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In the Shadow of Basel: HowCompetitive Politics Bred theCrisisMatthias Thiemanna

a Institute for Sociology, Goethe University, Frankfurtam Main, GermanyPublished online: 05 Feb 2014.

To cite this article: Matthias Thiemann , Review of International Political Economy(2014): In the Shadow of Basel: How Competitive Politics Bred the Crisis, Review ofInternational Political Economy, DOI: 10.1080/09692290.2013.860612

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In the Shadow of Basel: How CompetitivePolitics Bred the Crisis

Matthias Thiemann

Institute for Sociology, Goethe University, Frankfurt am Main, Germany

ABSTRACT

What if global governance mechanisms undermine the capacity of nationalbanking regulators to deal with the deviant activities of their banks? Suchwas the case, this paper argues with respect to the Basel Accords and theregulation of the bank-based shadow-banking system. Securitization-activities by banks, driven by regulatory arbitrage have been an integralpart of the shadow banking sector and a central transmission mechanismduring the financial crisis. They have been identified as problematic by theinternational regulatory community since 1999, motivating reforms in Basel 2.This paper investigates why, nevertheless, regulatory loopholes that allowedbanks to engage in these activities without core capital charges persistedin almost all Western jurisdictions pre-crisis. It lays emphasis on the globalnature of the securitization business in conjunction with its nationalregulation, and shows that these national regulations on the fringes ofglobal banking regulation were driven by competitiveness concerns. TheBasel Accords were central in this dynamic, as they guaranteed the globalnature of this market and gave national banking regulators the leeway toexempt securitization-activities from global regulation. Rather thaneliminating competitive inequity concerns, the Basel Accords channelledthem to its fringes, where they introduced a regulatory race to the bottom.

KEYWORDS

regulatory arbitrage; securitization; global markets; national regulation.

‘the problem is that it doesn’t do any good, really for Basel 3 to be soconsistent even if applied as is written . . . if the accounting differsfrom jurisdiction to jurisdiction, . . . there is going to be a competi-tive issue if we don’t get the accounting converged at the same timethat we are trying to ensure that we have a consistent regulatorycapital treatment’ (interview Fed official, 27 March 2012)

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Review of International Political Economy, 2014http://dx.doi.org/10.1080/09692290.2013.860612

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http://dx.doi.org/10.1080/09692290.2013.860612

INTRODUCTION

The reasons for the outbreak and quick diffusion of the recent globalfinancial crisis have by now been well established. A run on the shadowbanking system1 in the summer of 2007 was identified as its trigger (cf.Gorton, 2010), and ‘securitization without risk transfer’ (Acharya et al.,2009) by the banks as a major transmission mechanism that concentratedlosses from securitization in Western banking systems (. IMF, 2009).Banks had ‘parked’ securitized assets, worth hundreds of billions of dol-lars in the shadow banking system, essentially engaging in proprietarytrading off-balance sheet, and in doing so, remained exempt from bank-ing regulation (Hellwig, 2010; Acharya and Schnabl, 2010). Whensuspicion over the quality of these securitized assets reached themoney markets, these refused to continue to refinance the proprietarytrading of banks and the assets parked in the shadow banking sectorreappeared on the balance sheets of banks, creating losses due to subse-quent write-offs.

As a consequence of these events, the G20 and other international bod-ies have identified the need to impose regulatory control over the shadowbanking sector and its linkages to the banking system as one of the mosturgent policy challenges (G20, 2011, paragraph 30; FSB, 2011; FSB, 2012,Gorton and Metrick, 2010; Adrian and Shin, 2009; Adrian and Ashcraft,2012a for different policy proposals). These debates, however, never suf-ficiently address the question as to why these activities of banks wereexempted from banking regulation in the first place. In other words,what allowed them to operate in the shadows? Without properly appreci-ating the reasons for this remarkable exemption, future regulation willlikely fail again. This article addresses the following question: given thatbanking systems remain among the most supervised and regulated sec-tors in the economy, why did banking regulators around the globe permittheir banks to evade core capital requirements by acting in the bank-based shadow banking system before the crisis of 2007? Regulators cer-tainly understood the dynamics of regulatory arbitrage2 driving thegrowth of this sector (Jackson, 1999: Jones, 2000; Major, 2012: 548f) and,as the revised framework for securitization of the Basel 2 accord finalizedfrom 2001 to 2004 shows, developed measures to close regulatory loop-holes (although these only came into effect in 2008). So, then, why didthey not regulate before the crisis? To answer this question, this articleinvestigates the formation of ten national regimes in the most importantWestern economies from the start of the new negotiation on an interna-tional regime for securitization exposure in 1999 until its implementationin 2008.3 In order to argue that regulatory inaction can only be explainedby the mismatch between the level at which the problem occurred

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REVIEW OF INTERNATIONAL POLITICAL ECONOMY

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(globally) and the level at which banking regulators could address it(nationally), I draw on documentary analysis and 64 semi-structuredinterviews conducted with key economic agents involved in the activityand regulation of the bank-based shadow banking sector4 betweenAugust 2010 and March 2012.

The idea that the increasing cross-border integration of financial mar-kets undermines national policy solutions remains a common one. Globalgovernance mechanisms are seen as a possible way to mitigate theseeffects (inter alia Kapstein, 1991: 24, Slaughter, 2003: 11). But, what ifglobal governance mechanisms themselves undermine the capacity ofnational banking regulators to deal with the regulatory capital arbitrageactivities of their banks? In the case of bank-based shadow banking, theglobal Basel Accords caused and cemented this mismatch between thenational and the global. Although global Basel standards for core capitalrequirements arose in order to level the competitive playing fieldbetween American, European, and Japanese banks, the undefined reachof these rules led to the national reappearance of concerns over competi-tive disadvantages. This multilevel dynamic in banking regulationshifted the problem of competitive disadvantages from the centre ofbanking regulation to the margins, the shadow banking sector. In theshadow banking system, regulatory arbitrage of banks to circumventcostly capital requirements coincided with unresolved frictions betweennational and international banking regulation, which led to inaction bynational regulators.

In the next section, I discuss the linkage between the financial crisisand the shadow banking sector and the three entry points for regulationwhere supervisors could have acted, but did not. Subsequently, I bothpresent current arguments in the debate as to why securitizationremained loosely regulated and suggest that these hardly explain the uni-form exemption across countries. I, then, show that the way that the BaselAccords were set-up weakened the capacity of nation states to regulateglobalizing financial markets. Next, I provide summary tables describingthe almost uniform exemption from regulation in the ten countries stud-ied until 2008 and contrast it with the initiatives against regulatory arbi-trage in the revision of the Basel Accords. This movement towardsregulatory exemption is then explained in greater depth and analyzed inthree case studies: Germany, the US, and France. The last section dis-cusses the implications of the case for future global regulations, such asBasel 3 and weighs the benefits of normative fragmentation. Based onthis discussion, I identify possible future research sites to investigate ifand how the negative dynamics emerging from the structural mismatchbetween global financial markets and national regulations can becontained.

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THIEMANN: IN THE SHADOW OF BASEL

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SHADOW BANKING, THE FINANCIAL CRISIS AND THEENTRY POINTS FOR REGULATION

Since the onset of the financial crisis, much research has been undertakento identify the scope and the functioning of what has been identified bymany as the epicentre of the financial crisis, the shadow banking system.While the debate has evolved from a sole focus on ‘highly levered off-bal-ance sheet vehicles’ (Pozsar, 2008) to include the entire system ‘of creditintermediation that involves entities and activities outside the regularbanking system’ (FSB 2011)5 with competing definitions of the shadowbanking system (FSB, 2012; Claessens et al., 2012: 4, Mehrling, 2011: 117),a general consensus exists that ‘the shadow banking system decomposesthe simple process of deposit-funded, hold-to-maturity lending con-ducted by banks into a more complex, whole-sale funded, securitizationbased lending process that involves a range of shadow banks’ (Poszaret al., 2010: 13). The network of linked organizations fulfilled the samefunction as a banking system, albeit a shadow banking system. Althoughthe production of credit was restructured so that no single entity couldbe characterized as a bank proper, banks backstopped these entities for afee in case their operations in financial markets were to run into trouble(Adrian and Ashcraft 2012b:5f). Banks were thus an important element inthis new system of ‘market-based credit intermediation’ (Mehrling,2011), especially in the ‘internal shadow banking system’ (Pozsar et al.2010: 15).6 In this part of the system, banks were seeking to engage inbanking business while circumventing banking regulation. By exploitingtechniques of regulatory, tax and, economic capital arbitrage and ratingsarbitrage (ibid.: 29f), banks’ support for and engagement with theshadow banking system was structured to ‘optimize’ regulatory costs.This strategy is the most evident with respect to off-balance sheet entitiesthat banks sponsored, which lay at the heart of the ‘internal shadowbanking system’ (Pozsar et al. 2010: 15).

