problem?

The financial crisis was a bank run on so-called shadow banks (Krugman 2009). Theshadow banking system consists of non-depositary banks, for example, investmentbanks, hedge funds, special purpose vehicles (SPV), structured investment vehicles(SIVs), and asset-backed commercial paper (ABCP) conduits, and certain activities likesecuritization, securities lending, and repo. It essentially provides the same functions asthe traditional banking system, that is, shadow banks engage in credit intermediationand maturity transformation – funding longer-term financial assets with short-termliabilities. But, rather than relying on the money deposits of their customers as tradi-tional banks do, shadow banks fund their investments with money market instruments,such as mutual funds, short-term commercial paper, and repos.1 Traditional banks enjoythe privilege of a publicly provided safety net to prevent their collapse in bank runs. Inreturn for this privilege, they are under tight regulatory control. Shadow banks,however, are not under the same regulatory obligations as traditional banks and, intheory, should not enjoy the privileges of a publicly provided safety net either (Ricks2010).

The lack of regulatory oversight is an important incentive for creating shadow banks.Significant parts of the shadow banking system emerged through various techniques ofregulatory arbitrage to realize greater rates of return than in the traditional bankingsector (European Commission 2012, p. 5). Driven by the desire for ever higher rates ofreturn, the shadow banking sector increased in size from $11.7 trillion to $26.8 trillionbetween 2002 and 2009 (IMF 2010). In the US, its size outgrew the regular banking sector(Pozsar et al. 2010, p. 5). The Financial Stability Board (FSB 2012a, pp. 8–9) estimated theshadow banking sector at around $67 trillion at the end of 2011, which is about 25percent of the global financial system.

Traditional banks entered the market and sponsored SPVs and SIVs, thus, creatinginterdependencies between the traditional and the shadow banking sector (IMF 2010,pp. 16–19). Importantly, shadow banks are not subject to the capital reserve requirementsthat traditional banks are under and, therefore, enjoy unrestricted possibilities for lever-aged investments. Additionally, because SPVs are kept off banks’ balance sheets, neitherdo the latter have to increase their core capital buffers if they sponsor SPVs.2 Thus,traditional banks can indirectly engage in unrestricted leverage. This way, the shadowbanking system has exacerbated the creation of the credit bubble (Adrian & Shin 2009).

In order to maximize regulatory and tax arbitrage, most shadow banks are incor-porated in offshore financial centers (OFC). While there is no generally accepted defini-tion of an OFC, in this paper the term refers to states or dependent territories whichintentionally create regulations and tax rules for the primary benefit and use of those

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not resident in their geographical domain. Regulation and taxation are designed tocircumvent the legislation of other jurisdictions. Often, OFCs create a deliberate, legallybacked veil of secrecy that ensures that those making use of the regulation cannot beidentified to be doing so (Palan et al. 2010, pp. 33–35).3

Analytically, two functions of OFCs can be distinguished – financial regulatoryhavens and tax havens. Tax havens offer very low or zero taxes and strict bank secrecyrules. They do not exchange tax relevant information with other countries or only undervery restrictive conditions. A financial regulatory haven offers light financial regulationand supervision, less stringent reporting requirements, and no trading restrictions. Thisoften includes no or modest minimum capital requirements and opacity on the beneficialowners of the businesses incorporated there. While the analytical distinction is valid, inreality, most OFCs offer both tax and regulatory loopholes to the benefit of owners ofbusinesses incorporated there. For example, jurisdictions, such as the Cayman Islands orthe British Virgin Islands, aim to attract business through both low tax and light regu-lation. On the other hand, Switzerland is a tax haven, but not a financial regulatory haven.For the purposes of this paper, a jurisdiction will be considered an OFC if it offers at leastone of the two functions.4

In order to benefit from regulatory and tax advantages, non-residents register off-shore corporations, of which the infamous SPVs and SIVs are examples.5 While tradi-tional banks sponsor shadow banks and will often manage them from onshore states, forlegal purposes they are largely located in OFCs. For example, around 60 percent of allhedge funds are located offshore, with the Cayman Islands being the most prominentlocation (TheCityUK 2011).6 Also, many of the SPVs that failed in the crisis were incor-porated offshore. Well-known and publicized examples are the German IKB Bank andSachsen LB, which had managed their deals with mortgage-backed securities throughSIVs in Ireland and Delaware. HSH Nordbank has about 150 off-balance-sheet subsid-iaries in OFCs (Troost & Liebert 2009). The Cayman Islands were the largest foreignholder of US mortgage-backed securities (Lane & Milesi-Ferretti 2010).

Though OFCs are often very small states, data on aggregate financial flows shows thatthey are major players in the global financial system and tightly interconnected withonshore jurisdictions. In 2007, the Cayman Islands (6th), Switzerland (7th), Luxembourg(9th), and Jersey (16th) ranked among the biggest financial centers as measured by theirassets and liabilities (Palan et al. 2010, pp. 25–27). Fifty-one percent of the world’scross-border assets and liabilities were held in OFCs (Palan et al. 2010, p. 51). In order toreveal some of the linkages between important economies and offshore centers, one canfocus on bilateral data. For example, in 2007, foreign assets and liabilities of the USagainst offshore centers amounted to a sum that is about 45 percent of US gross domesticproduct (GDP) (in comparison: 56 percent against European area countries, and 19percent against Japan). The European area had assets and liabilities against offshorecenters of about 52 percent of its GDP, compared to 72 percent against the US(Milesi-Ferretti et al. 2010). Importantly, the funds only get channeled through OFCs. Ananalysis of financial flows shows that OFCs are used as intermediaries between largefinancial institutions in onshore financial centers (IMF 2010).

OFCs increase financial risk in at least five ways. First, given their lax incorporationrules, they make it easier to register SPVs. Second, as a result of lax oversight and lack ofcooperation with onshore jurisdictions they enable onshore financial institutions to hidethe risks involved in their offshore subsidiaries from regulators. Third, the low or zero



taxes lead to higher profit margins and, thus, increase the incentive for risky behavior.Fourth, and related, by using SPVs in tax havens certain quality requirements on credit tobe securitized could be avoided (OECD 2009, p. 48). Fifth, the tax advantages offered byOFCs foster the debt bias of investments. As interest payments can be deducted as costs,whereas dividend payments cannot, most tax systems advantage debt over equity financ-ing. This effect is exacerbated by the low or zero tax rates in OFCs; the interest paymentslower onshore tax burdens, and the profit can be accumulated tax-free offshore.7 Overall,this increases the propensity to take on credit and to work with ever higher leverage ratiosin investments.8 The tax bias toward debt conflicts directly with financial regulation,which tries to lean against debt (cf. IMF 2009). Taken together, these features of offshorefinance increase investment profit margins and make the shadow bank strategy moreattractive. To some extent, OFCs feed the shadow banking system.

