Compliance with international soft law of G20 and OCDE: the case of Swiss Banking Secrecy

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Compliance with international soft law of G20 and OCDE: the case of Swiss Banking Secrecy

Outline

Introduction

I. Facts

II. Theoretical Approaches

2.1 Legitimacy of international norms (Frank)

2.2 Cost-Benefit Analysis (Neuhold)

III. Empirical Evidence

3.1 Legitimacy applied to facts

3.2 Cost-benefit analysis

3.2.1 Economic sanctions

3.2.2 Loss of reputation

3.2.3 Domestic costs

Conclusion

Bibliography

Introduction

In the middle of the financial crisis, during the G20 London Summit held on 2 April 2009, politicians declared that "the era of banking secrecy is over". This declaration targeted 49 countries including Switzerland.

In this paper we will discuss how Switzerland decided to comply with the soft rules of G20 and OECD in 2009, thus undermining its system banking secrecy.

In the first part we will briefly analyse the current situation of Switzerland concerning the banking secrecy.

In the second part we will give two possible theoretical explanations of the Swiss behavior. According to Tomas M. Frank, States comply with international norms because they perceive them as legitimate. On the other hand Hanspeter Neuhold describes the cost-benefit trade-off that states must consider when deciding whether to comply or not with international law.

In the third part of the paper, we will apply the empirical evidence to these two above approaches. First, we will study Frank's legitimacy concept in the light of empirical facts. It appears that Switzerland did not percieved G20 and the OCDE rules as legitimate. Therefore Frank's rule legitimacy is not the reason of Swiss compliance. Second, we will see how the cost-benefit analysis apply in this case. We will see that eventual economic sanctions, the fear of reputational damage and certain domestic costs acted as incentives for Swiss compliance in 2009.

I. Facts

Since the end of 19th century Switzerland practices banking secrecy through the law of obligations and the civil law. The banking law which includes the article 47 on banking secrecy was adopted on the 8 November 1934. This article forbids a bank employee to disclose any information about its clients. The violation of this article leads the penal sanctions: the bank employee risks six month of prison and a a fine of 50'000 swiss francs. This legislation favoured the developement of the banking sector in Switzerland, especially the private banking industry. However it also promoted tax evasion from Europe and other countries of the world. It is impossible to give an exact figure concerning undeclared funds held in Switzerland. However, according to the 2010 joint report of KPMG and Helvea, Switzerland detain 880 billion of undeclared swiss francs (on a total of 4000 billion swiss francs). The breakdown is the following: 220 billion CHF from Grmany, 220 billion CHF from Italy, 115 billion CHF from France and 325 billion CHF from the rest of the world.

States suffering from tax evasion toward Switzerland regularly targeted the Swiss. Starting from the years 2000, the OECD started its fight against tax havens. In 2005 it proposed a Model of Tax Convention which aimed to reduce tax evasion by information-sharing between states. However Switzerland largerly ignored international pressures concerning the banking secrecy. It claimed its juridical differentiation between tax evasion and tax fraud. The first case concerns the non-reporting of income. The second, the intentional falsification of documents. Switzerland shared information with national tax authorities only in the case of tax fraud.

In the middle of the financial crisis, several governments, including France and Germany, decided to include the tax haven and banking secrecy issue in the agenda of emergency measures, in parallel with banking regulation and supervision. To take concrete actions and decisions, political leaders adopted a new international entity, the G20. During the crisis it replaced the old G7 forum and gained in importance. This new arena permitted to convey messages as well as take decisions at the international level. G20 mandated the OECD to publish a list of non-cooperative tax havens for the London Summit of the 2^nd April 2009. This list is composed of four cathegories:

- Jurisdictions that have substantially implemented the internationally agreed tax standard (white list)

- Jurisdictions that have committed to the internationally agreed tax standard, but have not yet substantially implemented (intermediary list)

- Other financial centers (grey list)

- Jurisdictions that have not committed to the internationally agreed tax standard (black list)

Switzerland found itself on the "grey list" (It is to note that Switzerland is not member of G20 but is a founding member of the OECD).

In order to be removed from the OECD grey list, Switzerland had to sign 12 bilateral agreements on the double taxation according to the OECD Model Convention on double taxation. The Swiss reluctance to adopt OECD standards resides in the article 26 of the Model Convention. This article is the legal basis for the bilateral information sharing for tax purposes. It is a source of obligation for the exchange of information for the contracting parties. This article undermines the swiss legal basis of the banking secrecy.