Banks officially reduced assets on their balance sheets by legally trans-ferring them to Securitization Special Purpose Entities (SSPE) but main-tained control over them economically. Some have aptly described SSPEsas ‘essentially robot firms that have no employees, make no substantiveeconomic decisions, have no physical location, and cannot go bankrupt’(Gorton and Souleles, 2007: 550). Banking conglomerates managed assetsoff-balance sheets via these shell companies, which without the conglom-erates’ liquidity support, were not independently viable.

Instead of interest income from the assets on the balance sheet, bankingconglomerates generated fees for the liquidity provision and otherservices to the special purpose entities, where they placed the assets,thereby swapping the risk exposure to the assets for an exposure to theSPE (Gorton and Souleles, 2007) (s. Figure 1 below). Acharya and Schnabl

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(2009: 2) provide a good explanation of the business model of these off-balance sheet entities:

Banks use off-balance sheet vehicles to purchase long-term andmedium-term assets financed with short-term debt. However, con-trary to other forms of securitization, such as mortgage-backedsecurities or collateralized debt obligations, banks effectively keepthe credit risk associated with the conduit assets. Hence, as long asbanks are solvent, conduits are risk-free for outside investors butcan generate significant risks for banks. In exchange for bearingthese risks, banks have access to low-cost funding via the asset-backed commercial paper market.

When money markets ran dry during the ‘run on the shadow bankingsystem’ (Gorton, 2010), the liquidity lines granted to the SSPEs by thebanks were drawn, and hundreds of billions of dollars of impaired assetsplaced into these vehicles were returned to the balance sheets of banks.Eventually, structured investment vehicles carrying $400 billion disap-peared completely (Gorton, 2008: 44), and the Asset-Backed CommercialPaper (ABCP)-market shrank by $550 billion, almost 50 per centin theyear to September 2008 (Acharya and Schnabl, 2009: 40). ‘Securitizationwithout risk transfer’ (Acharya et al. 2009), epitomized by the return ofsecuritized assets on the balance sheets of banks during the crisis greatlyaided in turning a local subprime crisis into a global financial one. Inessence, the banking system was not prepared to deal with the unex-pected credit losses of these assets, which had been transferred out of it

Figure 1 The role of banks in securitization Sources: BCBS, 2009, Brinkhuis andvan Eldonk, 2008

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in legal form. The problem was that while they were officially sold, banksremained exposed to them in an implicit understanding between banksand investors (Gorton and Souleles, 2007). By making off-balance sheetactivities as expensive in terms of core capital as on-balance sheet activi-ties, thereby removing the possibilities for regulatory arbitrage,7 how-ever, banking regulators could have ended these acts of regulatorycapital arbitrage. All three entry points for such regulation centred on theregulatory treatment of the special purpose entity needed for securitiza-tion to work (s. Figure 2 below).

The first entry point for regulation centres on how to regulate and tosupervise the securitization-special purpose entities themselves, as theseare active agents in financial markets emitting commercial papers intothese markets and buying up debt. Should they be considered as a creditinstitution or as a financial institution? The second one asks if, in regula-tory terms, the SPE should be deemed a subsidiary of the banking con-glomerate which sponsors it? This status would imply the application ofcore capital requirements to the assets inside the SPE. The third accesspoint pertains to the liquidity lines granted by the banking conglomer-ates to their securitization SPEs: should there be a core capital charge forthese liquidity lines or not? Evidently, banks were taking on risks ingranting these liquidity lines.

Figure 2 The role of banks in securitization and the three entry points for regula-tion Sources: BCBS, 2009, Brinkhuis and van Eldonk, 2008

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Early on, regulatory frameworks for securitization in the US andother developed countries sought to limit the most blatant attempts ofregulatory arbitrage in this area (for example, when banks transferredcredits but not the risk of default attached to them). Consequently, bankshad to withhold core capital for letters of credit granted to securitizationvehicles and other contractual obligations that effectively inhibited anyrisk-transfer from the banks to financial markets (Boemio and Edwards,1989), nevertheless, banks continued attempts at circumvention(Moody’s, 1997). But, liquidity support by the banks for SPEs of less thanone year remained exempt from capital charges. As a reaction, in orderto avoid core capital charges specified in Basel 1, liquidity supportgranted to securitization-SPEs were structured to end after less thanone year (actually, 364 days,) but they were renewed the day of theirexpiry, a blatant example of regulatory arbitrage. These three accesspoints remained unregulated in the international regulatory framework,Basel 1, as the securitization technique flourished in the spots unregu-lated by Basel 1. Remarkably, they were also exempted from mostnational regulations, up until the new Basel Accord came into full forcein 2008.

COGNITIVE CAPTURE AND STRUCTURALCONSTRAINTS OF REGULATORS

Many authors have noted the lack of regulation of securitization activitiesof banks pre-crisis (cf. Acharya and Schnabl, 2009: 20–25, who review thelack of regulation in several countries, Adrian and Ashcroft, 2012b,Adrian and Shin, 2009), but a dearth of explanations for this widespreadregulatory exemption exists. As I will show below, the argument of cog-nitive capture (as a particular form of regulatory capture), which hasbecome a prominent explanation for regulatory leniency before the crisis(e.g. Baker, 2010; Buiter, 2012; Turner, 2010) cannot account for the almostuniform global lack of regulation. Instead, I argue that we have to takeinto account the structural constraints that national regulators were fac-ing with respect to the securitization activities of their domestic banks,constraints which were partially shaped by the Basel Accordsthemselves.

Theories of cognitive capture point to the neoliberal spirit of the late1990s held at the helm of the Federal Reserve Board and other regulatorsthat favoured self-regulation (e.g. Greenspan, 1998). As Buiter (2012) haspointed out:

Regulatory capture can be direct or cognitive. In this crisis blindfaith in the self-regulating properties of financial markets playeda major role, with Alan Greenspan as the prophet of socially


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beneficial self-regulation and Ben Bernanke and many others pro-viding the scholarly underpinnings (Buiter 2012: 5, emphasis mine;also Bhid�e, 2011, 105; Eichengreen, 2003).

US regulators at that time believed in the self-regulatory powers ofmarkets, where market discipline exerted by rational, informed marketagents was judged superior to regulators’ arbitrary risk-assessments(Jones, 2000: 49f). Regulators were seen as inevitably behind the curve ofthe more correct perception of risks by market agents. In this view, regu-latory arbitrage by market agents was seen as a means to correct the mis-takes of regulators, as correcting for arbitrary and often unnecessarilyexpensive capital requirements. A general prohibition of these activitieswas deemed ‘counterproductive (and politically unacceptable)’ (Jones,2000: 49; Major, 2012). The belief in the superiority of private agents’assessments of new financial products and services led regulators, so theargument goes, to evaluate the risks of securitization based on the sameconcepts and numbers bankers used (Baker, 2010: 653f; Turner, 2010).

Theories of cognitive capture, however, mostly focus on the Anglo-Saxon sphere (in particular the US and the UK)8 and, therefore, cannotaccount for the largely homogeneous failure to regulate securitizationactivities of banks on the global level (see. Tables 1, 2, 3 below). It seemshardly convincing that regulators in all of the countries faced with theregulation of this sector of the shadow banking system were cognitivelycaptured.9 These doubts extend to the mechanisms seen as responsiblefor the spread of cognitive capture. Baker (2010), for example, links cogni-tive capture to post-graduate education in economics in Anglo-Saxonuniversities. But, regulatory agencies in non-Anglo-Saxon countries arenot majorly staffed by economists trained in such universities. Instead,regulators are often schooled domestically, sometimes in special univer-sities directly linked to the central bank where practical matters of regula-tion as well as abstract economic models are taught.10 The strength ofcognitive capture as an explanatory variable is further weakened by signsof regulatory awareness regarding the motives behind the growth ofsecuritization activities of banks and its negative impacts on regulatorycontrol in the 1990s. These can be found at the national as well as theinternational level.