When the market for mortgage-backed securities collapsed, the instability of shadowbanking became apparent. Almost the entire emergency policy response was aimed atpreventing the default of shadow banks and their sponsoring traditional banks (Ricks2010). While off-balance-sheet shadow banking and OFCs were certainly not the solecause of the crisis, they have played a significant role in the complex interaction of severalfactors that caused the credit bubble and its bursting.9

This description of the OFC–shadow banking complex shows that we are dealing witha phenomenon of supply and demand. On the demand side, firms, investors, and otherfinancial market participants (usually from onshore states), search for ways to minimizetheir regulatory and tax obligations in order to increase their profit margins. On thesupply side, sovereign jurisdictions are free to design their rules in ways that meet thedemand. All states have joined the competition and tried to supply the demanded rules.While OFCs are notable for pursuing such policies in extreme ways, onshore states alsotry to attract financial activity and foreign tax base. The US state of Delaware and theNetherlands are examples, which enable the registration of shell companies to profit fromvery low tax rates. Other important financial centers with light regulation are Singaporeand, most prominently, London and New York.10 Accordingly, many observers includethese jurisdictions on their list of OFCs (Palan et al. 2010, pp. 41–44). Apart frominstalling regulatory gaps themselves, onshore jurisdictions have often allowed – or atleast abstained from disallowing – their firms to access light regulations and taxes off-shore. At the least, large, developed, presumably onshore economies want to make surethat they do not lose the headquarters and well-paid jobs of multinational companies.They have often followed Margaret Thatcher’s advice: “If you can’t beat them, join them!”(Cited in Eden 1998, p. 659).

Thus, I am not claiming that OFCs are individually responsible for causing financialinstability. Under conditions of liberalized capital flows, jurisdictional competition, inwhich both OFCs and onshore states are involved, is a systemic condition. It is thiscondition that can be seen as a major cause of globally deregulated financial capitalismand the ensuing instability. OFCs are merely an extreme manifestation of jurisdictionalcompetition.

3. Jurisdictional competition and domestic politics

Given these undesirable results, we can expect a collective interest in curbing suchjurisdictional competition. However, in regulatory competition, countries can benefit



individually from undercutting each other’s regulatory standards to attract financialactivity. The result is inefficiently low regulatory standards (race to the bottom). Largeand small countries are differently affected by this outcome and, thus, have diverginginterests in such asymmetric competition (see e.g. Genschel & Schwarz 2011, pp. 341–342). Large developed countries cannot sustain their economies on the basis of theactivities of the financial sector alone, but also have to guard the financial sector’sinteractions with the real economy. The domestic economic base, which would be sub-jected to inefficiently low taxes and may suffer from very low financial regulatory stan-dards, is too big relative to the size of foreign financial activity that could be attracted.11

For them, it should be collectively preferable to come to a cooperative agreement tocurb regulatory competition. For small offshore states, the situation is different.Because their domestic economic base is small compared to the size of foreign financialactivity that they can attract, they can overcompensate the potential welfare loss oflower regulatory standards. They oppose collective agreements to curb jurisdictionalcompetition.12

Overall, this makes the strategic structure an asymmetric prisoner’s dilemma. Largecountries have classic prisoner’s dilemma preferences, and small countries have deadlockpreferences. Overcoming an asymmetric dilemma is demanding, but possible. If the large,developed countries collectively disallowed their resident financial actors to use theoffshore and shadow banking device, then it would no longer be profitable for OFCs tooffer those services. Large countries could, as a group, pressure small states into compli-ance.13 Based on this insight, we can, in the following, concentrate on the large countrygovernments alone.

What would be needed at the international level to achieve this is an institution thatcan define binding regulatory standards for all countries. Because the standards are notself-enforcing under this particular strategic structure, this institution would also have toprovide monitoring and enforcement. Moreover, the regime needs to encompass all largecountries to make it impossible to free ride and exploit those adhering to the standards;that is, a broad agreement is needed.

In the previous paragraphs, I have intentionally used “countries” to describe thegeneral workings and incentive structure of state competition. I now expand this modelby focusing on (large country) governments and their preferences in two-level games. Inline with Singer (2004) I assume that governments or regulators maximize a combinationof electoral support and campaign contributions or other rents from interest groups.Extending on Singer, they also have to mediate domestic and international pressures; theyaim to stay within the win set that satisfies both domestic and international demands(Putnam 1988). Thus, collective action and effective regulation will hinge on two con-straints at the international and one at the domestic level.

On the international level, there is, first, the competitiveness constraint describedabove. While making it impossible for their banks and businesses to use the shadowbanking and offshore device would lead to better regulated markets and prevent taxrevenue losses, large country governments would also run the danger of losing financialactivity (and with it, well-paying jobs). To avoid these adverse effects they need to makesure that the other large country governments also implement such policies. To achievethis, they have to manage and overcome the credible commitment problem posed by theirconflicting individual incentives to continue undercutting one another. Second, govern-ments also need to manage a distributive conflict amongst each other. Some of the large



countries, notably the UK and the US, have larger financial sectors than other industri-alized countries. The countries with big financial sectors have less to gain from strictregulation and may, thus, be more hesitant to support it, or at least can be expected tohold out longer to extract side payments.

The domestic constraint consists of societal interests, which influence governmentalpreferences on financial regulation. We can distinguish between two conflicting pressures.On the one hand, domestic business and financial interests profit from regulatory and taxarbitrage possibilities offered by shadow banking and the offshore device. They lobbyonshore governments to refrain from reform efforts and promise campaign contribu-tions or other rents in return. On the other hand, politicians in onshore states can behypothesized to be under electoral pressure to push for reform. Given that the generalpublic in onshore states suffers welfare losses, there should be majorities favoring effectivereform. The logic of collective action (Olson 1965) suggests that the small group ofbusiness and financial interests, which enjoys significant and concentrated benefits, is ableto exert more influence on governments than the general electorate.14 This seems all themore likely in the field of finance. As it is a very complex matter, it will be difficult for theelectorate to fully grasp the issues involved. Likewise, political decisionmakers willdepend, to some extent, on the expertise of financial market actors. There is an informa-tion asymmetry on top of the collective action problem of interest mobilization. All in all,this makes it likely that financial interests can successfully influence or even capturegovernments to refrain from effective international collaboration and stricter regulation.Nevertheless, we also have to account for the desire of elected politicians to accommodatepopular sentiments in favor of stricter regulation. Note that governments cannot accom-modate both domestic demands in substance, but they may try to square the circlesymbolically, for example, by passing regulations that seemingly address the problems,but, in reality, leave loopholes for financial actors that are invisible to the public. This way,they would be able to realize both rents and reelection.

