Bank secrecy in offshore centres and capital flows: Does blacklisting matter?

• Published date: 01 January 2017
• Author: Donato Masciandaro,Olga Balakina,Angelo D’Andrea
• Date: 01 January 2017
• DOI: http://doi.org/10.1016/j.rfe.2016.09.005

Bank secrecy in offshore centres and capital flows: Does

blacklisting matter?☆

Olga Balakina, Angelo D’Andrea, Donato Masciandaro ⁎

BocconiUniversity, Economics,via Sarfatti 25, 20146Milan, Italy

abstractarticle info

Articlehistory:

Received16 April 2015

Receivedin revised form 28 September2016

Accepted28 September 2016

Availableonline 17 October 2016

JEL classification:

F21

K42

Thisstudy analyses cross-bordercapital flowsin order to verify the existenceand direction of the effectof the soft

regulationpromotedby internationalorganizations againstbanking secrecywhich characterizedthe so called tax

and financialheavens. This effectis called in the literature StigmaEffect, but both the existenceand the direction

of thestigma effect are farfrom being obvious.The international capitalflows can simplyneglect the relevanceof

the blacklisting,or worst, the attractiveness ofbanking secrecy can produce a race to thebottom: the desire to

eludemore transparent regulationcan sensibly influencethe capital movements.We test whether being includ-

ed and laterexcluded from the FATF blacklistis an effective measurethat influences countries’cross-border cap-

ital flows. Using annual panel data for the period 1996–2014 , we apply our framework to 126 countries

worldwide.We find evidence that in generalthe stigma effect does not exist.

© 2016 ElsevierInc. All rights reserved.

Keywords:

Bank secrecy

Offshorecentres

Internationalcapital flows

Name andshame regulation

Money laundering

1. Introduction

On April 2016revelations of the PanamaPapers spotlightedthe role

that bankingsecrecy –which is offered in the so called tax and financial

centres andterritories –perform in the global economy. The facts have

caused increasingconcern that banking secrecy lies at the centreof an

international web of illegal and criminal conduct. In parallel, several

policymakers in advanced countrie s have emphasised the need for

enforcing the blacklisting tool againstthe territories that breach trans-

parency standards. But does the blacklisting work?

Banking secrecy is anevergreen issue for the national and interna-

tional debate. In the aftermath of the Global Financial Crisis the fight

against bank secrecy as well as against ta x and financialhavens has

become a politicalpriority in advanced countries.

It is oftenthe case that internationalorganisations and nationalgov-

ernments do not have strong legal instruments to impose strict mea-

sures to prevent and combatbanking secrecy. For this reason, soft law

practices, such as blacklisting, have been introduced. The aim of the

soft law tools isto put the investigated country underintense interna-

tional financial pressures, using th e “name and shame”approach.

Under the “name and shame”approach, institutional regulatoryorgani-

zations and/ornational governments disclosenames of non-compliant

countries and/or non-compliant ba nks to the public, supplementing

the disclosure with forms of of ficial opprobrium (Brummer, 201 2).

This approach is increasingly applied in the international context and

it aims to address policy coord ination problems among nationa l

policymakersand regulators (Greene& Boehm, 2012).

This paper looks at cross-border capital flows in the period 1996–

2014 in order to verifythe existence and the direction of the so-called

stigma effect, i.e. the effect of the blacklisting in addressing bankin g

secrecy.

Country compliance with the intern ational standards of the

blacklisting policy named Anti-MoneyLaundering and Combating the

Financing of Terrorism –AML/CFT thereafter –gained momentum in

the nationalpolicymaking all aroundthe world in the last twodecades.

Established by the Financial Action Task Fo rce (FATF) in 1999,

nowadays theinternational standardconsists of 49 Recommendations,

dealing respectivelywith anti-money laundering (forty recommenda-

tions) and combating terrorist fin ancing (nine recommendations) .

Since 2000, FATF has periodically issued lists –blacklists thereafter–

of Non-Cooperative Countries and Territories(NCCTs), which identify

the jurisdictions that FATFbelieves to be non-compliant with interna-

tional best practices.