Already in 1995, the Deutsche Bundesbank linked the six-fold growthof securitization from 1980 to 1995 to the reduced regulatory burdens inthis field as compared to bank-credit, which created incentives for‘innovations for circumvention’ (‘Umgehungsinnovationen,’ DeutscheBundesbank 1995: 21). The first working paper of the Basel Committee in1999 goes even further when it evaluates the impact of Basel on bankbehaviour. The authors note large-scale and accelerating acts of


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regulatory arbitrage in the field of securitization. They find it to be mostpronounced in the field of Asset-Backed Commercial Paper-conduits,where banks transferred assets into special purpose entities, which refi-nance them with the help of commercial paper (with the duration of lessthan one year). This form of securitization allowed banks to reduce thecore capital they were required to hold, without changing the risk expo-sure of the bank (Jackson et al. 1999: 24; Jones, 2000; Balthazar, 2006;33–5). The study of the Basel Committee for Banking Supervision (BCBS)in 1999 on US-banks shows the degree to which some financial institu-tions have become engaged in the Asset-Backed Commercial Paper(ABCP-) market and Collateralized Loan Obligations (CLO) market togain advantages from regulatory arbitrage11 and indicates acceleratingpossibilities for such regulatory arbitrage (Jackson et al. 1999:25). Theirconclusion is rather dramatic:

The available evidence suggests, therefore, that the volume of regu-latory capital arbitrage is large and growing rapidly, especiallyamong the largest banks. Securitisations are motivated by a numberof factors . . .. in many cases the effect is to increase a bank’s appar-ent capital ratio relative to the riskiness of its actual book, which ismaking the ratios more difficult to interpret and in some cases lessmeaningful. (., :. 26)

In this document, the fact that banks were hiding their true risk expo-sures with the help of securitization is clearly communicated, as is thefact that the numbers used by regulators to manage risk-exposurebecome less meaningful. This means that knowledge about the negativeconsequences of regulatory arbitrage occurring within the realm of secu-ritization activities of banks was disseminated among regulators in 1999,well before the financial crisis.

Regulatory arbitrage in the realm of securitization was one factor thatmotivated the process of revision of the Basel Accords that started in1999 (Blundell-Wignall and Atkinson, 2010: 10; Balthazar, 2006). Thesedebates produced concrete proposals to close certain regulatory loop-holes in the area of securitization from 2000 onwards, some of whichwere incorporated in the revision of the Basel Accords (Basel II) in 2004.These international debates cannot be treated as exogenous to nationalones in large Western countries, as regulators from these nations aremembers of the Basel Committee.12 They, therefore, were likely aware ofthe international debates on acts of regulatory arbitrage in the field ofsecuritization and the proposed measures to remedy the situation. Theseevents suggest that the problem did not predominantly reside in thecapacity of independent information gathering or understanding by


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regulators (cognitive capture) but, instead, in resolute action by nationalregulators to close these gaps.

Regulatory and cognitive capture are certainly among the factors thathelp us to account for the lack of regulation, but relying on these factorsto explain the absence of regulation in almost all developed Westerncountries is clearly stretching their explanatory power. Instead, they canbe analyzed as proximate causes of the lack of regulation, an outcome ofthe agency of bankers and regulators within the regulatory context oftheir time (Kahler and Lake, 2003: 28). However, to explain the lackof regulation in such a cross-nationally persistent manner, it seemsadvisable to inquire into the remote causal factors, ‘the socio-institutionalcontext, and the particular historical conjuncture in which actors findthemselves’ (Young, 2012: 669), and to focus on ‘the interactive inter-dependence. . . between the properties of the given regulatory structureand the properties of the policy field concerned’ (Mayntz 2010:-. 3).

Poszar et al. come close to such a structural explanation when theypoint to the ‘fractured nature of the global financial regulatory frame-work’ and ‘a collection of one-off, uncoordinated decisions by accountingand regulatory bodies regarding the accounting and regulatory capitaltreatment of certain exposures’ (2010: 29) as the source of arbitrageopportunities that underlie the growth of the bank-based, ‘internalshadow banking system..’. This article links these two aspects and sug-gests that these uncoordinated decisions by national accounting and reg-ulatory bodies were nevertheless structured by the common situation allregulators were facing, which acted as structural constraint for the pru-dent regulation of this global market.13 National regulatory bodies wereasked to oversee a financial innovation that evaded global regulationwhile their banks were competing in the global market created by thisfinancial innovation based on national regulatory costs. Despite regula-tory concerns at the national level, the competitiveness concerns emerg-ing from this situation induced a dynamic of persistent regulatoryexemptions for the bank-based shadow banking sector.

Prior work in International Political Economy on the regulation ofglobal financial markets in the absence of global governance has shownthat the lack of international agreement generates the forces which pre-vent the effective regulation of international markets domestically, evenif the regulators prefer it (inter alia Underhill, 1997b: 18; Mosley andSinger, 2009: 422). The regulation of such ‘international markets’ that sitat ‘the nexus between national and international affairs’ (Farrell andNewman, 2010: 630, see also Mosley, 2010; critical Drezner, 2010) areheavily influenced by how other nations regulate them. National deci-sions in the absence of international agreements are often characterizedby concerns over an even playing field for domestic actors and regulatorycompetition where domestic agencies are removing regulatory


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restrictions or oversight in order to permit domestic market players togain a greater market share (Underhill, 1997a: 6).14 What is exceptionalabout the case of securitization activities of banks, however, is the rolethat a global governance mechanism, the Basel Accords, played in gener-ating this global market and in preventing its effective regulation.

HOW THE BASEL ACCORDS FURTHERED THEBANK-BASED SHADOW BANKING SECTOR AND

LIMITED ITS NATIONAL REGULATION

It is well known that the introduction of Basel I, and – in particular – thecore capital requirements accelerated the development of securitization(e.g. Balthazar, 2006). Securitization SPEs such as the now infamousStructured Investment Vehicles were invented by banks to deal with thenew core capital requirements (. Ehrlich et al., 2009), and those countrieswhich did not have a regulatory infrastructure in place in order to permitthe transfer of bank assets from balance sheets came under pressure bytheir domestic banks to achieve such regulation, like that in Japan(Kapstein, 1991: 28). But, there are two further linkages between the Baselframework and the development of securitization which have not yetbeen sufficiently taken into account but need to be appreciated in orderto understand the widespread regulatory exemption of these activities.These regard both the global nature of the market for securitizationwhere banks are buying up credits from their customers and are trans-forming them into securities and the fact that conditions under whichbanks compete in it are determined nationally.

Kane (1987: 114) comes closest to the structural critique developed inthis paper when he argues that the inevitable time gap between the eva-sion of regulation by private firms and the closure of these loopholes bythe supervisors (what he calls the ‘regulatory dialectic’) is greatest whenthe rule-maker is an international body. This statement seems to be borneout by the fact that, while regulatory arbitrage in securitization was iden-tified as a problem in 1999, it still took nine years for the revised BaselAccord to become operative. What Kane does not consider is the nationalregulatory reaction to regulatory arbitrage during this time gap in whichan international response is prepared. This reaction, I posit, is structuredby competitiveness concerns of regulators for their domestic banks, rein-forced by the limiting effects the Global Accord has on the regulatorypowers of national regulators.

The rule of home country regulation, a primary element of interna-tional banking regulation since the first Basel Concordat in 1975 (Herring,2007: 202f), undermines the capacity of national regulators to imposecommon regulation for domestic and foreign banks in the securitizationbusiness on national grounds. The rule of home country regulation


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implies that by signing up for the Basel Accords, one accepts the bankingregulations of other countries as appropriate if they are deemed to be incompliance with Basel and do not impose additional charges for theiroperation domestically (Pistor, 2010 for an in-depth treatment).15 Thisimplies that if foreign banks have more lax regulation, they can securitizelocal credits according to their domestic rules which carry fewer costs forsupervision and therefore outcompete domestic banks in the local marketfor securitization.

The capacity to impose market access restrictions has been identified inthe literature on regulatory competition as the lever that permits regula-tory convergence towards a higher common denominator, as nationswith large domestic markets can impose their views on other countriesthrough the threat of market access restrictions (Murphy, 2004: 13:;Simmons, 2004: 50 for the US position on core capital requirements, seealso Drezner, 2007). However, what has not been considered in this litera-ture is that once the threat of market access restrictions has been used toachieve global legislation, it cannot be used again. Domestic supervisors,even those of states with large markets, no longer have the leverage toforce foreign overseers to raise regulatory costs on financial innovationsthat emerge to evade the Global Accord. Furthermore, introducing meas-ures that go above and beyond the global Accord to deal with the risksthis financial innovation generates will impose a competitive disadvan-tage on domestic banks in these global markets without impacting theoperation of foreign banks at home.