After the strong international pressures, Switzerland agreed to cooperate. The 24 September 2009, Switzerland was removed from the grey list after signing the last (12th) agreement with Quatar.

II. Theoretical approaches

In this second part of the work we will analyse two theoretical approaches in order to understand why states comply with interntional norms. First we will study Thomas M. Frank's approach and the concept of legitimacy of international rules. Second we will focus on the cost-benefit analysis of Hanspeter Neuhold.

These approaches deal with international rules in general. However our case of banking secrecy and Switzerland focuses on soft law of G20 and OECD. Soft low is considered less binding than "hard law" - the traditional set of rules which govern International Law which the traditional form of rules (treaties, Security Council resolutions, customary international rules). Soft law may be defined as principles, codes of conduct, codes of practice, etc. We will consider that these two theoretical approaches suit for traditional as well as soft law.

2.1 Legitimacy of international norms (Frank)

In his approach Thomas M. Frank states that usually states comply with international norms, and this even in the absence of superior coercive power. Moreover states adopt a compliant behavior even if, sometimes, it contradicts state's self-interest. This statement contradicts the Austinian legal vision. According to that vision, laws are issued by a sovereign and they are backed by threat. In the contrast of this Austinian view, Frank uses another factor to explain state's obediance with non-coercive international rules. He explains that states will tend to comply with international rules if they are percieved as legitimate. Frank analyses four factors which will make a rule legitimate: the determinacy (linguistic component), the symbolic validation (cultural component), coherence of application of rules and the adherence of primary rules to secondary rules. For Frank, legitimacy is a matter of degree, in other words some rules are more legitimate than the others.

The first component of legitimacy is the determinancy (the linguistic component). It means that a rule should convey a clear message and be transperent. We should immediatly see through the language of such rule. Such rule will clearly state what is permitted and what is not and thus, making it more delicate for states to bypass compliance.

The second component is the symbolic validation. In order for a rule to be legitimate, the authority of the rule has to be symbolically communicated. The use of symbols such as flags and hymns communicate the authority of rules. Symbolic validation can take the form of ceremonies/rituals or the pedigree of the rule. The pedigree refers to the root-depeness and the historical origin of a rule. Rituals tend to communicate and ratify the international norms.

The third component of legitimacy is the coherence of application of a rule. If a rule is coherently applied and respected by all parties, the symbolic validation will take place and states will tend to comply with this norm. In turn, if a rule is not equally applied to all or violated, the states will not comply with this international rule.

The fourth component is the adherence of international norms to a normative hierarchy and community. It refers to the the procedural and institutional framework of international law. Frank makes a distinction between primary and secondary rules. The first set of rules are rules of conduct and obligation. The second type are "rules about rules": how rules are made, interpreted and applied. The frame of lawmaking institutions, treaties and courts is crucial. The degree of legitimacy of international law will depend how well the primary rules are connected to the set of secondary rules.

Frank's approach doesn't imply that international law is always respected by States. But we can distuingish between a compliant behavior and a violation. The reunification of the four components of legitimacy of a rule decribed above, make the rule repect more probable.

2.2 Cost-benefit analysis (Neuhold)

To understand Neuhold's cost-benefit analysis, we need to state the following assumtion: states are viewed as self-interest and rational actors of the international arena. The self-interest of a state will motivate its behavior and interaction with other states. The strategic interaction with other states will generate a set of payoffs. Thus the compliance or non-compliance with international norms should be seen in a prisma of long-term national interests and the classical PD game. These postulats are part of the rationalist and neorealist theories. Neuhold adds that the bahavior of one state will be linked to the expected behavior of another state.

While a state makes a decision to comply or not with international norms, it will do a cost-benefit analysis of the situation. The state's bahavior will be based on the result of such analysis. If the cost of non-compliance is higher than the benefit, the state will decide to comply.

The author points out that there is no monopoly at the international level which can enforce a state's compliance. However, despite the evident benefits that states can get from non compliance, we observe that international norms are respected. This is due to the fact that the cost of such behavior is higher then the benefit.

When states make calculations of costs and benefits, they take into accountthe magnitude and consequences of possible sanctions, the probability of those sanctions being imposed and the probability of detection of the non-compliant behavior.

Neuhold describes three types of costs that might be imposed on the non-compliant state.

