This is a guest post by Patrick Emmenegger, Professor of Comparative Political Economy and Public Policy at the University of St. Gallen, as part of the Duck of Minerva’s Symposium on Structural Power and the Study of Business. This post draws on ideas developed at greater length in Emmenegger’s article found here. Links to other posts in the symposium can be found here.
The United States of America is the most powerful country in the world but when it comes to interactions with international banks, it looks surprisingly feeble – at least according to conventional wisdom. Two types of international banks seem beyond the reach of U.S. law enforcement authorities. On the one hand, some banks are primarily located in other countries and thus protected by these countries’ legal sovereignty. Absent international cooperation, these banks – although influencing international capital flows in important ways – seem beyond the reach of national law enforcement. On the other hand, the largest international banks are typically located on U.S. soil but considered to be “too big to fail.” Since their collapse could endanger the viability of the global financial system, these banks are off-limits for criminal prosecution, because history shows that criminal prosecution of such banks leads to their collapse.
The conventional wisdom, however, is no longer true. As the recent conflict between Switzerland and the United States of America over Swiss banking secrecy shows, U.S. law enforcement authorities have developed the capacity to target both small banks abroad and large international ones. Paradoxically, the growing economic interdependence of financial activities has strengthened – rather than weakened – the U.S. position.
The reason for this is the U.S. financial market’s centrality in the global system of financial relationships. Centrality here means that there is virtually no possibility for a bank to be internationally active without repeatedly trading in U.S. dollars, with U.S.-based institutions, or with other banks that trade in U.S. dollars or with U.S.-based institutions. However, by doing so, international banks are, from the point of view of U.S. authorities, subject to U.S. jurisdiction. This combination of international banks’ economic dependence on access to the dollar-based financial system and U.S. authorities’ ability to control access to it makes international finance structurally dependent on the USA.
The structural dependence of banks on access to the dollar-based financial system is so strong that even the mere possibility of exclusion can lead to the banks’ collapse. Banks therefore try to avoid criminal indictments at any cost. Indictments lead to bankruptcy through a combination of reputational damage, collective behavior, and the ISDA master agreement, which sets out the standard terms that apply to all over-the-counter transactions between banks. Generally, a criminal indictment by U.S. authorities is considered sufficient grounds for other banks to sever ties, thereby depriving the indicted bank of any liquidity within a relatively short period. If banks collectively believe that an indictment endangers a bank’s economic survival, they have strong incentives to end transactions with the indicted bank. Through such collective behavior, worries about the disastrous effects of criminal indictments become self-fulfilling prophecies.
The threat to indict is thus more than just a reporting of ongoing criminal investigations. Rather, it triggers an immediate response by concerned parties. The drastic consequences of criminal indictments therefore strengthen the bargaining position of prosecutors in agreements with banks. U.S. authorities must simply credibly convey that they are considering a criminal indictment and can then use this threat to force banks to assent to costly agreements.
This structural dependence on access to the dollar-based, U.S. controlled financial system also affects banks that have no representation on U.S. soil because like virtually any other bank, these banks repeatedly trade in U.S. dollars, with U.S.-based institutions, or with other banks that trade in U.S. dollars or with U.S.-based institutions. There is simply no hiding from Uncle Sam.
But what about banks that are simply “too big to fail?” They cannot escape, either. Remember that banks do not collapse because of costly agreements with prosecutors but rather because of how markets react to indictments. The key for the U.S. authorities is therefore to manage market expectations. Banks immediately sever ties with the incriminated one because they expect other banks to do the same. If they are, however, reasonably sure that U.S. investigations will not lead to the bank’s collapse (for instance because other important banks signal that they are not going to sever ties), they have no reason to stop conducting transactions. Hence, what U.S. authorities need to do is to keep the other banks informed about the process to prevent panic reactions.
The conflict over Swiss banking secrecy shows how U.S. authorities have constantly refined their capacity to deal with international banks. They have mastered the use of threats of criminal indictments to reach more punitive agreements with banks, even if these banks have no representation on U.S. soil. In addition, U.S. authorities have learnt to perform the balancing act of using threats to extract concessions, while managing market expectations to avoid panic reactions. In this way U.S. authorities have managed to get banks to plead guilty that were previously deemed off-limits for criminal prosecution.