This helplessness is aggravated by the fact that the Basel Accord oper-ates on ‘dependent rules’ (Pistor, 2002: 107f), where fundamental termsused in global standards are defined by national laws. For the case ofshadow banking, the crucial national laws defined the perimeter of bank-ing supervision and the construction of consolidated balance sheets. TheBasel Accord makes it mandatory to supervise banking conglomerateson a consolidated basis (including all financial subsidiaries), built on theconsolidated financial statement of banking conglomerates (BCBS, 1988:3, point 10), but it does not specify under which conditions a companyqualifies as a subsidiary of a conglomerate, nor does it determine whensuch a subsidiary is deemed a financial subsidiary. Instead, consolidatedbalance sheets are constructed based on national accounting rules, andthis accounting information is then translated into capital requirementsaccording to national banking laws, which decide if a subsidiary is afinancial institution or not. If it is not, the subsidiary falls outside ofbanking supervision, which means that no core capital requirements willbe applied to the assets of that subsidiary. The decision to change theseframeworks lies entirely in the realm of the national legislative.

Basel did not correct for the differences between national accountingframeworks or for the national differences regarding the scope of


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banking supervision. Instead, the international accord was placed uponthese national rules, thereby imposing heterogeneous production processregulation on off-balance sheet financing activities of banks.16 Heteroge-neous production process regulations have been identified as the key fea-ture for inducing a competition in regulatory laxity (Murphy, 2004: 6), asbanks in jurisdictions with very loose national regulations gain a compet-itive advantage in the securitization business.

We thus find in the centre of the international banking accord, whichsought to reduce competitive inequities globally and was hailed fordoing so (Kapstein, 1991: 24), a source of such inequities which could notbe influenced by the international accord itself, threatening the levellingof the playing field at the margins (Scott and Iwahara, 1994; Jackson et al.1999: 41). The Accord did not resolve the problem of competitive inequi-ties, but instead, shifted the problem to the perimeter of supervision andthe perimeter of consolidated financial statements, the outer marginsof the Basel Accords where national supervisors had to decide how toregulate. At this point, heterogeneous production process regulation,coupled with the impossibility of imposing market access restrictionshifted the balance of power between industry and national regulators infavour of the former.

NATIONAL INACTION AT THE MARGINS OF BASEL

Due to the specific constellation of international and national rules elabo-rated upon above, national perimeters of supervision came under pres-sure to converge towards an international minimum, as a large perimeterautomatically meant a competitive disadvantage for banks from thosecountries. This question was especially important for banks’ use of spe-cial purpose entities for securitization-purposes. As an organizationalform, these entities were used to circumvent the Basel rules, but theircapacity to do so depended upon their exemption from the nationalperimeter of supervision. As seen in Tables 1 and 2 below, the nationalperimeter of supervision shifted almost uniformly in favour of the exclu-sion of SSPEs. But before, for the reader to understand the mechanicsinvolved better, the sequence of steps that involve national accountingrules and national banking laws in the regulatory treatment of specialpurpose entities used for securitization is shown in Figure 3 below.

The first step involves the question if the accounting framework doesrequire the consolidation of these SSPEs in the financial statement (finan-cial scope of consolidation). In a second step, the question is if these enti-ties are considered a credit or a financial institution according to nationallaw? If they are, they have to be supervised by national banking regula-tors or national financial market regulators respectively, but if they arenot, they have to be ignored, even if they appear in the financial


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statements of banks. If the answer to either one of these questions is no,then banking conglomerates from these countries do not have to with-hold core capital against these special purpose entities.

The friction between national and international regulation created aspecific concern over competitiveness attached to accounting rulechanges for consolidation (interview banker France, 25 March 2011; bank-ing regulator Germany, 1 July2011; banking regulator US, 27 March 2012;PwC, 2006: 3; Bens and Moynihan, 2008). Any reform of national account-ing standards that could force securitization SPEs on the balance sheet oftheir sponsoring banks forced national banking regulators to answer thequestion of whether capital charges should be applied to the newly con-solidated assets or not. This question became charged with concerns overthe international competitiveness of the domestic financial sector, as itdirectly threatens the profitability of the securitization business. It is,thus, not surprising to see the US as well as most European banking regu-lators answer this question negatively.

This persistent exclusion was no coincidence; instead, eight out of tenregulators consciously decided to exempt SSPEs from core capitalrequirements when changes in accounting rules threatened their inclu-sion in the perimeter of banking supervision. In the case of the US, thesudden demise of Enron in 2001 due to off-balance sheet SPEs led to arevision of US-accounting rules for SPEs. The new rule issued in 2003(Fin, 46) had an immediate impact on the securitization activities of banksin in the US, halting expansion and leading to massive restructuring ofsecuritization-programs in order to avoid on-balance sheet consolidation(Bens and Moynihan, 2008: 1027). In October 2003, the US banking regu-lators issued a temporary exemption of newly consolidated securitization

Financial scope of

consolidation

Supervisoryscope of

consolidation

1. Is the SPE a subsidiary of the banking conglomerate in terms of financial accounting?

2. Is the SPE deemed a financialinstitution?

Figure 3 The two level-process to recognize SPEs in banking supervision


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Table 1 The consolidation of securitization SPEs in financial accounting termsand their inclusion in the scope of banking supervision

Country

Accounting Rules regardingthe on-balance sheet status ofSPEs

The question of the inclusion ofSPEs in the scope of bankingregulation

Netherlands Medium SSPEs are not includedAccounting policies: since 2001

explicit accounting rule tocapture SPEs, however, dueto governance problems onlyfully applied by 2005(interview regulatoryadviser, Amsterdam10 June 2011)

since 1997 (DNBMemorandumin zake securitizatie) nottranslated into prudentialregulation (interview Dutchbanking manager 6December 2011)

Germany Easy SSPEs are not includedUntil 2009, securitization SPEs

were usually not captured inGerman Generally AcceptedAccounting Principles(GAAP)

In 2005, introduction ofInternational FinancialReporting Standards (IFRS)

Link between German GAAPand banking regulation wassevered at the momentconsolidation becamepossible in German GAAP in2010

USA MediumUntil 2003 securitization SPEs

were usually not captured,when FIN 46 is introduced

SSPEs are not included for thecalculation of core capitalcharges, but assets ofconsolidated SPEs aretranslated into simpleleverage ratio

Italy Easy SSPEs are not includedUntil 2004, securitization SPEs

were usually not captured inItalian GAAP, IFRS isintroduced in 2005

Link between accounting andprudential consolidation issevered in March 2006(Schiavello and Mimun, 2007)

Canada MediumVery relaxed until 2004, until

Accounting Standards BoardGuideline 15 (AcG-15) isissued, transposing Fin 46into Canadian law

SSPEs are not included for thecalculation of core capitalcharges, but assets ofconsolidated SPEs aretranslated into simpleleverage ratio

Belgium Easy SSPEs are not includedUntil 2004, securitization SPEs

are not captured in BelgianGAAP.

IFRS is introduced in 2005

When consolidation occurs infinancial accounting, only theequity of SPEs isconsolidated in prudentialterms, as they are notbanking institutions (Dexia,2009: 11)

(continued)


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SPEs from the calculation of core capital requirements that was madepermanent in July 2004.17 The US banking regulators therefore made ‘amaterial distinction between two kinds of activities with essentially iden-tical risks’ (Adelson, 2003: 6),18 confirming the regulatory loophole thatallowed the evasion of core-capital requirements.

European banking supervisors also were confronted with this questionin 2005 when all large European bnks had to apply the InternationalFinancial Reporting Standards (IFRS) (Gilliam, 2005 : 315). As it is moredifficult to achieve deconsolidation in IFRS than under US rules

Table 1 (Continued )

Country

Accounting Rules regardingthe on-balance sheet status ofSPEs

The question of the inclusion ofSPEs in the scope of bankingregulation

UK Easy SSPEs are not includedRelaxed before 2004, IFRS is

introduced in 2005Excluded from the calculation

of core capital requirementsaccording to FSA rules (RBS,2009:5)

Spain Difficult SSPEs are included from 2005onwardsBefore 2005, securitization SPEs

were usually not captured inSpanish GAAP. Since 2005strictest rules in Europe, dueto intervention by Spanishbanking regulator,goldplating IFRS-rules

strict link, non-permissive: ifSPE is consolidated, corecapital charges are applied

France Difficult Yes (from 1999 until 2004)In 1999, an accounting rule is

introduced by the bankingregulator to capture SPEs onthe balance sheet, until 2004(under French GAAP forbanks)

In 2005, introduction of IFRS

French banking regulatordelinks the prudentialtreatment of securitization-SPEs from their accountingtreatment in 2005 (Amis andRospars), after losing thebattle for strict accountingstandards

Portugal Difficult Yes (from 2005)Before 2005, securitization SPEs

were usually not captured inPortuguese GAAP, bankingregulator was goldplatingIFRS (Millennium BCP, 2011:9f)

Since 2005, strict use ofconsolidated SPEs forprudential regulation,non-permissive

Sources: ECB, 2001; Acharya and Schnabl, 2010; Thiemann, 2012: BDO, 2011; Bank ofEngland, 2007: 60; Banco de Espana Circular 3/2008; Millennium BCP, 2011; Dexia, 2009;PWC 2006. The categories easy/medium/difficult are meant to measure the difficulty ofachieving off-balance sheet status for SSPEs in these jurisdictions.