The first type of costs are economic sanctions. The aim of economic sanctions is to restrict foreign trade and finance. It has for objective to modify the bahavior of the targeted state, to retribut or punish it, or to send a signal. The sanction can be used against a state or a business entity of a state, which is a non state target. But the aim of the sanction remain the same. The effect of such sanctions may be slow and will mainly depend on the degree of integration of a country in the international economic system. The more a state dependent on international trade and investments, the stronger is the effect. Moreover, only large states with big shares in international trade and financial services can effectively impose an economic sanction.The most influancial economies in the world are G10 countries. Among them USA has a leading role in the financial end economic system. This country has a very strong power by allowing the access to its domestic market. Thus these countries have the best position to impose effective economic sanctions.

The second type of costs that a state can face is a loss of reputation. By being labeled as non respectful of international law, a faces various direct and indirect "costs" by being seen in a negative way by the international community. By breaching international obligations, a state becomes vulnerable to all kinds of attacks by other states and international institutions. As for today, even the biggest powers can't simply ignore the international law.

The third and the last cost that the author mentions is a domestic one. If the violation doesn't bring expected results, the domestic political opponents can use it as argument against the power in place. Because of this fact, democracies are the types of regimes that will contribute the most to the respect of international norms. In the contrary, an authocratic state will not take into consideration political opposition when deciding to comply with international law or not.

banking secrecy economic costs

III. Empirical evidence

In this third part of the work we will apply the empirical evidence to the theoretical concepts. We will analyse the theories in the light of recent events which occured during the financial crisis in 2009 and conclude which of these approaches seem to be the most appropriate in the Swiss case.

3.1 Legitimacyof international norms (Frank)

In this section we will determine if Switzerland decided to comply with G20 rules because it percieved the rule as legitimate, according to Frank's approach.

The soft international rule was expressed by the grey and black lists that OECD established for the second summit of G20 in 2009. The black list names countries that are labelled as non-cooperative tax havens. The grey list includes countries that have agreed to improve the banking transperency, but haven't signed yet 12 agreements of double taxation (according to the Model Tax Conventionon on income and capital, OECD). Switzerland was included in this grey list.

First we determine the degree of determinancy of the soft law of G20 and OECD. We consider that this listing conveyed a very clear message and was easy to interpret. Switzerland knew exactly what it had to do in order to be removed from this list: it had to sign 12 agreements of double taxation with other countries. In that sense this OECD soft rule may be seen as legitimate.

Secondly, we can discuss the symbolic validation factor and the ability to communicate the authority of a rule. Concerning the pedigree, we consider that the G20 summit is a new entity which only recently replaced the G7. It was created in 1999 after the Asian financial crisis. However it is only starting as of 2008 that this entity was used by states as an international arena to resolve problems and convey meassages. The OECD started its listing system in 2000. It is a relatively new way of imposing the soft rules concerning the financial transparency. Even if the norms are not deeply rooted, the rituals of the G20 tended to confirm the legitimacy of the OECD soft law. Three important summits of G20 were held in Washington (november 2008), London (april 2009) and Pittsburg (september 2009). During the London summit the head of the states clearly reaffirmed the necessity of respecting the OECD rules. These statements symbolically validated the soft legal norm and increased its legitimity. So we find that the soft norm did not have a strong pedigree but was symbolically validated through the rituals of the G20 summits.

Thirdly, looking at the coherence of application of the soft law, we can ask: Is this soft anorm is equally applied to all states? Here the empirical evidence shows that the OECD lists did not include some states that are considered as having an opaque financial system. The Chinese states of Hong Kong and Macau are not included. The US states such as Delaware are not included either. Moreover all the British irlands such as Jersey and Gernsey are not included. This absence from the OECD lists is explained by the use of the trust system by these states. The trust is a tax system where a trustee administrate in the favor of a settlor. The settlor is not a legal owner of the funds and can thus escape (in part) from the wealth tax or the income tax. Trusts can take various forms depending on the legislation. Thus, although this legal setup is different to banking secrecy, it nevertheless contributes to tax evasion, which is the primary issue the G20 was looking to adress. The Swiss domestic opinion perceived this exclusion of the trust systems from the OECD lists as deeply unfair. Thus the G20 and OECD soft rule was not equally applied to all states. States with the trust system had an advantage compared to states with banking secrecy. The legitimacy of the G20 rule can therefore be seen as diminished because it was not coherently applied to all states of the international community.

