Regulatory competition and international cooperation
Recent research has shown that regulatory competition does not necessarily lead to downward pressures on regulation, but may at times also push the level of regulation upwards. Extending David Vogel's "California effect" argument, this paper shows that such upward pressure may not only result directly from the dynamics of the competitive process but also from international cooperation. Evidence from two case studies on international capital market regulation is used to identify the conditions under which cooperation in the shadow of regulatory competition is likely to succeed or fail. The successful multilateral standardisation of banking capital requirements in the BIS is compared to failed attempts to harmonise interest taxation across EC member states. 1. THREE DYNAMICS OF REGULATORY COMPETITION In recent research it has become common to argue that the globalization of markets leads to downward pressures on regulation. Regulation, according to this view, is costly to the regulatees. Mobile targets of regulation reduce their regulatory cost by moving to jurisdictions with low levels of regulation. Governments in turn offer easy regulation in order to attract larger shares of mobile factors and production processes with the result that regulation spirals down to ever lower levels (Scharpf 1995: 10) A well publicised early example of such a deregulatory spiral is the American experience with corporate chartering. In the US, corporate charters are granted by the individual states. Yet, since all states are required to recognise each others' charters, they competed for incorporations by offering corporation friendly chartering requirements. In the course of this competition, the level of protection for shareholders, employees, customers, and the general public has been progressively lowered: a race to the bottom. Since the race was won by Delaware, the notion that regulatory competition develops a deregulatory dynamic has been called the "Delaware effect" (Cary 1974; Vogel 1995: 5) Yet, as David Vogel has shown in a recent book, economic integration and regulatory competition may also at times push the level of regulation upwards (Vogel 1995) Strict regulation need not be a competitive disadvantage. High standards may even favour domestic producers, because it is often easier for them to comply than for foreign competitors. Hence, industry may occasionally even lobby for higher levels of protection. Once a rich country with a large market has adopted a higher standard, foreign producers are forced to adapt if they do not want to lose market access. Foreign governments may react by raising their own level of regulation, thus starting a regulatory race to the top. Think of California as an example: In recent decades, California has been the pacesetter in environmental regulation, both nationally and globally. Environmentally conscious Californians demanded progressively higher levels of protection regarding car emissions and other fields, and the Californian market was large enough to pull other states along. Hence, the competitive ratcheting upwards of regulatory standards has been called the "California effect" (Vogel 1995: 6) However, upward pressure on regulation may not only result from competitive dynamics. It can also be caused by international cooperation. Sometimes, competing states manage to stop their competition through collective action. The deregulatory spiral is then countered by a cooperative turnaround. The purpose of this paper is to analyse the factors which determine whether such turnarounds occur and are successful. The analysis is based on two case studies. The first story recounts the successful standardisation of capital adequacy requirements in international banking. It demonstrates that multilateral cooperation among nation states can stop a deregulatory downward spiral and turn it around into a race to the top. The second case shows that this strategy is not always available. The failure of the EC to counter tax competition by agreeing on a common withholding tax on interest payments gives some clues as to when cooperative turnarounds are likely to fail. The plan for the paper is as follows: The cases are presented in section 2. Section 3 compares the evidence, and section 4 offers an structural explanation for the observed variance. From this base, section 5 develops two potentially very general propositions about the structural determinants of successful cooperation. Section 6 summarises the results and speculates on their significance for international relations research at large. 2. INTERNATIONAL COOPERATION IN CAPITAL MARKET REGULATION The banking case and the taxation case were selected for basically two reasons. First, they both concern the regulation of financial markets. Due to the high transborder mobility of financial assets, regulatory arbitrage is particularly strong in these markets, and the peculiar problems of regulatory competition correspondingly easy to observe and analyse. Second, the cooperation success in banking regulation was achieved within the comparatively "weak" institutional setting of the Bank for International Settlements (BIS) whereas the cooperation failure in tax coordination occurred in the institutionally much "stronger" arena of the European Union (EC) Hence, success and failure cannot simply be attributed to institutional factors. This rules out an institutional explanation and thus renders the structural account, suggested by this paper, more plausible. It is differences in the underlying constellation of interests rather than differences in the institutional environment which explain the divergent outcomes of the two cases. 2.1 A Case of Success: Standardising Capital Adequacy Requirements in International Banking After the second world war, the integration of the world financial markets had reached a historical low. National markets operated largely independent of each other. They were selfcontained and inward looking. Only during the 1960s did they begin to open up. Capital controls were lowered, Euromarkets developed in London and elsewhere, and the volume of international financial transactions increased. The collapse of the Bretton Woods system in 1973 and the first oil shock added further momentum to the re emergence of international finance. The 1980s reinforced the trend through rapid innovations in communication technology, radical innovations in financial services, and political moves towards market liberalisation of the 1980s (Cerny 1993: 63 65) As the regulatory and technical barriers between national markets eroded, the potential for regulatory arbitrage increased. Borrowers and lenders gained significant leeway to reduce their net regulatory burden by evading from high regulation jurisdictions to places where standards and regulations were lower. Tough standards turned into a locational disadvantage. Fear of large scale capital flight decreased the autonomy of national regulators to implement their preferred level of regulation. The risk of a deregulatory spiral increased (Bryant 1987: 139) The effects of market integration and regulatory competition were ambiguous. The efficiency of the financial system grew, but so did its vulnerability (Bryant 1987: 87 91; Peccioli 1983: 11 12) The inherent risks of financial integration were exposed by a couple of spectacular bank breakdowns Herstatt, Franklin National Bank, Banco Ambrosiano which showed that given globalized financial markets the illiquidity of even a single bank could lead to chain reactions, which infect banks and banking systems all over the world. At the same time, the ability of banks to withstand shocks declined, because the intensified international competition forced them to operate on a smaller basis of bank capital. Banks became more fragile while the potential damage of a breakdown of the global financial system increased. The concern for the solvency of banks reached a crisis level when in 1982 Mexico announced its inability to meet upcoming interest payment obligations. Politicians and bankers feared that the debt crisis might spread to other Latin American borrowers, and endanger a large number of international banks which had only very limited reserves to absorb losses from unpaid debt (Kapstein 1994: 87) "Governments in the major industrial countries became increasingly uneasy about a general decline in the capital strength of their banks" (Herring/ Litan 1995: 107) Central bankers at the BIS the "club" of the world's thirteen most important central banks[2] declared that a "further erosion of capital ratios should be resisted and supervisors should not allow the capital resources of their major banks to deteriorate from the present levels." (Reinicke 1995: 161) However, unilaterally keeping capital ratio requirements stable or even raising them threatened to undermine the international competitiveness of national banks. The defence of capital ratios, therefore, required coordinated, multilateral action. To this end, regulators from the most important financial centres started negotiations on a common standard under the auspices of the BIS. The negotiations turned out to be difficult. Part of the difficulty was technical. National definitions and measurements of bank capital differed widely among the BIS member states, making agreement on what constitutes capital and how much capital is enough for international banking hard to achieve. The institutional differences between anglo saxon and continental banking further increased the conflict, suggesting different approaches to capital adequacy. Germany and Switzerland took the most extreme position, arguing that their national regulations were up to the task, and that only the other countries should act to stabilise the banking systems (Reinicke 1995: 162) The technical problems were eventually resolved when in 1984 a special working group developed a methodology for the cross country comparison of