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(Adhikari and Betancourt, 2008), European banks were about to suffer anautomatic competitive disadvantage with respect to their American com-petitors in the securitization business. In the final instance, domestic pref-erences of banking regulators shaped the transition to IFRS differently(Enria and Texeira, 2011: 9), but preferences favouring prudence had toovercome domestic opposition from both banks and finance ministriesgenerated by competitive inequity concerns. We see this in Table 1 above,where only Spain and Portugal choose to apply core capital charges toSSPEs, while the other European countries exempt them. Especiallyinformative is the case of France, which after convergence to stringentoff-balance sheet accounting rules for securitization in 1999 reverses itsposition in 2004.

Another arena in which the pressure for regulatory exemption oper-ated was national banking laws, where the crucial question was the clas-sification of securitization SPEs as credit institutions, financialinstitutions, or neither of the two. This classification had important con-sequences for the supervision of these entities, as it determined whichregulators were responsible and which regulatory requirements applied.Table 2 again documents a trend towards regulatory exemption, whereSSPEs are treated in no jurisdiction as credit institutions and only in veryfew as financial institutions.

The exemption of SSPEs from the status of credit institutions and finan-cial institutions required special derogations and exemptions. Thesepractices clarify the legal accommodation of nation states to the practicesof securitization as the decision to treat securitization SPEs explicitly notas credit institutions is the regulatory foundation, the conditio sine quanon of the securitization business for the purpose of regulatory capitalarbitrage. If SSPEs were treated as credit institutions, the reduction ofcore capital to a sliver would have been impossible.19

Securitization-special purpose entities that engage in the selling ofsecurities and buy up loans or ABS might be qualified as credit institutions.The European banking directive, for example, specifies that if an institu-tion takes in deposits or other repayable funds from the public and grantscredits for its own accounts (77/780/EEC Article 1, becoming part of 89/646/EEC; 2000/12/EC; 2006/48/EC20), it is a credit institution and needsto comply with all banking regulations, including the ownership of suffi-cient core capital.21 Securitization-SPEs, conversely, operate on minus-cule equity which is incompatible with its status as a credit institution. Inorder to facilitate these operations, states were changing their laws (Aus-tria 2005, the Netherlands 1997),22 or opening up loopholes, as in France,where the rules classifying the acquiring of receivables on a regular basisas a credit operation are not applied to domestic securitization vehicles,based on the implicit derogation that they do not constitute credit institu-tions (EFMLG, 2007a:26). As securitization-SPEs were not considered


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Table

2Theclassificationofsecu

ritiza

tionSPEsin

Western

EuropeanEU

mem

bers,Can

adaan

dtheUS1

Country

SPEsconsidered

acred

itinstitution

SPEconsidered

afinan

cial

institution

SPEunder

the

supervisionofthe

ban

kingsu

pervisor/

finan

cial

markets

supervisor

State

Supervision

USA

No

No

No

No,iffunded

by

professional

investors

Can

ada

No

No

No

No(deleg

ated

tocred

itratingag

encies,w

ho

approvethem

)Austria

No(explicitin

ban

king

law

since

1July

2005

),before

yes

No

No

No

Belgium

Inprinciple

yes,b

ut

than

ksto

Royal

Decreeof7July

1999

,no(EFMLG20

07a:

27)

No

Iffunded

bythegen

eral

public,theministry

offinan

ce.

No,iffunded

by

professional

investors

France

Yes,b

utim

plicit

exem

ptionforFrench

SPEs

No,b

utthefundwhois

man

agingtheSPEis

CustodiansofSPEsare

supervised

,by

ban

kingan

dfinan

cial

supervisors

Yes

German

yNo

No

No

No

Irelan

dNo

No

No

No

Italy

No

Yes

Ban

cad’Italia

(inform

ationonnotes

andassets)

Yes

(continued)


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Table

2(Continued

)

Country

SPEsconsidered

acred

itinstitution

SPEconsidered

afinan

cial

institution

SPEunder

the

supervisionofthe

ban

kingsu

pervisor/

finan

cial

markets

supervisor

State

Supervision

Luxem

burg

No

No

Yes,thefinan

cial

supervisor,ifissu

edto

thepublic(i.e.n

ot

toprofessional

investors)

No,ifissu

edirregularly

orto

professional

investors

Netherlands

Yes,b

utexem

ptionin

ban

kinglaw

which

allowsitto

be

considered

notas

acred

itinstitution,ifit

isonly

sellingto

professional

investors

No,u

nless

itisacred

itinstitution

No;u

nless

deemed

acred

itinstitution

No

Portugal

No

No,b

utthefundwhois

man

agingtheSPEis

considered

tobea

finan

cial

institution

Yes,ifthesp

onsorisa

ban

k,then

both

by

finan

cial

and

ban

kingsu

pervisor

Yes

Spain

No

No,b

utthefundwhois

man

agingtheSPEis

considered

tobea

finan

cial

institution

Finan

cial

Market

Supervisor

Yes

England/W

ales

No

No

No

No

Source:EFMLG,200

7b;S

yntheticAssets,20

09;C

han

t,20

09;IMF,200

7;IM

F,200

4.Note:1Mem

bersoftheEU,w

hichjoined

in20

04orlaterareexcluded

dueto

thelack

offinan

cial

sophisticationin

thesemarkets,whichmeansthat

secu

ritizationactivityisminim

al.


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credit-institutions, they were excluded in principle from the ‘taking ofrepayable funds from the public’ by the European Banking Directives(EFMLG, 2007a: 26f). Nevertheless, in order to allow SSPEs to sell ABSinto financial markets, most European legislators chose to limit the inves-tor base of securitization SPEs to institutional or professional investors(EFMLG, 2007a:28), rather than to the general public. Doing so allowedthe circumvention of the prohibition in the European Directive as well asrelaxing the regulatory supervision from minimal to none (ibid., Table 2above).23

But, in most jurisdictions, the exemption of securitization SPEs fromregulation went even further than that, also excluding them from the sta-tus of a financial institution (see Table 2 above). Following the SecondDirective of the European Community in 1989, an entity should be classi-fied as a financial institution if it is trading for its own account or forothers in transferable securities (s. 89/646/EEC, Annex). SecuritizationSPEs are trading in transferable securities for themselves or for others,thus requiring remarkable legal ingenuity to avoid that status for SSPEs.Nevertheless, only four of the 15 countries analyzed classified them asfinancial institutions (see Table 2 above). This lack of supervision reducesthe regulatory burden on securitization-SPE and, thus, the costs for thesecuritization business, but it also reduces the information available toregulators.

This trend towards regulatory exemption can also be seen with respectto the early adoption of regulatory measures, which were developed dur-ing the revision of the Basel Accord (1999–2004) and designed to limitregulatory arbitrage in the securitization sector. One measure in therevised accord proposed the imposition of core capital requirements onthe liquidity lines banks had granted to securitization-SPEs, which hadbeen exempted due to a maturity of less than one year to that date.24 Thismeasure was first proposed in the second consultative paper by theBCBS, published in January 2001 (BCBS, 2001: 88f). In the interim periodfrom the first draft in 2001 to 1 January2008, regulators had the choice toimplement portions of the framework ahead of time according to domes-tic preferences. The widespread lack of core capital charges on liquiditylines with the duration of less than one year before 2008, as depicted inTable 3 below, is revealing in this respect.

In most countries, these measures were implemented at the latest pos-sible date, with a 0% conversion factor before 2008. Imposing a level ofregulation stricter than international requirements of the time implied acost disadvantage for domestic banks, which is why most regulators didnot adopt the measures before the latest possible date.

Comparing the different regulatory frameworks for securitization inEurope, the US and Canada on these three issues allows us to establishthree different groups in terms of regulatory stringency. In the first group


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of countries (Netherlands, Belgium, Germany, UK, and Italy), no regula-tion is imposed on the securitization sector before 2007–08). Comprisingthe second group, we find the hegemonic US, and as a follower in termsof regulation, Canada, in an intermediary position, where regulatorsimpose some regulation ahead of Basel 2, however, below Basel 2requirements. In a third group (Spain, France and Portugal), internationalproposals are exceeded and implemented ahead of time. In the following,I will compare one case from each of these groups (Germany, the US andFrance) to provide qualitative evidence for the role competitive inequityconcerns played in the regulation of the securitization business of domes-tic banks. I base my analysis on documentary data and the semi-struc-tured expert interviews that I undertook in these three countries. The USand France are the most informative on the role of structural factors, asnational regulators did intervene in those countries to close some regula-tory loopholes, but as we will see, were constrained in their actions bycompetitive inequity concerns. But, even in the case of Germany, wherecognitive capture clearly occurred, competitive inequity concerns alsoplayed a role.

