by Matthias Thiemann*

How can we understand the growth of a system of credit provisioning outside of the realm of bank regulation since the 1970s which linked non-banks and banks in a convoluted system of market-based banking, securitization and wholesale finance which burst into the public consciousness with the 2007-9 crisis as the shadow banking system? While we can observe this general trend, why do we see differences in this trend fractured according to different national legal and supervisory traditions?

My recent book The Growth of Shadow Banking: A Comparative Institutional Analysis (Cambridge University Press, 2018) aims to provide answers to these questions by exploiting the variance in the exposure of banking systems around the world with respect to shadow banking, using in-depth process tracing and focusing on the US, the country where modern shadow banking originated, Germany and the Netherlands as countries with high exposure, and France as a country with low exposure, despite common EU regulation. The book is based on more than 80 expert interviews with banking regulators, bankers, auditors and accounting scholars in these 4 countries. The book seeks to explain these divergent trends without falling into the traps of a literature that explains these issues by regulatory or cognitive capture. Not because these issues did not play a role, but because these theories employ a view of the agency of regulators which is too simplistic at best.

Instead of treating regulators as either bought or dopes, I seek to place the decisions of banking regulators to not regulate these off-balance sheet activities of banks, on the one hand, into their structural context, both on the national and the transnational level and, on the other hand, to their embeddedness in the regulatory networks that determine the compliance with national banking regulation. Studying the processes of the regulatory dialectics between rule evasion and re-regulation in these countries, I show that the rise of shadow banking and its continued growth were not the outcome of regulators being persistently duped by the “smartest guys in the room” or all bought by the lucrative prospects of future employment. Instead, I link its growth to the particular structural situation in which banking regulators found themselves, where regulatory competition with non-banks domestically and banks from other jurisdictions globally structured their behavior, as they formed a dialectical unity with the regulated, sharing common interests at the same time.

The book first traces the growth of shadow banking to the rising competition between banks and capital market activities since the 1950s in the United States, which threatened the disintermediation of banks and the impossibility of the Fed to prudentially intervene in the behavior of non-bank actors. Being thus constrained, they instead sought to facilitate the capital market activities of their banks from the 1970s onwards. Focusing on the Asset-Backed Commercial Paper market, I show however that this support was not unconditional and that it was subject to persistent reviews over what was and what was not allowed. This critical stance of the Fed, which in turn provoked industry innovations, came to a halt with the shift from Paul Volcker as the chair of the Fed, who had become increasingly critical of these activities, to Alan Greenspan, who was largely hands-off. Evidence drawn from interviews with the Fed officials shows how the Fed itself was internally riven between those who wanted to clamp down on these activities and force them back into the balance sheets of banks and those favouring a hands-off approach. Interestingly, this conflict would come to the fore again with Enron scandal in 2001 and would be resolved through the anticipated introduction of rules envisioned in Basel II in the US.

And here is the second element I point out in the book: the attempt to pry open the global banking market, in full swing since the 1980s leads to a difficult position for national banking regulators. Since the first Basel Accord in 1988, banking regulators as an epistemic community have sought to level the playing field by introducing transnational rules which could and should be implemented nationally. These “global” rules for banking activities were to both permit fair competition and ensure financial stability. And yet, here is the paradox: as global rules establish a level playing field, they put a disadvantage on the national re-regulation of activities that are designed by legal engineers to circumvent these global rules. The normal delays between innovation and re-regulation are expanded on the global level (from Basel I to Basel II it took 15 years to agreement and implementation) and national re-regulation in the meantime is disadvantaged due to the competitive disadvantages that national banks face in a global market for banking activities when their rules are stricter than those of their competitors. I show that both these arguments were advanced by bankers and demonstrate how they structured the agency of banking regulators. Aggravating this dynamic is the fact that global rules are placed upon national accounting rules, which by chance provide competitive advantages to banks from certain countries, as certain shadow banking activities are excluded from the purview of banking regulation by accounting definition. This in turn exerts pressure on other countries to adjust their rules to allow the expansion of these activities domestically.

Europe is the looking glass for these trends. Since 1988, with the first European banking directive, the competitive struggle to open national banking markets has been on the agenda. Due to the impossibility to agree to common banking rules and to install a common banking supervisor, European bureaucrats and politicians adopted the compromise of implementing Basel I on a binding European level and of enforcing it through national regulators. This institutional set up enshrined the contradictions mentioned before and amplified them by binding the fate of national regulators and the fate of national banking champions together. I show this best via the Dutch case, where rule evasion by banks was spotted in 2004, but was not corrected due to “competitiveness concerns” for its national champions, waiting for Basel II to come into force European wide in 2008. In Germany, which possibly is closest to a case of regulatory capture, the banking regulator is subordinated to the ministry of finance, which follows a conscious strategy to encourage shadow banking, seeking to wean Germany off its dependence on bank credit. Lastly, the case of France presents a case of successful pre-crisis regulation of parts of the shadow banking sector. This happened, on the one hand, due to the discretionary powers of the banking regulators to enforce its own interpretation of rules, its strong interactions with the compliance officers in the banking and auditing community which allowed for awareness of rule evasion as well as sanctioning power with respect to these agents. Hence, it was proximity to the regulated, not distance, which allowed the French to regulate shadow banking. At the same time, the structural context of a profitable oligopoly in France, with low foreign banking presence was helpful in weakening banks’ demands for rule relaxation.

After the 2007-8 crisis, several regulations regarding the interaction between banks and crucial capital market actors have been strengthened in Europe, the US as well as globally and some of the shadow banking activities seen pre-crisis have disappeared. And yet, the structural conditions, which facilitated its growth still exist. Regulatory competition and economic patriotism still exist; diversity of accounting systems still exist; competition between banks and non-banks providing credit still exists, which in turn leads banking regulators to go soft on their banks due to an impossibility to impose “prudential market regulation”. In that sense, the book does not expect the phenomenon of growing shadow banking activities to shrink (see for instance the recent developments in the leveraged loan market in the US). And yet, it offers several insights how the regulation of shadow banking activities could function better, by encouraging more, not less contact between regulators and financial institutions and by relying on expertise of compliance officers and other intermediaries to overcome information asymmetries. In this respect, the book opposes simple accounts of capture theory and shows that the current focus on transparency and arms-length relationships cuts regulators off from industry knowledge.

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* Matthias Thiemann is Assistant Professor of European Public Policy at Sciences Po. He holds a PhD in Sociology from Columbia University and has published widely on financial regulation pre- and post-crisis as well as the role of European public development banks in these newly reconfigurated financial markets.

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