Based on these theoretical considerations, we can derive conjectures on the reformprocess after the financial crisis. Broadly speaking, the scenario is one of feeble andineffective reform. While they feel pressured by their electorates to come up with stricterrules, governments are unlikely to agree on and implement effective regulation andsupervision if the international situation corresponds to a collective dilemma and if, atthe domestic level, they are strongly influenced by interests opposed to reform (Putnam1988; Zangl 1994). In such a situation, the international and domestic forces againstreform reinforce each other: the competitive pressures at the international level makegovernments more susceptible to the arguments of business interests; and these argu-ments are more credible because of the existence of jurisdictional competition. Underthese conditions, the regulatory response should (at best) remain feeble – at both thedomestic and international levels.15 In addition to this general and broad expectation wecan specify the following observable implications:

• Considerations of jurisdictional competition should play an important role in thereform process. We should find evidence at both the international and domesticlevels that governments are aware of the competitive situation they are in.

• We should see big country governments as agenda setters for regulation, pushingfor collective agreements on stricter regulatory standards. But we can also expectfailure of these initiatives.



• We should see countries with large financial sectors opposing strict and effectiveregulation or at least holding out.

• At the domestic level, in particular, we should find that countries justify theabsence or feebleness of domestic reform with concerns for their countries’competitiveness.

• We should see significant efforts of lobbying by financial interests making exten-sive use of the argument that stricter regulation endangers a country’s competitiveposition.

• Nevertheless, it is likely that governments wish to respond to the demands forreform by the electorate. In order to square the circle between this need on the onehand and concerns for competitiveness and business pressures on the other, theywill adopt tough rhetoric and symbolic policies. Overall, there will, at best, beincremental reform.

4. Reforms after the crisis

To see if the conjectures are borne out I describe and evaluate the regulatory andsupervisory activity related to shadow banking after the crisis. There are, in principle,three approaches to the regulation of shadow banking (FSB 2011a, p. 8). The firstconsiders shadow banking to be part of the banking sector and would simply subject it tothe very same regulations in terms of capital requirements, supervision, and so on, asregular banks (broad direct regulation). This would, of course, only be effective if theywere also implemented by OFCs, otherwise direct regulation could be circumvented. Thesecond develops specific direct regulations for each type of shadow bank entity or activity.Special regulations for hedge funds or money market funds, or certain restrictions onsecuritization, serve as examples. Again, in order to be effective, OFCs would have to goalong. The third approach eliminates the banks’ vulnerability in relation to the shadowbanking sector by indirect regulation of the links between traditional banks and shadowbanks. This would include measures such as risk weights and additional capital buffers forbanks dealing with the shadow banks they sponsor. Indirect regulation could be done bythe home states of banks, that is, large developed countries, without OFCs’ cooperation.

With the distinction between these three approaches in mind, I now turn to the actualpolicy initiatives after the crisis. I first focus on the international level and then turn to thedomestic level in the US and the European Union (EU), where I look at Germany, the UK,and France. These countries are major players in the international reform debate andwere all affected, albeit to different degrees, by the breakdown of the shadow bankingsystem. Also, the size of their financial sectors varies. It makes up a more significant partof the economy in the US (around eight percent of gross value added) and the UK(around nine percent), than in Germany and France (around four percent and4.7 percent, respectively) (Broughton and Maer 2012, p. 5). Accordingly, we expect theformer to be more hesitant in reregulation. Throughout, I will draw out the links betweentheory and empirical evidence.

4.1. The international levelAfter the crisis, arguably the most visible institutional change is the fact that the G20,rather than the G8, has taken the lead in crisis response. The enlarged club has heldseveral summits since the peak of the crisis and has set the reform agenda. The G20



pledged “to extend regulation and oversight to all systemically important financial insti-tutions, instruments and markets” (G20 2009a, p. 4). It also set (and continues to do so)more specific tasks for the international financial institutions to pursue. With respect toOFCs, it set out “to take action against non-cooperative jurisdictions, including taxhavens. We stand ready to deploy sanctions to protect our public finances and financialsystems. The era of banking secrecy is over” (G20 2009a, p. 4). The fact that the initialsteps have been taken by a group of large and developed countries shows that myexpectation that those countries should have an interest in stricter regulation is borneout. Likewise, the enlargement of the group to 20 is evidence of the fact that actorsunderstand the need to create a broad multilateral initiative.

In the following, I provide an overview of the regulatory activity that has followedthese strong and ambitious statements of the G20. I start with taxation and move on tofinancial regulatory aspects.

4.1.1. TaxationOne of the immediate political reactions to the crisis that received a lot of public attentionwas the attempt to exert pressure on OFCs to refrain from harmful tax practices. Asinstructed by the G20, the Organisation for Economic Co-operation and Development(OECD) reinvigorated its ongoing project on harmful tax practices. The project had beenlaunched in 1998 and had so far made little progress. While it was initially envisaged as abroad effort to address (legal) tax avoidance and (illegal) tax evasion, it ultimately endedup targeting only tax evasion. The major reason for the curtailment of the project wassuccessful domestic lobbying by business interests in the US arguing that if US firmscould no longer use the offshore device they would have a competitive disadvantageagainst European firms whose foreign profits were exempt from home country taxation(Rixen 2008, pp. 132–142). In response to US demands, the OECD settled for an inef-fective standard of information exchange on request between national tax authorities.16

This episode is an example of business lobbying and concerns for national competivenessreinforcing each other, as expected in my explanation. The required bilateral tax infor-mation exchange agreements (TIEA) were, however, only forthcoming at a very slowspeed, even though tax havens had quickly agreed to the rather soft standard of the OECDand were, thus, removed from a black list the organization had drawn up (Rixen 2011a,pp. 215–220).

After the crisis, the OECD began to regularly report to the G20 on progress achieved.The OECD-sponsored “Global Forum on Transparency and Exchange of Information forTax Purposes” – with 110 member countries the expected broad multilateral forum –continues its peer reviews of the legal and regulatory frameworks for transparency andexchange of information in member jurisdictions. In April 2009, the OECD issued a newblack list. The 46 listed countries were asked to reinforce their efforts at negotiatingbilateral TIEAs. By the end of May 2012, the number of TIEAs had increased to 518(OECD 2012). One of the reasons identified jurisdictions are so willing to enter intoTIEAs is that the OECD has stated that once a country has signed at least 12 TIEAs, it willbe taken off the list. Many tax havens, therefore, conclude TIEAs among each other inorder to get such a stamp of approval. Because all jurisdictions are considered coopera-tive, the G20 never had to prove that its threat of sanctions was credible.

While the willingness of OFCs to enter into TIEAs represents progress over theprevious situation, this does nothing to ameliorate the major shortcoming, that is, the



limits of the OECD standard of information exchange on request. More important in thecontext of this paper, all of the efforts to rein in evasion do not address any of the taxdistortions that cause financial instability. While the crisis provided the impetus foraction, the policies pursued do not address the tax loopholes that contributed to thecrisis. This shows that, as predicted, large country governments engaged in symbolicpolicies to accommodate popular sentiments by continuing to pursue a project that theyhad agreed on earlier for different reasons and that had already been curtailed to meet theneeds of business interests and competitiveness concerns.