COMPETITIVE INEQUITY CONCERNS AND NATIONALREGULATORY ACTION FROM 1999 TO 2008

Germany

In the case of Germany, whenever the question arose, banks were persis-tently exempted from core capital charges for their securitization

Table 3 Entry point 3: the application of core capital charges to liquidity lines

CountryApplication of capital charges to the liquidity line with lessthan one year (credit conversion factor)

Netherlands latest possible entry date 2007/8 (20%), before 2008 0%Germany latest possible entry date 2007/8 (20%), before 2008 0%USA 2004 (10%)->, below the 20% envisioned in Basel 2Italy latest possible entry date 2007/8 (20%), before 2008 0%Canada 2004 (10%)->, below the 20% envisioned in Basel 2Belgium latest possible entry date 2007/8 (20%), before 2008 0%,UK latest possible entry date 2007/8 (20%), before 2008 0%,

(FSA, 2001: 119)Spain 2002: 100% (Acharya and Schnabl, 2010); 2007/8 (with a 50%

conversion factor, no 20%, see circular 3/2008 of Banco deEspana)

France 2002 (20%)Portugal 2002: 100% (following Spain) 2007/8 (50%)

Sources: ECB, 2001; Acharya and Schnabl, 2010; Thiemann, 2012; BDO, 2011; Bank of Eng-land, 2007:60;Banco de Espana Circular 3/2008; Commission Bancaire 2002; FSA 2001.


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activities. However, despite evident cognitive capture (Thiemann,2012), these were not the only reasons for regulatory laxity. InGermany, the banking regulator is subordinated to the Ministry ofFinance, and the concern over the internationally low profitability ofGerman banks at the finance ministry made the closure of regulatoryloopholes less appealing to the regulator (interview German financialregulator 7 Jan. 2011). The general guideline for the regulation ofGerman banks was to apply international standards, but no nationalregulation that went beyond in order not to worsen German bank-profitability as compared with their international peers (interview reg-ulatory advisor; big four, 15 June 2011). In the case of securitization,this implied active intervention by the banking regulator to make sureno national regulatory changes would push the regulatory costs ofGerman banks above the international minimum.

The Ministry of Finance evaluated securitization-activities of theirbanks as a means for German banks to deepen their skills in dealing withcapital markets and to increase their fee income (for the position of theMinistry of Finance, Asmussen, 2006). In line with this policy stance ofthe Ministry of Finance, the German banking regulator opposed account-ing rule changes in 2002 in the wake of Enron, which would have forcedGerman banks to withhold core capital charges against their consolidatedSecuritization-SPEs (BaKred, 2002). Again, in 2005, when more stringentinternational accounting standards (IFRS) were introduced, the Germanbanking regulator continued to exempt the securitization-SPEs ofGerman banks from any core capital charges. The goal was to generateminimal regulatory costs based upon international standards in order toallow German banks to compete in the market for securitization, which –even domestically – was quite contested by other European and Ameri-can banks (interview German banker involved in securitization, 15 June2011).

The United States

The position of the US overseers with respect to the securitization busi-ness of their nation’s banks was more restrictive than that of theirGerman peers, expressing early on concerns over regulatory arbitrage inthat sector. Nevertheless, in the process of rule-making, they adoptedregulation that was less stringent than Basel II, and revealingly, alsoweaker than they themselves initially envisioned.

On 8 March 2000, the six US supervisory agencies announced theirintention to raise capital requirements for banks selling securitiza-tions with early amortization features into the market. They arguedthat those banks which transform receipts on credit card receivables,home equity loans, or commercial loans into revolving short-term


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securitizations or Collateralized Loan Obligations (CLOs) continue toassume the credit risks stemming from these underlying contracts,even though they have legally transferred them off-balance sheet.25

This fact led the regulator to suggest that these securities placed off-balance sheet should be weighted with 20 per cent of the capitalrequirements they generate if they remained on-balance sheet(Federal Register, 2000: 12,330). In November 2001, in their follow-upon the rule proposal, the US banking regulators decided not to imple-ment this credit conversion factor. While the regulators reiteratedtheir concerns (Federal Register, 2001: 59,614),26 they did not pass afinal rule, as they deemed the proposed rule too risk-insensitive tothe specifics of each single transaction (Federal Register, 2004:44,913). In October 2003, the regulators issued another rule-proposal(Federal Register, 2003: 56,568). This time it was more sophisticatedin terms of measuring early amortization risks, based on the thirdconsultative paper of the Basel Accord of 2003 (Federal Register,2004: 49,913). However, in July 2004, when the revised Basel-Accordhad just passed, this new rule was again not adopted. The regulatorsjustified this decision by quoting the concerns of five commentatorsthat:

coordinating both the timing and the substance of an early amorti-zation capital charge internationally would help maintain a levelplaying field across countries and would avoid requiring US bank-ing organizations to implement new capital rules, only to requirethem to implement slightly different rules in the future when theagencies implement the Basel changes. (Federal Register, 2004:44,913, emphasis mine)

Regulators agreed to both points and delayed their decision until theBasel framework was transformed into US-rulemaking (ibid.), sidingwith the international competitiveness of their banks over prudence inthe regulatory framework.27

In the same ruling of July 2004, the US-regulators exempted newly con-solidated securitization-SPEs from core capital requirements and intro-duced a 10 per cent credit conversion factor for liquidity lines of less thanone-year maturity. Initially, in accordance with the provisions in the finalrevised version of the Basel Accord, they had proposed a 20 per centcredit conversion factor (BCBS, 2004: 125 for the standard approach; 138for the advanced approach). Which arguments did they advance to jus-tify this reduction? Did they perceive the international approach to beexcessive with respect to the actual risk-exposure of their banks or was itthe concern over the competitiveness of their banks in this market? Both


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issues did play a role as one can read in their official explanation for therule-making:

Seven commenters stated that the proposed 20 percent credit con-version factor for short-term liquidity facilities was too high giventhe low historical losses and the overall strength of the credit riskprofiles of such liquidity facilities. . . . . One commenter noted thatthe proposed capital charge would put US banks at a competitivedisadvantage relative to foreign banks and non-bank fundingsources. The agencies generally agree with these commenters.(Federal Register, 2004: 44,910, emphasis mine).

US-regulators decided to apply capital requirements which were lowerthan the ones agreed in the Basel Accord, as these, on the one hand,seemed to diverge from industry experiences (pointing to cognitive cap-ture), and as they, on the other hand, threatened the competitiveness ofUS banks. It is hard to discern empirically the respective impact of cogni-tive capture and competitiveness concerns in these rulings, but it isimportant to note that bothwere powerful factors shaping regulation.

This view was confirmed in an interview with a current high-rankingofficial at the Fed, who joined the Fed in 2005.28 According to his informa-tion, industry data on historical loss-exposure played an important rolein the risk-assessment of these securitization activities by the FederalReserve in 2003. At the same time, he acknowledged from his own expe-rience that competitive inequity concerns are a constant concern innational rule-making, especially with respect to accounting rules. Askedhow often he encountered the argument of the level playing field in hisown work, he answered:

it is very frequent, and since the crisis it has been almost on adaily basis, because of Basel 3. . .the problem is that it doesn’t doany good, really, for Basel 3 to be so consistent . . ., if the accountingdiffers from jurisdiction to jurisdiction, because we in the XYZtask force we deal with this level playing field issue every day(high-ranking official, Federal Reserve Washington, DC, 27 March2012).

Level playing field issues, especially those caused by different accountingtreatments and their interaction effect with regulatory capital require-ments are a main concern for this regulator. In his work he has to makesure that American banks are not more affected by the global Accordsthan their European peers, while at the same time ensuring prudent regu-lation. Cognitive capture might play a role in how he evaluates what pru-dent regulation should look like, but the impetus to compare the national


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impact of the Basel Accords with respect to foreign competitors stemsfrom the patchwork nature of global regulation.

The impact competitive inequity concerns stemming from these fric-tions had on national rulemaking regarding securitization activities ofbanks are the most visible for the case of France. There, cognitive captureof the regulator was rather absent, nevertheless, final regulation stillended up being less strict than initially envisioned.

