In the Shadow of Basel. How Competitive Politics Bred the Crisis

Policy Study

This article by Matthias Thiemann critically investigates the reasons for the lack of regulation on the shadow banking sector and its linkages to the banking system. The author poses a fundamental question: Why did banking regulators around the globe permit their banks to evade core capital requirements by acting in the bank-based shadow system before the crisis of 2007?

Off-balance sheet securitisation activities by banks have been a central transmission mechanism during the current financial crisis. Banks had “parked” securitised assets, worth hundreds of billions of dollars in the shadow banking system, essentially engaging in proprietary trading-off balance sheet, exempt from banking regulation. When suspicion over the quality of these securitised assets reached the money markets, these refused to continue refinancing the proprietary trading of banks and the assets parked in the shadow banking sector reappeared on the balance sheets of banks, creating losses due to substantial write-offs.

The paper by Matthias Thiemann argues that regulatory inaction by banking regulators was caused by the mismatch between the level at which the problem occurred (globally) and the level at which banking regulators could address it (nationally).  In particular, the paper argues that concerns over competitive inequities and the possibility for the exclusion of certain activities from international banking regulation through national laws were the structural conditions for the regulatory race to the bottom for off-balance sheet securitisation activities of banks. These pressures emanating from the national regulation of global markets explain why regulatory action to close these loopholes has been mostly absent before the crisis.

Author Matthias Thiemann: Post-Doctoral Student, Centre For Capitalism, Globalization And Governance, Essec Business School, Cergy Pontoise, France

See other recent articles by Matthias Thiemann: Regulating the off-balance sheet exposure of banks: A comparison pre- and post-crisis