4.1.2. Financial regulationFrom 1998 on, OFCs had been under the scrutiny of the Bank for International Settle-ments (BIS), the International Monetary Fund (IMF), and the Financial StabilityForum (FSF). After the Asian financial crisis, developed countries launched an initiativeto promote standards of financial regulation to be adopted by middle- and low-incomecountries and OFCs. The standards that were promoted were presumably already inplace in high-income countries. Thus, as predicted, the initiative for stricter regulationcame from the governments of large and wealthy countries. Often the standards hadbeen developed by private actors from these countries, which also had a significant sayin their development (Mosley 2010, p. 725). In 2000, the FSF had drawn up a black listof 42 OFCs (FSF 2000) and delegated the task of assessing their regulatory systems tothe IMF, which launched an OFC assessment program alongside its general FinancialSector Assessment Program (FSAP) and repeatedly reported on the progress of bothprograms. In the formulation of their policies, large country governments were verymuch aware of the competitive situation they were in. All reports and statements bystate representatives stress the need to act collectively as individual initiatives wouldonly lead to the diversion of financial activity to lesser regulated areas (Drezner 2007,p. 142).

The IMF reports found that most countries, including OFCs, adhere to the regulatorystandards. Often, OFCs had even stricter standards than so-called onshore jurisdictions(IMF 2005, pp. 4–6). In 2008, it was, therefore, decided to integrate the OFC program intothe FSAP carried out jointly by the IMF and the World Bank and, thus, to prepare thesame Reports on the Observance of Standards and Codes (ROSC) that all countries aresubject to. The main shortcoming in the FSAP framework is that the IMF and World Bankdo not have the authority to enforce the standards and codes. They can merely hope thatthe publication of regulatory gaps and the implied moral suasion lead to improvementsin the respective countries. Further, even in the case of positive ROSCs, there are oftenlarge, but hidden, gaps between the formal adoption of international standards and realcompliance (Walter 2010, p. 33). Also, the assessment by the IMF does not pay sufficientattention to the fact that regulators often simply assume that they are only responsible forregulating their domestic banks – a task that they often fulfill very well and in line withthe standards – and do not assume responsibility over foreign branches or subsidiaries(Troost & Liebert 2009).

The lack of enforcement capacity is a result of a lack of political will on the part oflarge country governments to act vigorously against countries violating financial stabilitystandards. Whereas in the FATF initiative against money laundering, the US, shaken up by9/11, put its political clout and credible threats of sanctions behind the policies and,consequently, substantial progress was achieved (Drezner 2007, pp. 142–145; Tsingou



2010), there was far less resolve in the IMF/FSF case (cf. e.g. Palan et al. 2010,pp. 209–210). As expected, concerns for the competitiveness of the financial industries,which are irrelevant in the case of money laundering, can explain this difference. Withrespect to financial stability, large countries could not agree on effective measures, butwanted to present regulatory activity to their audiences.

After the crisis, the picture has hardly changed. The FSAP remains the only interna-tional instrument to monitor offshore and onshore jurisdictions. The renamed FSB wastasked to develop an effective peer review program to assess compliance with regulatorystandards that should explicitly include, but not be limited to, uncooperative OFCs (G202009b, pp. 1–2). Compared with the FSF, the FSB has a somewhat stronger mandate(including the task to design supervisory colleges and to set up an early warning system),to promote financial stability, a wider membership (with all G20 countries joining), moreresources, and a more permanent internal organizational structure (with a full-timeSecretary General), than its predecessor. Nevertheless, just as its predecessor, the FSB doesnot possess any formal powers and merely aims at international policy coordination.While the FSB is now allowed to assess countries’ compliance record and publish itsreports (Helleiner 2010, pp. 8–12), it still does not command any “hard” means ofenforcement. Instead, it will carry out this task by essentially relying on FSAP assess-ments. “ROSCs have been an ineffective tool for promoting compliance in the past; nordid they prevent the build-up of financial fragility in the major centres before 2008”(Walter 2010, p. 35). There is little change in the overall program and the incrementalreforms will not promote financial stability.

In addition to the FSAP program, there are other policy initiatives concerned withbetter regulation and supervision of the shadow banking sector. At the November 2010Seoul Summit, the G20 asked the FSB to develop recommendations for improvedregulation of the shadow banking system. The FSB set up a task force chaired byAdair Turner of the UK Financial Services Authority and Jaime Caruana, GeneralManager at the BIS. The task force shares the view that shadow banking is an importantsource of financial instability in the manner described in this article. The FSB high-lights the importance of a “global approach to monitoring and policy responses”because of the danger of unhealthy competition for lower standards among jurisdic-tions (FSB 2011a, p. 5) and, thus, echoes the issue of state competition at the heart ofthis paper.

In a second report, prepared for the G20 meeting in Cannes, 11 recommendationswith a work plan to further develop them in the course of 2012 are outlined. Theyconsist of a mix of indirect regulatory measures: that is, measures that apply to bankssponsoring shadow banks, most importantly introducing risk weights, stronger capitalrequirements, and an improvement of accounting principles to force the consolidationof SPVs on their balance sheets; and specific direct measures, most importantly strictersupervision of money market funds, securitization, and hedge funds (FSB 2011b). Thetask of devising indirect measures is delegated to the Basel Committee of BankingSupervisors (BCBS), and that of devising direct measures to the International Organi-zation of Securities Commissions (IOSCO). In April and November 2012, the FSBreported on the ongoing work in the relevant five work streams (capital requirements ofbanks interacting with shadow banks, money market funds, other shadow bank entities,securitization and securities lending, and repo) and further specified their recommen-dations (FSB 2012b,c). In late 2012, the FSB also published its first “Global Shadow



Banking Monitoring Report,” which provides the most comprehensive collection ofaggregate data on the shadow banking system. Obviously, as emphasized by the FSB,such data are an important prerequisite of proper regulation and supervision (FSB2012a).

So what kind of specific regulations have the international bodies that the FSB relieson proposed so far? First, shortly after the crisis the BCBS agreed on minor amendmentsto Basel II, specifically asking for heavier risk weightings for securitization exposure andoff-balance-sheet vehicles so that they cannot be used as easily to circumvent capitalrequirements (BCBS 2009).17 These rules will also be part of the new Basel III agreement,as will be an increased scope of consolidation (FSB 2012b, pp. 5–6). While Basel III leadsto a significant improvement of capital reserve standards (with higher capital require-ments and the introduction of leverage ratios) in the regular banking sector (Goldbach &Kerwer 2012),18 most experts, including the FSB, agree that the rules are insufficient toseriously dampen the risks in the shadow banking sector (see e.g. Turner 2011). Accord-ingly, there is a real fear that the stricter regulations for regular banks increase theattractiveness of shadow banking. The FSB writes: “Although Basel III closes a number ofidentified shortcomings, both the incentives for, and the risks associated with, regulatoryarbitrage will likely increase as Basel III raises the rigor of bank regulation” (FSB2011a, p. 5).