Reviewof Financial Economics 32 (2017)30–57

☆The researchhas been supported by the BaffiCarefinCentre, Bocconi University.The

authors warmly thank the an onymous referees for their construct ive comments and

useful insights on earli er drafts. Donato Masciandaro pleasantly ackn owledges that

actingas Consultantfor the Inter-AmericanDevelopmentBank has been a unique andpre-

ciousexperienceto enrich his knowledgeon how the blacklistingprocessconcretely inter-

acts with the financial dynamics.The usual disclaimersare applied.

⁎Correspondingauthor.

E-mailaddress: donato.masciandaro@unibocconi.it(D. Masciandaro).

http://dx.doi.org/10.1016/j.rfe.2016.09.005

1058-3300/©2016 Elsevier Inc. All rightsreserved.

Contents listsavailable at ScienceDirect

Review of Financial Economics

journal homepage: www.elsevier.com/locate/rfe

In order to prevent and combat illegal financial flows, international or-

ganizations do not have hard legal commitmentsat their disposal; there-

fore they resort to blacklisting by FATF as a soft law practice. The aim of

the listing procedure is to put Black-Listed Countries (BLCs) under intense

international financial pressure, by employing the “name and shame”ap-

proach in order to produce the so-called stigma effect (Masciandaro, 2005,

2008). The stigma effect represents an inverse relationship between

blacklisting and international capital flows. Indeed, the event of being

blacklisteddecreases the international capitalflows towards a country.

Two sources of pressures on the BLC are expectedto work.

On the one side,most countries that interact with a BLC evaluate its

financialtransactions assuspicious. This occurrenceleads to more strin-

gent and costlymonitoring procedures.Banks operating in multipleju-

risdictionsare the most concerned by these monetarycosts, including

compliance costs. The AML/CFT cost of compliance seems to continu-

ously increase,at an average rate of about45 per cent (KPMG, 2011).

Along with monitoring costs, financial transactionswith a BLC can

imply reputational costs.Suspiciousfinancial transactions attrac t

more and more attention from supranational organizations, national

policymakers and regulators,and international media. For banking in-

stitutions, engagement in opaque financial tra nsactions can increase

reputational risks.Just to cite some recent and meaningful episodes, it

is worth mentioningthat in 2012-15 various international bankshave

been investigated for alleged illicit financial transactionsand fined, or

solicited, to improve their comp liance (Powell, 2013). Transacti ons

with BLCs canproduce such a kind of negativereputational effects.

Because of the potential damage caused by the stigma effect, inter-

nationalbanks may have a strongincentive to avoid businesswith BLCs.

In the same way, the stigma effect can be c onsidered as a conse-

quence of the “nameand shame”approach.

However both the existence and the direction of the stigma effect

are far from beingobvious. As it was pointed out in previousstudies –

(Masciandaro (2005, 2008) and Mas ciandaro, Takats, and Unger

(2007) –the AML/CFT non-compliance of a country can be attractive

under specific conditions,such as the potentialexistence ofa worldwide

demandfor non-transparent financialtransactions.A BLC can be attrac-

tive for bankingand non-banking institutions seeking to promote light-

ly regulatedproducts and servicesto their wealthyand/or sophisticated

clients. The internationalbanking industry as a whole can have incen-

tives to takeadvantages from the existenceof BLCs.

Thereforethe stigma effect,meant to be “astick”forall the countries

not in compliancewith the regulation,can turn out into “a carrot”.

The stigma paradox can emerge. A specific case of regulatory arbi-

tragethat creates the so-called “raceto the bottom”strategy,which im-

plies the desire to elude more pr udent regulation (Barth, Caprio , &

Levine, 2006) and that can sensiblyinfluence the international capital

movements(Houston, Lin, & Ma, 2012).

Finally,a third possibility has to be considered: the behaviourof the

international banking institutions in the cross-border business can be

simply driven by factors other than the stigma effect (Kudrle, 2009).

In this case, the stigma neutrality holds.

The relevance of the stigma effect has become increasinglyimpor-

tant in recent times, whenpolicymakers, regulators and scholars seek

to understand which institutional , regulatory and historical features

can attract or discourage internation al capital flows (Papaioannou,

2009; Reinhardt, Ricci, & Tressel, 2010; Houston et al., 2012; Qureshi,

Ostry, Ghosh, & Chamon, 2011; Mile si Ferretti & Tille, 2011; Chitu,

Eichengreen, & Mehl, 2013). The financial effects of regulationare par-

ticularlyrelevant when the AML/CFT rulesare under discussion.