France

The French banking regulator had been an ardent proponent of a prudentregulation of the securitization business of French banks. But thisapproach had to overcome domestic opposition from banks and financeministries, joined together by competitive inequity concerns. In 1999, thebanking regulator modernized accounting rules in order to control therisk-taking of their banks in their securitization business (interview rep-resentative French Banking Association, 11 May 2011) and in 2002 heimposed a 20 per cent core capital charge on liquidity lines (CB, 2002). Afinal accounting rule change in 2003, as a reaction to the Enron scandalmade off-balance sheet securitization by the banks even more difficult.This last step and the impending introduction of the internationalaccounting norms (IFRS) in 2005 led to a bundling of forces of those con-cerned over competitive inequities for banks in the securitizationbusiness.

An alliance of banks and the Ministry of Finance orchestrated an attackon the strict off-balance sheet accounting rules for securitization (inter-view member French accounting standard setter, 27 January 2011).French banks and the Ministry of Finance feared that the banks wouldlose market share to foreign competitors (interview French banking regu-lator, 3 February2011). In particular, this alliance sought to emulateAmerican rules for securitization-SPEs (Qualifying Special PurposeEntities), which were excluded from consolidation. Opinion No. 2004-Dof the Emergency Committee of the National Accounting Board estab-lished this possibility for exemption against the will of the bankingregulator. This exemption was motivated by:

the will of the CNC not to systematically include in the perimeter ofconsolidation securitization transactions, in order not to threatenthe economic advantages stemming there from, and this for reasonsof international distortion of competition (CNC, 2004: 229, transla-tion by the author, emphasis mine).

Overwhelmed by this coalition, the French banking regulator in 2005criticized these new accounting standards as too weak and decided to


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delink the prudential treatment of securitization-SPEs from theiraccounting treatment (Amis and Rospars, 2005: 57f). Instead, it intro-duced the significant risk transfer mentioned in the Basel framework forsecuritization in 2005. While it instituted comparatively high core capitalcharges in this framework with a risk-weighting of up to 1250% forunrated positions, leading to a 100% core capital charge for those assets(Amis and Rospars, 2005: 58), these changes led to less stringent regula-tion in this area than desired (interview bank manager France, memberof accounting standard setter, 25 March 2011; French banking regulator,3 February; former French banking regulator, 30 January 2011). Again, asevidenced by this case, the concerns over international competitivenesswere a driving force in national rulemaking, even against the oppositionof the banking regulator.

DISCUSSION

While we see variation in national regulatory regimes (notably, in Spainand Portugal), this paper has documented the general trend towards reg-ulatory exemption for the securitization activities of banks. This trendcan only be explained if the structural mismatch between the scope ofregulation – national – and the scope of market activity – global – aretaken into account, a mismatch paradoxically aggravated by the globalBasel Accords. The case of the bank-based shadow banking systemreveals the inevitable shortcomings of that Accord. What we observe isan iterative process in which the Basel Accord provokes financial innova-tion for the purpose of regulatory arbitrage at its outer margins whereglobal regulations do not apply and which, thus, needs to be regulatednationally. At the same time, the markets that are created by such regula-tory arbitrage are global markets because Basel grants banks complyingwith it the right to operate in all countries where the regulation isimplemented.

Competitive inequity concerns, which the global Accords seek to over-come, re-emerge at its margins with a vengeance, as the accession to theglobal Accords prevents countries from closing their markets to thosecompetitors which have looser regulations. As financial conglomeratescircumvent global rules, it is the lack of common rules for activities justoutside the global frameworks coupled with free market access thatimposes the structural conditions for a regulatory ‘competition in laxity’(Murphy, 2004). In this situation, techniques of circumvention aretolerated by national regulators, even hegemonic ones such as the US,until a global response is implemented. Independent of the attitudes ofnational regulators to these financial innovations, these structural condi-tions favour lax supervision.


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Research in the international political economy of financial regulationafter Kapstein’s early work on the Basel standards (1989) has mostlyfocused both on the growth of and on the increased importance of inter-national standards (Helleiner and Pagliari, 2011: 170; Macey 2003; Singer,2007; Drezner, 2007; Simmons, 2004). The shortcomings and deficienciesof these international standards, however, have remained less analyzed(but see Scott and Iwahara, 1994; Tarullo, 2008; Lall, 2012). This casestudy casts doubt on the belief that global regulations for financial mar-kets might be able to solve the problem of competitive inequity concernsand, thus, of overly lenient regulation (Kapstein, 1991). Given the diffi-culty of inventing a complete global legal framework from the basicterms upwards, it is likely that that jurisdictional competition will con-tinue to be a factor in the formulation of financial regulation, weakeningit despite regulators’ concerns, a conclusion which seems to be borne outby recent work on the regulation of the shadow banking system post-cri-sis (Rixen, 2013). On a normative level, this study then lends support tothose who speak out for principled minimalism (Pistor, 2010; Rodrik,2009; Sohn, 2012; Warwick Commission, 2009), which allows host-coun-try regulators to impose regulation above and beyond global rules ondomestic and foreign banks.

Scholars in IPE have identified the emergence of normatively frag-mented international regulation as an increasingly likely outcome for thepost-crisis world (Helleiner, 2009 ; Mosley, 2009; Germain, 2010, 2012)with ‘the co-existence of divergent national or regional standards’(Helleiner and Pagliari, 2011: 190). On the level of research, this studyadds further weight to Helleiner and Pagliari’s suggestion (2011) thatresearch in IPE should reorient itself towards the question which institu-tional set-up is needed to make such normative fragmentation work.30 Inthe wake of the global re-regulation after the crisis, there are many fieldswhere normative fragmentation has occurred and where concerns overcompetitiveness of domestic banks may prevent effective regulation.Fragmentation does not only occur in Asia or Latin America, but alsobetween the EU and the US, which, given their respective size, points tothese two as a major field of research (see also Muegge, 2013). Futurework may, for example, investigate if the lack of a common global agree-ment limiting the proprietary trading of banks leads to regulation whichis less strict than desired, observing the implementation of the Volckerrule in the US vs. those recommendations emerging from the Liikahnenreport in the Eurozone or the Vickers report in the UK.

Another field is the regulation of exchanges in derivatives markets thatare supposed to bring transparency to a hitherto non-transparent market,which might be watered down due to competitiveness concerns. On theone hand, central counter-parties may be burdened with different pru-dential requirements in different jurisidictions, providing those with


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lighter regulation a competitive advantage. On the other hand, the provi-sions allow theexclusion of certain derivatives contracts at the margins,allowing national leeway as to what has to be traded on more costlyderivatives exchanges, and what remains over the counter.

CONCLUSION

This paper has sought to answer the question why off-balance sheet secu-ritization activities of banks remained mostly unregulated before the cri-sis. The explanation advanced in this article focuses on the structuralconstraints that a national supervisor faces when he has the task to regu-late a financial innovation that evades global rules, providing a structuralaccount for national regulatory (in)action in the time gap between theevasion of international rules and international re-regulation. I argue thatthe possibility to exclude certain activities of domestic banks from inter-national banking regulation through national laws and the impossibilityto impose tighter rules on foreign banks explain why most nationalsupervisorsdid not close these loopholes before the crisis.

Although it was known to the international regulatory community atleast since 1999 that regulatory arbitrage was rampant in the securitiza-tion business (Jackson et al., 1999), most national regulators were waitingfor the new Basel Accord to come into force, rather than taking decisivesteps nationally beforehand. The problem of coordinating the coinstanta-neous introduction of national rules closing the regulatory loopholes in aglobal market prevented regulatory action, as national authorities sup-ported the competitiveness of national banks. This fact reinforces theneed for new institutions coordinating global regulation ‘where inade-quate regulation in one country has large effects on other countries . . .because of an induced race to the bottom’ (Stiglitz et al., 2010: 110). Bypointing to the mismatches between the level of regulatory action andthe level at which markets operate, my article is seeking to ground regu-latory action and its constraints with respect to the shadow banking sys-tem in the architecture of global financial markets within which it isembedded. As the case of France shows, even when regulators are fullyaware of the risks of a financial innovation, they still have to contendwith competitive inequity concerns. It is, therefore, insufficient to guardagainst cognitive or regulatory capture. What is additionally needed is toremove the obstacles to regulatory capacities inherent in the current set-up of liberalized financial markets.