Second, the International Accounting Standards Board (IASB) has revised IAS 27, astandard that determines under what conditions a bank will have to consolidate its SPVson the balance sheet. Negotiations at the IASB and FASB, which proved to be controver-sial, had been ongoing since 2003 and have renewed importance after the crisis. Therevised standard can be expected to be a more detailed specification of the previousstandard (IASB 2012). Importantly, however, the IAS had already been very strict evenbefore the crisis, requiring the consolidation of off-balance-sheet SPEs on banks’accounts. However, many national accounting rules, for example, those in the US, the UK,and Germany, which are binding for banks and are the basis for prudential regulation, didnot include that requirement (Thiemann 2011, pp. 18–30).

As the work within the FSB is still ongoing, it is certainly too early for definiteevaluations of this work, but one important observation can already be made. Theregulatory approach taken by the FSB and the other international bodies has clearly beena combination of the second and third approaches outlined at the beginning of thissection. This means that the clear-cut solution of subjecting shadow banks to regularbanking regulation is off the table. Instead, the result will be a large number of specializedand detailed rules for individual cases. Also, delegating different aspects of the problem todifferent agencies implies a fragmentation of the regulatory efforts. This is likely to makeit easier for interested parties to water down the rules and create loopholes.

Admittedly, at this point in time, my skeptical evaluation involves some speculation.What is certain, however, is that any decisions of these organizations – be it the BaselIII capital requirements or accounting rules – will have to be transposed into nationallaws to enter into force. As the case of the pre-crisis accounting rules reveals, domesticimplementation and compliance is crucial. As will be shown below, and in line with thebasic argument of this paper, jurisdictional competition and business lobbying aremajor factors at the domestic level, which will very likely turn post-crisis domesticmeasures into merely incremental reforms that fail to address the shortcomings of thestatus quo.



4.2. Domestic (and European) politicsIn this subsection I provide two brief case studies on the reform process in the US and theEU, where I focus on the positions of Germany, the UK, and France.

4.2.1. USAIn the US, the legislative process of financial reform in response to the crisis culminatedin the Dodd–Frank Act (DFA). Most commentators welcomed the bill, saying that itrepresents progress toward safer financial markets. Nevertheless, it is also widely agreedthat the DFA exhibits significant loopholes that were inserted to accommodate businessgroup pressure (Woolley & Ziegler 2012). Also, the quite fragmented US regulatorylandscape, which has received criticism by many, has not been changed. Most impor-tantly, the construction of the DFA is such that it sets out regulatory goals that still needto be implemented by different specific regulators. Many fear that in this process some ofthe more strict rules will be watered down further (Woolley & Ziegler 2012, p. 59).

And indeed, so far only 20 percent of the proposed rules have been implemented. Theregulatory agencies are confronted with intense lobbying efforts by the financial sector,which took out the bite of some of the regulations (see e.g.Narayanswamy 2011). This isalso true for the two measures that are considered to be the most significant to increasethe stability of financial markets. With respect to capital requirements, the DFA does notspecify targets because it was argued by Republican legislators that the US should wait forthe results of the Basel III negotiations – to protect the competitiveness of US financialmarkets, capital requirements should stay in tune with other countries’ regulations(Johnson 2011). Second, while in the legislative process discussions about proper regu-lations for the shadow banking sector played an important role, the final act did notcontain specific rules on this aspect. Instead, the responsibility to craft those rules lieswith the Federal Reserve and the newly created Financial System Oversight Council(FSOC). The FSOC is subject to intense lobbying by financial firms arguing againststricter capital requirements for both the traditional and shadow banking sectors bypointing to the competitive disadvantage this may imply for US banks vis-à-vis theirforeign competitors (Johnson 2011). In response, the FSOC pronounced that it may bedangerous to set capital requirements for banks too high because this may drive activityto the shadow banking sector. Not only does this raise the possibility of capital require-ments being too low for banks, but it also means that the FSOC does not appear to beready to further regulate shadow banking (Cooley 2011). All in all, these ongoing eventsnicely illustrate the logic of my explanation, with competitiveness concerns and interestgroup influence reinforcing each other.

In the area of accounting, the relevant US Generally Accepted Accounting Principles(GAAP) standards on the consolidation of SPVs were tightened. As a result, $1 trillionwas repatriated back onto balance sheets and an estimated equal size of SPE engagementswas sold by banks (Thiemann 2011, pp. 30–32). This can certainly be viewed as a success.But it remains to be seen whether banks will find new loopholes in the regulations in thefuture.

4.2.2. European Union (Germany, France, and the UK)In Europe, most of the regulatory rules for financial markets are made at the suprana-tional level of the EU and are then implemented in member states. Supervision, however,is mostly a national task. Therefore, I will focus on the role that the three governmentsplayed in regulatory efforts at the EU level, but will also refer to domestic reforms.



Pre-crisis, Germany was a vocal supporter of stricter global regulations for hedgefunds. At the same time, the Sozialdemokratische Partei Deutschlands (SPD)-Greengovernment liberalized domestic financial markets with the so-called investment mod-ernization law in 2003, enabling, among other measures, securitization and the introduc-tion of private equity firms (Vitols 2005). The main reason for these moves was toimprove the competitiveness of the financial sector vis-à-vis other countries (see e.g.Asmussen 2006). Post-crisis, one can observe continuity in this general pattern. At theinternational level, the government is a strong supporter of stricter regulations, arguingfor a financial transaction tax and better regulation of the shadow banking system. Francejoins in these efforts. Former French President Sarkozy was probably the most vocal of allpolitical leaders calling for stricter regulation. Both Germany and France have stated astrong preference for acting on a European if not a global level rather than at the domestic(Jabko 2012, p. 97; Handke & Zimmermann 2012). However, it can be shown that theresults at the European level have been meager, and that neither country has beensuccessful in implementing stricter regulation and supervision domestically, but bothhave been concerned with the competitive position of their financial systems.