3.2 Cost benefit analysis

Before making the choice to comply or not with G20 and OECD norms, Switzerland did a cost-benefit analysis, as according to Neuhman's approach.

Benefits:

At one hand the banking secrecy has a clear benefit for Switzerland. This country has a leading position in the wealth management business. UBS occupied the first place in the world concerning private banking and wealth management. It is an economic niche of the country. In Switzerland financial services are around 15% of the GDP. The financial sector employs 5% of the polulation. The total assets of all swiss banks amounted 733'808 billion CHF in 2009. Moreover total assets of banks exeed by far the swiss GDP. As example, we provide figures of the two largest banks, UBS and Credit Suisse in 2007:

UBS 2'542 billion CHF = 5.2 x GDP

Credit Suisse 1'415 billion CHF = 2.9 x GDP

By refusing to comply with OECD and G20 soft norms, Switzerland could preserve its banking secrecy. The wealth management industry would be renforced, avoiding the possible outflow of declared and undeclared capital. We could expect an additional inflow of funds, because investors would be reassured about the safety and ring-fencing of their assets.

Costs:

On the other hand, by non respecting the soft international law of G20, Switzerland would need to bear possible costs. We will now analyse the three types of costs according to Neuhman's approach: economic sanctions, the loss of reputation and domestic costs.

3.2.1 Economic sanctions

Switzerland considered the threat of economic sanctions by G20 members. Switzreland is highly integrated in the financial and economic international system. It has very little natural ressources and has a relatively small domestic market. Its main economic partner is the European Union. Financially, it is heavely dependant on investments in the USA. Concerning Swiss exports, 62% of it goes to EU and 9.7% to USA. Because of this dependency, the threat of economic sanctions is a very effective deterrent tool in the Swiss case.

Switzerland was thereatened by G20 members to be on the black list of tax havens. In an extreme case this would imply economic sanctions, travel restrictions and trade embargo. Such sanctions would affect the whole swiss economy and not only the banking sector. Concerning the banking sector, the main threat is an increased supervision and regulation by G20 and OECD members. It means that for banks such as Credit Suisse and UBS, it would be extremely difficult to make operations abroad, with increased compliance costs.

Switzerland understood that the probability of these sanctions was real and serious during the UBS Birkenfeld affair starting in 2008. The crisis started because a former UBS employee, Bradley Birkenfeld, helped a client to evade about 200 millions USD of taxable funds from the US Internal Revenue Services. When the case went public, a series of UBS employees admitted that a system was put in place to help escape US tax authorities. UBS was charged under the three levels of US internal law: civil, criminal and administrative. On the administrative side, the SEC (Security Exchange Commission) charged UBS for the violation of cross-border transactions. On the criminal side, UBS was charged to market tax-evasion strategies to attract US clients. In the civil procedure UBS was accused to hide 20 billion non-declared dollars in its accounts and asked to hand over account information on more than 19'000 clients. For the first two procedures an arrangement was found and UBS had to pay a penality of 780 million of dollars to the SEC and released information about 250 UBS clients. But the civil procedure is still pending.

With the autorisation of FINMA, UBS released information on 250 clients. By doing so, the Swiss domestic law on the banking secrecy was violated (article 273 of the Swiss criminal Code). Only the Swiss Parliament would have had the power to allow such adecision, not the Federal administration. In such extraordinary circumstances, several legal criminal complaints were deposed aginst FINMA and UBS.

During all this affair, there was a serious threat of the USA closing closing UBS subsidiaries in the USA. Some consider that it would have been the end of UBS as the whole company. This case showed to Switzerland that the threat on its economy and banks are serious enough. UBS suffered big losses during this affair. (Not only did it pay a 780m million fine but also suffered a loss of 492 million Swiss Franc on its good will.) Moreover FINMA had to intervene in the affair. The shadow of economic sanctions is a large cost that Switzerland considered when deciding to comply with OECD and G20 norms and were the most important considerations for Switzerland when it decided to overlook (and some say abondon) its traditional banking secrecy.

3.2.2 Loss of reputation

The reputation is one of the factors which can explain why Switzerland decided to comply with non-binding soft law of OECD and G20. The loss of reputation is one of the costs that Switzerland has to bear according to the Neuhman's approach. As a financial center, it is important for Switzerland to be viewed as a stable financial place to attract investors. By blacklisting some countries (Switzerland was on a grey list) OECD clearly attacks the reputation of these financial centers. Here we are in the situation where third parties sanction a behavior of a state.