To date, accounting frameworks and perimeters of banking supervi-sion remain different around the globe (FSB, 2011). If these differentscopes of consolidation persist, the pressure on national banking regula-tors to reduce the scope of their prudential perimeter of supervision or toallow their banks in other ways to compete will continue. Just as recent


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regulatory initiatives have increased core capital requirements for bank-ing activity (esp. Basel 3; Blundell-Wignall and Atkinson, 2010: 23), thispressure for national exclusion will increase accordingly. Structuralreform is needed to ensure that obstacles to cooperation do not ‘weighdown the capacity of the regulatory policy makers to keep up with mar-ket innovation’ (Underhill, 1997b: 20). If no changes to the global financialarchitecture occur, these structural conditions at the margins of bankingregulation will persist. This suggests that national regulatory permissive-ness of global shadow banking will continue to be a persistent feature ofthe regulatory landscape, sowing the seeds of a future crisis.

ACKNOWLEDGEMENTS

The author would like to thank the editor as well as three anonymousreviewers for their comments. In addition, thanks go to Tom DiPrete,Ewald Engelen, Stephany Griffith-Jones, Martin Hellwig, Till-MartinKaesbach, Jongchul Kim, Jan Lepoutre, Daniel Mertens, Andreas Noelke,Katharina Pistor, Michael T. Schuyler, Gunnar Trumbull, Natascha Vander Zwan, Josh Whitford and the participants of the workshop on finan-cialization at the University of Dublin on 5 and 6 May 2012 and the work-shop on Securitization at the University of Amsterdam on 14/15 October2012 for helpful feedback and suggestions for this article. All remainingerrors are the sole responsibility of the author. Research for this articlewas supported by the Sciences Po Columbia University Exchange Fel-lowship 2010/2011, the Columbia Travel Fellowship in autumn 2011 andthe Max Planck Visiting Doctoral Student program.

NOTES

1. The shadow banking system has been defined by economists at the FederalReserve as ‘‘financial intermediaries that conduct maturity, credit, andliquidity transformation without access to central bank liquidity or publicsector credit guarantees’’ (Pozsar et al. 2010: 11). Its most important character-istic is that it is in the business of extending credit to the economy withouthaving the status of a bank and, thus, not subject to banking regulation.

2. Regulatory arbitrage can be defined as ‘‘those financial transactions designedspecifically to reduce costs or capture profit opportunities created by differ-ential regulation or laws’’ (Partnoy, 1997: 227).

3. These countries are France, Germany, Spain, the Netherlands, the USA, Can-ada, Portugal, Italy, Belgium, and the UK.

4. This included central bankers, financial regulators, senior bankers, and audi-tors in France, Germany, the Netherlands, Canada, and the US as well asemployees of national and international accounting standard-setting bodiesand various rating agencies. The interviews focused on the political strugglesover the national regulation of securitization under the background of inter-national regulatory developments. I am therefore able to compare the stated


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aims of national regulators with respect to regulations with the actual results(congruence analysis) and to verify the motivations and dynamics in inter-views via process tracing (Hall, 2006).

5. This evolution of the debate has led to the explicit consideration of MutualMoney Market Funds as shadow banking entities (Adrian and Ashcraft,2012b). It has also led to a shift from the sole focus on the supply side ofshadow banking, asking why and how financial agents developed productsin the shadow banking sector (a main argument being regulatory arbitrage)to ask also how the demand side for shadow banking emerged (Pozsar andSingh, 2012) and how the shadow banking system emerges differently inEurope vs. the US (Tyson and Shabani, 2013: Jeffers and Baicu, 2013).

6. In the external shadow banking system, broker-dealers and other financialcompanies used banks as ‘‘backstops’’ for their operations, but banks werenot the driving force in the evolution of shadow banking activities.

7. How sensitive this activity was to regulation can be gauged from the fact thatthe growth of the American Asset-Backed Commercial Paper market came toa halt between 2001 and 2004, when it was not clear if SPEs were to be consid-ered part of the banking conglomerate according to US prudential regulation(Acharya and Schnabl, 2010: 40).

8. For a study applying it to the Dutch case, see Aalbers et al., 2011: 1790.9. Or, for that matter captured by material incentives.10. This is the case for France’s banking regulator and for the central bank in

Germany. In line with this argument, the stance of the French regulator dis-cussed below can be analyzed as the direct opposite of cognitive capture.Nevertheless, final regulation in France is less strict than regulators theredesired, suggesting other mechanisms than cognitive capture at work.

11. ‘‘On the basis of the available information, the securitisation activities ofthese companies loom large in relation to their on-balance sheet exposures.As of March 1998, outstanding non-mortgage ABSs and ABCP issued bythese institutions exceeded $200 billion, or more than 12% (25%), on average,of the institutions’ total risk-weighted assets (loans). For several institutions,the combined issuance of ABSs and ABCP approached 25% (50%) of totalrisk-weighted assets (loans).’’ (Jackson et al. 1999:, 24)

12. Indeed, most of the countries investigated in this article have been membersof the Basel Committee that debated this framework between 1998 and 2004(Belgium, Canada, France, Germany, Italy, Netherlands, Spain, UK, USA).

13. The argument bases itself on Andrews (1994), who develops the concept ofstructural features in the international political economy that constrainnational policy autonomy, in his case monetary policy.

14. Regulators of such markets face a delicate task as ‘‘no regulator wants to beheld responsible for crushing an industry under the weight of onerous regu-lation. Regulators, therefore, must walk a fine line between stability and com-petitiveness’’ (Singer, 2007: 23).

15. This exemption of host country regulation applies in particular to branches offoreign banks used for securitization, whereas subsidiaries could be subjectto additional regulatory charges. Complete acceptance of foreign bankingregulation was instituted in the EU in light of the implementation of Basel 1with the banking passport in 1990 (Pistor, 2010).

16. The international diversity on consolidation regarding securities activitiesand other financial entities and the role of national law in determining whatwill be consolidated for regulatory capital purposes is acknowledged in therevised Basel Accord (BCBS, 2004: 7). However, the problem is not rectified.


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17. The Canadian banking regulator copied the measure.18. Corporate lending secured by customers receivables and Asset-Backed Com-

mercial Papers19. A simple Dutch SSPE, issuing $50 million (a rather small sum) was operating

with a leverage of 1:2770 (based upon Brinkhuis and van Eldonk, 2008).20. These acronyms stand for the first and second directive on the coordination

of laws, regulation and administrative provisions relating to the take up andpursuit of the business of credit institutions from 1977 and 1989, the SecondBanking Directive from 2000 and the Capital Requirements Directive from2006. All of these documents are available at <http://eur-lex.europa.eu/fr/index.htm>.

21. When the SSPE buys loans or an asset-backed security from a seller, it is atleast indirectly linked to a credit-activity. The question is, does such indirectlinkage constitute credit activity or not? In the case of France for example,‘‘acquiring receivables on a regular basis constitutes a credit operation’’(European Financial Markets Lawyers Group, 2007a:26, in the followingEFMLG, 2007a).

22. This was the direct motivation of the regulatory changes in the Netherlands,as a Dutch banking manager confirmed via personal correspondence Dutchbank manager (12 July/2011).

23. The measure copies US regulation, which since the Investment Company Actof 1940 exempts institutional investors from supervision (Horsfield-Brad-bury, 2008: 24f).

24. It envisioned a 20 per cent conversion factor for the assets that are guaranteedby the liquidity lines of a bank operating in the simple ratings basedapproach, and a slightly lower measure for those banks operating in theinternal ratings based approach. In addition, a framework in which only asignificant risk transfer from the banking conglomerate to the SSPE permittedregulatory capital relief was established (. BCBS, 2004:116–39).

25. The reader should note that this continued exposure to credit-risks of assetswhich were securitized was one of the main transmission mechanisms dur-ing the financial crisis.

26. S. Calomiris and Mason, 2003: 4–9 for a history of these regulatory concernsdating back to the early 1990s.

27. The threat of a deviating implementation in the US, it seems, should be con-trollable by the three regulators, given that Basel is passed and the new rulesare equivalent to Basel.

28. Unfortunately, no access to a Fed official directly responsible for these deci-sions could be gained, as they had moved on to other, more important globalpositions with tight schedules.

29. See note de presentation, accessible at <http://www.anc.gouv.fr/sections/normes_privees/avis/avis_2004/note_aviscu_2004d/downloadFile/file/note_aviscu_2004d.pdf?nocache=1318335589.2.>

30. S. Sohn, 2012 for an investigation of the East Asia region.

NOTES ON CONTRIBUTOR

Matthias Thiemann is a Junior Professor for the sociology of finance, bankingand money at the Goethe Universitaet, Frankfurt am Main. Prior to his appoint-ment, he was a Postdoc at ESSEC Business School. Prior peer-reviewed articleshave been published in Competition and Change, UNDP Discussion Paper Series,Soziale Systeme and New School Economic Review, Business and Politics.


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