At the European level, the most visible change is the establishment of a new super-visory structure. It consists of the European Systemic Risk Board (ESRB), hosted by theEuropean Central Bank (ECB) in Frankfurt and in charge of monitoring macropruden-tial risk and three new bodies: the European Banking Authority (EBA) in London, theEuropean Insurance and Occupational Pension Authority (EIOPA) in Frankfurt, and theEuropean Securities Markets Authority (ESMA) in Paris. Their task is to coordinatethe national supervisory agencies and promote cooperation among them. France sup-ported this reform, while Germany was more hesitant, as the Bundesbank feared a loss ofsupervisory authority. The UK was even more skeptical. It considered the new agencies a“French plot” to intervene into its financial markets (Jabko 2012, pp. 103–104). Thesefears seem to be wildly overdrawn, however. To the contrary, the new structure is too weakto be up to the task of cross-border banking supervision. For one, it would be preferableto have one agency that deals with banking, insurance, and securities in a comprehensivefashion. Further, and more importantly, it is not enough to coordinate national supervi-sors. Stringent supervision would need supranational competencies, ensuring thatnational supervisors will not turn a blind eye to “their” banks’ cross-border activities,including shadow bank and OFC engagements.19

With the Capital Requirement Directive (CRD), the EU will implement Basel III inEurope. The legislative process is still ongoing, but the current Commission draft(COM[2011] 453 final), like the Basel template, contains few regulations aimed at theinterface of regulated banks and shadow banks. In Germany, regulators have expressedsimilar sentiments as those in the US, stating that it was necessary to ensure that thestricter rules under Basel III would not drive activity into the shadow banking sector. Atthe same time, the responsibility for strengthening regulations is pushed to the interna-tional level with the argument that unilateral action would threaten competitiveness ofthe European banking sector (Kuehnen 2011). France has generally shown little enthu-siasm about strengthening capital requirements, as it did not want to endanger thecompetitive position of its large universal banks (cf. Jabko 2012, p. 104).

In terms of accounting rules, the EU had urged the IASB to strengthen its standardson the valuation of securitization and the consolidation of SPVs. When the IASB deliv-ered, however, the Commission did not approve the standards. Reportedly, the reason for



this was resistance by French, German, and Italian policymakers and banks, which wouldhave been seriously undercapitalized on the basis of the new rules (Quaglia 2011). Thisfits the pattern of advocating reform internationally, but not delivering domestically forfear of losing competitiveness. Likewise, while Germany modernized its law on GAAP(Bilanzrechtsmodernisierungsgesetz) in 2009, for the purposes of prudential supervisionand determining capital reserve requirements, banks are still not required to put SPVs ontheir balance-sheets (Thiemann 2011, p. 20).

The EU has also pursued specific direct regulatory measures aiming at shadowbanking entities. The Alternative Investment Funds Manager (AIFM) directive targetshedge funds. The legislative process was accompanied by heavy lobbying of the fundindustry. The UK, together with financial interests, opposed the directive. France(together with Germany) was the most important proponent. After a contested legisla-tive process, the compromise saw the UK accept the legislation, but France accepting thatoffshore funds continue to be granted access the EU market (Woll 2012, pp. 201–208).The new rules require the managers of AIFM to register with the competent authoritiesof the respective EU member country in which the management is located. Thus, themanagement will be subject to this requirement, irrespective of where the fund itself isincorporated. Upon registration, managers will receive a European-wide passport thatallows them to market their services everywhere in the EU. Managers will be subject tothe supervision of their home member state. They will be required to provide thecompetent authority with data on their business activities. However, apart from therequirement that the country in which the fund itself is incorporated has signed a TIEA(see above), there will not be any restrictions on the AIFM’s business models. Thus, it isnot clear how the directive can help to improve financial stability in the shadow bankingsector.

In addition, the Commission is currently reviewing existing legislation on Undertak-ings for Collective Investment in Transferable Securities (UCITS) and the Markets inFinancial Instruments Directive (MiFID) with a view to broaden the transparency andoversight of non-equity instruments and enhance consumer protection in the area ofinvestment funds (European Commission 2012, pp. 9–12).

While these few paragraphs are too short and superficial to do justice to the com-plexities of financial regulation in the EU, it is apparent that central predictions of myexplanatory account are borne out: the fact that even those countries that are in favor ofreform at the international level do not come forward with domestic reform exemplifiesthe logic of the collective action problem inherent in jurisdictional competition. Only iflarge, developed countries move in lockstep can reform be effective. Also, we can see thatthose countries with smaller financial sectors are more in favor of reform (Germany andFrance), than countries with bigger financial sectors (the UK, and also the US). Likewise,the influence of business pressure is visible.

5. Alternative explanations

In this section I consider alternative explanations for the outcome of feeble and symbolicregulation. While I am not aware of fully developed alternative accounts which aim atexplaining the failure to effectively regulate shadow banking, I shall briefly contrast myexplanation with three potential alternatives – the first based on states’ regulatory power,the second on the influence of societal interests, and the third on ideas and norms. I aim



to show that such accounts, while they certainly provide important insights into the caseat hand, miss important aspects, which my explanation captures.

5.1. State powerA prominent class of approaches to the political economy of global financial regulationrefers to state power as an important explanatory factor. In those accounts, power isusually operationalized as market share. The expectation of these accounts is that thepreference(s) of the most powerful state(s) determine(s) the regulatory outcome.Simmons (2001, pp. 597–600), operating under a unitary state assumption, considers theUS to be the hegemon with a preference for liberalized, but well regulated, financialmarkets. As described above, the case of shadow banking exhibits a dilemma structure. Inher 2 ¥ 2 matrix of possible configurations, it fits into the scenario of “significant negativeexternalities” for the hegemon and a “low incentive to emulate.” She maintains, in linewith my expectations, that, under these circumstances, reregulation is difficult to achieveand will have to rely on multilateral institutions and threats of sanctions. However, in heraccount the hegemon should be able to push through its desired outcome of stricterregulation by employing positive and negative sanctions. Even though threats of sanc-tions were clearly part of the package, such an account fails to correctly predict theoutcome observed in this case, that is, feeble regulation. One plausible reason for this maybe that all states are locked into competition and not even powerful states are strongenough to pressure their competitors into collaboration.

But this cannot prematurely be taken as evidence corroborating my explanation, as itmay also be the case that powerful states do not have a preference for stricter regulation.This leads us to a second set of alternative explanations – societal or political interestswhich program the preferences of powerful states.

5.2. Adding societal interestsThe first competing explanation referring to societal interests can be developed by build-ing on Drezner (2007). He links the focus on power with societal interests. He argues thatthe international regulatory outcome will be determined by the most powerful states, butthat societal interests determine the actual preferences of those states. In his account thoseinterests facing the highest adjustment costs to the new regulations determine a govern-ment’s preference. In the case at hand this would mean that the preferences of great powergovernments derive from the interests of the financial industry. Therefore, we should seeno efforts at regulatory reform at all. This is not corroborated empirically. Clearly, thereare regulatory initiatives by great power governments.