Thispaper aims to empiricallyevaluate the trend,magnitude andro-

bustness of the stigma effect, b y focusing on the impact of the FATF

blacklisting on the relationshipsbetween international financial flows

and the BLCs bankingsystems.

So far empirical evidence is spa rse and mixed (Kudrle, 2009;

Masciandaro, 2013)–with cases of stigma effect,stigma paradox and

stigma neutrality being detected–and therefore inconclusive.

To understandthe kind of influence t hat FATF blacklisting can have

on BLCs, our research focuses on how internation al capital flows re-

spond to the stigma signals providedby the FATF. The stigma effect is

based on the assumption that blacklistingprocedures alter the attrac-

tivenessof a country for capital flows.The non-complianceof a country

with AML/CFTstandards (listing)can decrease the overallamount of fi-

nancial transactions (volume effect) and/or decrease its efficiency to

manage thosecapitals (cost effect).Of course, the opposite canhappen

when a countryis delisted.

In this paper we aim to find empirical evidence of whether and to

what extent FATF blacklisting affects the volume of financial transac-

tions. Thestigma effect, as a signal thatenables to distinguishbetween

compliant and non-compliant cou ntries, can have deterring effects ,

since transactions with non-compliantcountries imply highermonitor-

ing and/or reputational costs.Observing the signal, international banks

allocate their activities accordingly. The effects of blackl isting subse-

quently manifest.

The rest of the paper is organized as follows. Section2 contains the

review of the literature. In Section 3 we discuss our data and present

theidentification strategy.Section 4 reports the empirical model and re-

sults. Section 5 concludes.

2. Related literature

Blacklisting procedures have been introd uced in 2000. Since that

time relatively few economic studies on the stigma ef fect have been

produced.

The first theoreticaland empiricaldiscussion of thestigma effect as a

controversialissue is found in Masciandaro(2005). The study highlight

how in the aftermath of 9/11, growing attention has been paid to the

role of lax financial regulation in facilitating money launde ring and

the financing of terrorism (criminalfinance).

Two interactingprinciplesare commonly described in thedebate on

the relationship between money laundering and regulation: a) illegal fi-

nancial flows are facilitated by lax financia l regulation; b) countries

adopting lax financial regulation do not co-operate with the interna-

tional effort aimed at combati ng criminal finance (Internation al

MonetaryFund, 1998; Holder, 2003).These two principles characterize

the mandate of the FinancialAction Task Force (FATF) for the preven-

tion of money laundering and terrorism finance.

On the one hand, in orderto address the problems associated with

criminal finance risks, it is fundamentalto develop legal standards for

regulation. FATF standards (Re commendations) have become th e

benchmarkfor measuring thedegree of laxity of AML/CFTfinancial reg-

ulation in everysingle country setting.

On theother hand, faced withthe problem of the lack ofinternation-

al harmonization and coordination , the FATF uses a list of specific

criteria in order to monitor the compliance of countries with interna-

tional standards.Those lists of compliance are commonly describedas

blacklists (Alexander, 2001; Mas ciandaro, 2005; Verdugo Yepes ,

2011). Blacklistingrepresentsthe cornerstone of the internationalregu-

lation, with the effort to reduce the risk that some countries or terri-

tories can turn into havensfor criminal financial activities.Blacklisting

is based on the stigma effect,i.e. the threat for a listed country to face

a drop in capitalinflows and then the erosion ofits competitive advan-

tage after the inclusion in the list (Hampton & Christensen, 2002).

Here the possibility of the stigma paradox occurs. Focusing on the

supplyof regulation, thestudy notes that variousjurisdictions,notwith-

standing the blacklisting threat, delay or fail to change their financial

rules,confirming their non-cooperative attitude(reluctant friend effect).

Furthermore, although the fact that most jurisdictions in the blacklist

enact regulatory measuresin an effort to be removed from it, it remains

to be proven that regulatory reformsare sufficient to guarantee a real

change in the countrynon-cooperative attitude, with a decreasingap-

peal for black capital flows (false friend effect). The existence of these

31O. Balakinaet al. / Review of Financial Economics32 (2017) 30–57