Financial centers like Switzerland want to provide an image of astable and secure environment investements. As consequence it would be able to attract more investors, and in the case of Switzerland more wealthy clients. A large part of the Swiss wealth management business is constitued by foreign clients who are seeking political and economic stability. The Swiss reputation is its brand for banking indistry and for financial centers in general. Because of this business environment, Switzerland is particulary vulnerable to bad publicity and scandals.

By being put on the grey list of OECD in 2009, G20 attacked the Swiss reputation and undermined its financial stability. Additionally the UBS scandal was equally damaging for the Swiss reputation.

We could see that putting Switzerland on the grey list of the OECD was very effective. Switzerland signed the required number of agreements on the double taxation and the exchange of information and thus complied with the soft norms of G20. We consider that the loss of reputation was also an important cost taken into account by swiss authorities.

3.2.3 Domestic costs

According to Neuhman's approach, there is a third type of cost which is the domestic one. Switzerland has a strong democratic regime. In general public opinion and the political parties were strongly supporting the banking secrecy. Some politicians even proposed to inscribe the banking secrecy in the Swiss Constitution. By deciding to comply with international norms the Swiss government went against the public opinion. However the eventual losses that the country would suffer resulting from eventual economic sanctions and the fear of reprobation in the future by political oponents led Switzerland to te way of compliance.

Despite the clear advantages that Switzerland would have (in the form of additional funds and the preservation of current clients), if it would adopt a non-compliant behavior, the weight of possible costs appeared too high. The decision was taken to comply and abondon to some extent the swiss banking secrecy.

After appliyng the empirical evidence to the theoretical approaches of Frank and Neuhold, it appears that the second approach suits better for the explanation of the Swiss compliant behavior. The soft law of G20 and OECD does not seem to be perceived as legitimate by Switzerland. By contrast, the eventual costs of non compliance apparently overshadowed the benefits and brought Switzerland to respect international norms.

Conclusion

We have seen that during the financial crisis of 2009, Switzerland together with other states was listed by the OECD mandated by the group of G20. I order to be removed from the list, Switzerland had to sign twelve agreements on double taxation. Despite obvious desadvantages, switzerland agreed to comply with international demands.

We descibed two theoretical frameworks which could explain the Swiss compliant behavior in this case. The first framework is Frank's concept of legitimacy. States tend to comply with international law if the percieve rules as legitimate. The second is Neuhold's cost-benefit analysis. States will only comply when costs of non-compliance are higher that benefits.

In the light of empirical evidence, we find that Frank's approach has a weaker explanatory power. Even if the degree of determinancy of the OECD soft rule was high enough, we found mixed results concerning the symbolic validation. Moreover the rule was not coherently applied due to the exclusion from OECD listings of States with trust systems. Because of all these factors the international rule was not perceived as legitimate by Switzerland, yet it complied with it.

In turn, empirical facts tend to support Neuhol's theory. Switzerland is a highly intergrated country to whom economic sanctions could bring real damage. The probability of such sanctions was shown by the UBS case in United States. Additionaly the OECD listing affected the Swiss reputation as a stable financial center. Finally the strong democratic system and the fear of opponents in the case of negative repercussions led Swiss decision-makers to comply with the OECD norms.

Bibliography

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Alexander (Kern), Economic Sanctions, Law and public Policy, Great Britain, Palgrave Macmillan, 2009

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Sharman (J.C.), Havens at storm - The struggle for global tax Regulation, London, Cornell Studies in Political Economy, ed.by Peter J. Katzenstein, Cornell University Press, 2006

Zaki (Myret), Le secrate bancaire est mort, Vive l'йvasion fiscale, Lausanne, ed.Favre SA, 2010

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Frank (Thamas M.), Legitimacy in the International System, Oct. 1988, The American Journal of International Law, Vol.82, No.4

Neuhold (Hanspeter), The Foreign "Cost-Benefit" analysis revisited, 1999, Jahrbuch fur Internationales Recht, Vol.42

Swati Aggarwal (Swati), Poddar(Ankur), Razdan (Peevush), The future of Bank Secrecy & Switzerland, 2009, www.talentureadvisory.ch/ufiles/files/UID4AF17FF224562_ITA_PDF1.pdf

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