Alternatively, one might assume that governmental preferences reflect the interests ofthe electorate. As the empirical evidence shows, this is not the case. Third, as in myexplanation, governments could see a need to balance the interests of the electorate andthe financial industry (Singer 2004). In Singer’s model, regulators care for the competi-tiveness of their countries’ financial industries, but at the same time have to satisfyelectoral demand for financial stability (to which they are only indirectly responsive viathe fear of intervention by their principal, the legislative). Accordingly, following a severecrisis, regulators should react to a drop in the electorate’s confidence in financial stabilityby successfully engaging in international regulatory harmonization with their peer regu-lators from other countries. As has been shown, while there are of course attempts atinternational regulation, these did not result in stringent regulation.



A very plausible reason for the failure of all three versions of a societal interestexplanation lies in state competition that is part of my explanation. While I assume, justlike Singer, that domestic politics is about balancing financial interest groups and elec-toral pressure, my account extends on his by taking the international competitivenessconstraint seriously, whereas in his account international regulatory harmonization willbe forthcoming.20 Also, as I have argued, governments try to square the circle; theysoothe electoral demand for reregulation, while at the same time not endangering theirindustries’ competitive position by relying on symbolically potent (but actually feeble)policies.

All in all, neither power nor a focus on domestic societal interests (alone) can providea better explanation for the outcome of feeble regulation. These accounts underestimatethe constraints that state competition for financial activity present to governments.

5.3. IdeasWhile I am not aware of a constructivist account that aims at explaining the failure toregulate shadow banking, one could construct such an account. A constructivist couldargue that effective reregulation is not forthcoming because the belief into the neoliberaldogma (“the market will take care of itself efficiently”) among policymakers is still verystrong. On the face of it, such an account seems rather implausible in the currentsituation, as a majority of policymakers have called for stricter regulation or even explic-itly declared the era of neoliberalism to be over.21 But a softer version may nonetheless beplausible. For example, Sharman (2006) has argued that the OECD project on harmfultax practices failed because the OECD, whose authority derives from its status as animpartial expert bureaucracy devoted to the liberal market ideology, could not convinc-ingly argue against tax competition. An analogous account may be constructed for thecase of shadow banking and the IMF and/or the FSB.

In itself, such a constructivist account is plausible. But are norms of appropriatebehavior the best explanation for feeble regulation? Sharman himself acknowledges thatin order to answer in the affirmative, competing hypotheses have to be rejected. Withrespect to rationalist accounts, he argues that the failure to effectively regulate tax havenscan also not be explained by state competition and the influence of business interests onlarge country governments. This claim can be refuted. As I have demonstrated elsewhere(Rixen 2011a), both factors have played an important role in the failure of the OECDproject. The evidence collected in this paper shows that this is also true for the case ofshadow banking and OFCs. Consequently, my rationalist account cannot be rejected bythe norm-based argument.

6. Conclusion

I have shown that shadow banks and OFCs played a significant role in the financialcrisis. Fundamental regulatory change in this area could, thus, be expected, and politi-cal leaders and policy experts, indeed, made the connection and called for suchreforms. However, overall, the regulatory activity after the crisis can be summarizedunder the heading “more of the same.” While some institutions, most importantly theFSB, are strengthened, their basic workings and formal powers are not enhanced. Theystill merely aim at coordination. Also, the institutional landscape remains fragmented.In consequence, a coherent policy toward shadow banking and OFCs has not been



formulated. While the international institutions would, thus, be ill-equipped to achievesignificant progress in reining in jurisdictional competition anyway, their crisisresponse so far does often not even target the crucial links between shadow banks,OFCs, and financial instability. The actual content of regulatory efforts after the crisiscan often not be linked to the causes of the crisis. Likewise, the policy recommenda-tions by the FSB have settled for a mix of indirect regulation and a series of specificregulations for certain shadow bank entities or activities, and did not further explorethe clear-cut solution of subjecting shadow banks to regular banking regulation.Instead, the result will be a large number of specialized and detailed rules for individualcases. This may lead to regulators losing sight of the big picture and systemic risksinvolved in shadow banking. In any case, it is still open, whether domestic regulatorswill actually pursue the recommended policies. At the domestic level, the case studieson the US and the EU corroborate the conjecture that responses are feeble and incre-mental at best.

I have also shown that the reason for this reform trajectory can be found in govern-ments’ concerns about international competitiveness. There is ample evidence that largecountry governments perceive themselves to be in a situation of jurisdictional competi-tion. In particular, those countries with large financial sectors are hesitant to agree onstrict and binding international standards. While a rationalist approach that adopts aunitary state assumption would expect governments to be able to overcome this collectiveaction dilemma, the failure to do so is a result of capture by interest groups, whichbecomes visible if we adopt a two-level game perspective.

Competitiveness concerns and interest group influence are even more apparent atthe domestic level. Reforms are feeble in all four countries and are significantly sloweddown by the interference of financial and business interests. Even those countries advo-cating a strong international reform agenda do not follow through domestically. Thus,while some have expected the crisis to provide a strong enough stimulus for govern-ments to solve their collective action problems and free themselves from the grip offinancial interests, the basic political constellations and mechanisms that drove policybefore the crisis still hold after the crisis. Nevertheless, the crisis has spurred regulatoryactivity. Policymakers try to square the circle between jurisdictional competition andfinancial interest capture on the one hand, and public demands for stricter regulationon the other, by resorting to incremental, but often ineffective and symbolic, reformmeasures.

On a general note, the case of shadow banking and OFCs exemplifies a fundamentalasymmetry in the dynamics of financial market regulation. While governments are in aposition to open up to global financial markets and deregulate their financial sectorsindividually, reregulation hinges on collective action. While of course, governments areformally free to reregulate unilaterally, doing so is self-defeating under conditions ofjurisdictional competition. In contrast, unilateral deregulation and liberalizationpromise gains, at least in the short run. This can explain why the processes of deregu-lation and reregulation are so fundamentally different. While a deregulatory dynamic isquasi-automatic and market-like because its diffusion across countries is supported bystate competition, reregulation relies on the ability of reformers to craft effective collec-tive action in the face of a dilemma situation. Accordingly, reregulation is always aninherently political process, and, typically, a very protracted one. So far, it has not beenforthcoming.



Acknowledgments

Previous versions of this paper were presented at the Max Planck Institute for the Study ofSocieties in Cologne in February 2011, the ECPR General Conference in Reykjavik inAugust 2011, the meeting of the International Politics Section of the German PoliticalScience Association (DVPW) in Munich in October 2011, a workshop at CopenhagenBusiness School in December 2011, and a seminar at the Institute for Intercultural andInternational Studies (InIIS), University of Bremen, in January 2012. Participants at theseevents and, in particular, Jakob Ache, John Biggins, Reinhart Blomert, Sebastian Botzem,Peter Dietsch, Jan Fichtner, Philipp Genschel, Martin Höpner, Sonja Juko, Roy Karadag,Andreas Kruck, Peter Mayer, Manuela Moschella, Daniel Mügge, Lena Rethel, PeterSchwarz,Leonard Seabrooke,Matthias Thiemann,Eleni Tsingou,Cornelia Woll, and KevinYoung provided helpful comments and discussions; as did three anonymous reviewers andthe editors of this journal. Xaver Keller provided research assistance. I thank all of them.

Notes

1 A typical chain of credit intermediation in the shadow banking system is the following: A bank

that provides loans sells them to an SPV, which slices and bundles the loans and transforms

them into tradable bonds (securitization). SIVs, investment banks or hedge funds invest in

these long-term bonds. They do this with short-term funds that they raise by issuing money

market instruments like ABCP. Other shadow banking entities with deposit-like features, such

as money market funds (MMF), invest in these instruments.

2 In order to make sure that the SPVs could be kept off their balance sheets, banks had to play

a “legal game, which relied strongly on an interpretation of the law according to the letter of

the law rather than its spirit” (Thiemann 2011, p. 13).

3 There are, depending on the classificatory scheme used, between 40 and 72 states or dependent

territories which have positioned themselves as OFCs. For a list of countries that are OFCs

according to the “Tax Justice Network” (TJN), the OECD, and the IMF, see Palan et al. (2010,

pp. 41–44).

4 A third function, for which OFCs have come under scrutiny, money laundering, will not be

discussed. On this see, for example, Tsingou (2010).

5 In fact, most financial institutions in regulatory and tax havens are under the control of

non-residents using them to channel funds to other non-residents. This means that the

financial sector in regulatory havens by far exceeds the size necessary to finance the local

economy (cf. IMF 2000).

6 Importantly, while hedge funds are incorporated offshore, the location of management is

typically onshore, with New York and London being the most important locations by far

(TheCityUK 2011).

7 Given the focus on financial stability, I leave aside the adverse effects in terms of tax revenue

foregone. On this, see Rixen (2011b).

8 The sophisticated version of such thin capitalization is the construction of hybrid instruments

with many features of equity, but enough features of debt to attract interest deductibility. It has

been argued that the tax advantages offered by these instruments have been one of the major

drivers of securitization. In particular, Eddins (2009) has shown that, in theory, a trader can

realize risk-free profits, which consist entirely in tax revenues foregone, by structuring his

investments into credit default swaps (CDS) in certain ways.

9 For an excellent overview of the causes of the crisis, see Helleiner (2011).

10 The only difference between offshore and these onshore states is that the latter will try to

ring-fence the tax and regulatory privileges, whereas full-fledged OFCs can offer low taxes and



regulation to everybody and still support their states and economies. The reason for this is that

they are always small countries, in terms of population, that can make a living off an oversized

financial sector, even if it creates only few jobs and taxes. See also the discussion of the strategic

interaction in section 3.

11 This, plus electoral pressure (see below), can explain why large countries do not turn into

full-blown regulatory and tax havens themselves.

12 Note that, as opposed to large countries, for small countries this consideration is not changed

by incorporating governments that mediate between the domestic and international levels. In

OFCs, there should be no strong domestic opposition to maintain such a policy stance. As the

entire economy is geared toward the offshore sector and profits from it, both economic interest

groups and a majority of the electorate can be hypothesized to defend their country’s status as

an OFC. One may consider that such a condition – general support for deregulated finance

even from the broad public – may also hold in countries such as the US or the UK, where the

financial sector contributes a high share to value added. But empirical estimates show that the

economic benefits from finance are concentrated (Johal et al. 2012). Thus, it is theoretically

implausible from a rationalist and materialist conception of interest that the general public

should favor deregulated finance.

13 Technically speaking, the k group, that is, those countries that can sustain cooperation on

regulation without hurting themselves, comprises the large, developed countries. Together,

their market power is strong enough to not suffer losses if they enact stricter regulation.

However, in line with other works (e.g. Genschel & Plümper 1997), unilateral action even of

the country with the biggest market share would be self-defeating. While financial institutions

rely on access to the markets of large, developed countries, no single one, or even a minority

group of them, is important enough to be able to regulate unilaterally.

14 One may think that other domestic interests, most importantly organized labor, may

counterbalance business influence on governmental policy. However, it is in theory not clear

that organized labor will be in favor of regulating offshore finance (cf. Rixen 2011a).

Empirically, while they have expressed preferences for regulation, trade unions have rarely

campaigned or lobbied on the issue.

15 Note that one could also argue for the following alternative hypothesis: Given that

governments are in danger of capture by financial interests domestically, they should have an

incentive to gang up at the international level. Acting collectively, they would not be

susceptible to capture by small interest groups, but could rather serve the interest of the broad

electorate. This is actually the logic of Singer’s (2004) theory. However, this only works in a

perspective that is focused solely on the domestic level and treats the international level as

derivative of domestic politics. In contrast, in the two-level perspective adopted here, the

international competitiveness constraint is important in its own right, and there are

reinforcing tendencies of politics on the two levels. Last but not least, there are the additional

distributive conflict on the international level, and the fact that the electorate will be satisfied

with symbolic politics (being largely ignorant of the important regulatory details). Overall,

this leads me to not pursue this alternative hypothesis (but see the discussion of alternative

explanations in section 5).

16 Information exchange upon request is insufficient to effectively curb tax evasion because the

requesting state needs initial evidence of evasion to post a request. Because of the secrecy

offered by OFCs, it is usually impossible to get such initial evidence (see e.g. Sullivan 2007).

17 Even in its pre-crisis formulation, Basel II had already required banks to adjust their capital

reserves for SPV exposure. But during the phase-in stage of Basel II, this requirement was not

obligatory. Interestingly, some countries, such as France, had implemented it into national

legislation already, whereas others, among them Germany, had not, and were, thus, hit harder

by the collapse of the shadow banking system (Thiemann 2011).



18 Despite these improvements, many experts consider the Basel III capital requirements for

traditional banks to be too low to guarantee stability (see e.g. Admati et al. 2011).

19 The ongoing sovereign debt or euro crisis seems to have led policymakers to the same

conclusion. At least for large, systemically important banks, there are now serious plans for a

“banking union”, that is, truly supranational supervision.

20 The decisive difference is that in my explanation, national policymakers have to mediate

between both international and domestic politics, whereas Singer considers state competition

to be an endogenous variable of the dynamics of domestic politics. Thus, he implicitly assumes

that the dilemma on the international level can be successfully solved. This assumption may be

warranted if the relevant group of countries that can successfully engage in regulation, that is,

Schelling’s k group, is small. This is given in his Basel case (Genschel & Plümper 1997). But this

assumption does not hold in the case of the regulation of shadow banking – where the relevant

k group is bigger.

21 While (as a rationalist) one may think that such announcements are merely cheap talk, such

a view would not be in line with the constructivist notion of the civilizing force of hypocrisy

(Elster 1998).

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Documents

Why reregulation after the crisis is feeble: Shadow banking, offshore financial centers, and jurisdictional competition