Regulatory dilution and financial misconduct

Peter Szilagyi examines how shifting regulatory priorities and institutional incentives can change the calculus of financial misconduct.

French authorities are continuing their push to recover lost tax revenue from ‘cum-cum’ dividend tax fraud by banks, now estimated to be upwards of €4.5 billion ($5.3 billion). France is not an outlier. In Germany, authorities are currently investigating 253 cases involving a total of €7.3 billion. The CumEx Files project estimates global tax losses of up to €150 billion from a top-down reconstruction of potential losses across cum-cum, cum-ex and cum-fake dividend tax arbitrage schemes, including up to €36 billion in Germany, €33 billion in France, €27 billion in the Netherlands, €19 billion in Spain, €13 billion in Italy and €5 billion in the US.

The dividend schemes stem from loopholes, gaps and administrative weaknesses in national withholding tax systems. However, the schemes were engineered by banks and brokers for institutional clients, and could have been curtailed by clearer prohibitions on transactions lacking economic purpose, restrictions on proprietary trading and complex structured deals, stronger reporting and transparency requirements for short-selling and securities lending, and tighter conflict-of-interest rules supported by enhanced operational risk controls. Yet regulatory politics are shifting toward less rather than more oversight of bank behaviour and risk management. This resembles a familiar regulatory cycle, where as the political appetite for oversight diminishes, the conditions that enable financial misconduct re-emerge – even as the consequences of historic misconduct are still being confronted.

Regulatory softening: A new phase of the cycle

This pro-cyclical pattern is documented in both historical and political economy analyses. Almasi, Dagher and Prato demonstrate that regulatory cycles are not just the product of fading memory or lobbying pressure, but an interplay of financial innovation, public sentiment and the incentives of politicians, who take on regulatory risk to signal their competence. What is unusual today is the number of jurisdictions moving simultaneously in a lighter-touch direction, albeit for different reasons.

In the US, deregulatory initiatives are being driven by a political-ideological shift. US regulators have spent years debating the Basel III Endgame capital reforms. The 2023 implementation proposal suggested higher capital requirements for large banks, but that is now being re-worked into a more capital-neutral framework with any final agreement pushed later into 2026. Meanwhile, the Financial Stability Oversight Council (FSOC) has redefined its mission towards a more deregulatory agenda.

In the UK, regulatory dilution is tied to an agenda of competitiveness and growth, coupled with post-Brexit regulatory autonomy. The Leeds Reforms and the government’s Growth and Competitiveness Strategy build on the 2022 Edinburgh Reforms. However, they go considerably further, seeking to loosen post-2008 safeguards such as ringfencing and giving banks more freedom to take risk and expand their range of products and activities.

In the EU, the regulatory shift is driven less by ideology than by a technocratic push to simplify an increasingly complex rulebook and make requirements more ‘proportionate’ for smaller banks. Supervisors acknowledge that discussion has moved away from safety and stability towards complexity, reporting burdens and red tape. At the same time, proposals to expand the role of the European Securities and Markets Authority toward a single capital-markets supervisor have been opposed by member states like Luxembourg, Ireland and Malta. The result is a familiar European compromise: a little bit of simplification and an incremental harmonisation of rules, but ongoing fragmentation of supervision and enforcement. 

Regulatory fatigue is also apparent at supranational organisations. The Basel Committee on Banking Supervision, the Financial Stability Board (FSB) and the International Organisation of Securities Commissions (IOSCO) played a key role in shaping the post-2008 reform agenda, but their influence has weakened. Divergence is widening; as the US and the UK recalibrate, the EU has also postponed the binding application of the Fundamental Review of the Trading Book to 2027. A few jurisdictions, such as Switzerland, have moved ahead with stricter reforms, but they are exceptions.

Regulatory politics are shifting toward less rather than more oversight of bank behaviour and risk management.

How institutions decide to misbehave

The risks created by regulatory softening are not abstract: they filter directly into the decision-making processes of financial institutions. These rarely set out to behave unethically or illegally, but their choices are shaped by incentives. When facing an ambiguous trading or structuring opportunity, many implicitly conduct a simple cost-benefit analysis:

• how profitable is the strategy?
• how likely is detection?
• if detected, what is the probability of settlement versus sanction?
• if sanctioned, who bears the cost – the institution, the desk or the individuals involved?

A large body of research shows that rules deter financial misconduct only when enforcement is visible and credible: the existence of laws and regulations matters less than the expectation that violations will be detected and penalised. Bhattacharya and Daouk (2002) famously showed that the cost of equity in a country falls not after it passes an insider trading law, but after the first actual prosecution.

When regulators make permissive noises, when their resources are stretched, and when countries enforce rules unevenly, the perceived risk of getting caught plummets. That changes the internal calculus within financial institutions too, and a practice that was formerly considered off-limits can start to look acceptable, or even rational. Once the practice has been adopted, the pressure to keep the money flowing often trumps other concerns. Even when external warnings appear, the internal momentum makes it difficult to apply the brakes.

The cost-benefit logic is only part of the story, as organizational culture and behavioural biases are equally important. In high-pressure, high-status financial environments, an individual’s conduct is affected as much by group identity and loyalty as by formal rules. People adapt their ethical boundaries to perceived authority structures, and become reluctant to challenge superior performers or respected colleagues. What begins as a clever workaround or legal grey area gradually becomes ‘how things are done here’. The weakening of regulatory expectations accelerates this drift.

When regulators make permissive noises, when their resources are stretched, and when countries enforce rules unevenly, the perceived risk of getting caught plummets.

Why policing misconduct is harder now

The current phase of regulatory dilution coincides with growing structural difficulties in detecting and policing financial misconduct.

Firstly, supervisory resources are constrained. Good supervision requires adequate and timely resources, including budgets and experienced staff. International assessments repeatedly find that supervisory resources have not kept pace with the size and complexity of financial systems.

Secondly, misconduct is increasingly cross-border. A structured transaction can be intentionally engineered to pass through several countries. When misconduct is structurally international, supervision depends on cross-border cooperation, which is inherently difficult to coordinate. Many cases fall through gaps, especially when they involve markets, instruments or intermediaries that are already lightly supervised.

Thirdly, financial complexity is migrating into less transparent markets. Private credit has grown into a multi-trillion-dollar asset class, with light disclosure and diverse non-bank structures that are difficult to monitor. Fitch warns that the sector’s complexity and bank interconnectedness remain ‘untested through a full market cycle’. Cryptoasset and tokenised finance markets are also expanding rapidly, with much of the activity offshore, pseudonymous or organized through opaque structures. Parallel developments in AI-driven trading, analytics and data infrastructures add further opacity, with supervisors struggling to assess how risks are generated, transmitted or amplified.

A fourth and final challenge is the re-emergence of regulatory competition driven by capital mobility, domestic industry lobbying, and the absence of binding global supervisory frameworks. Acharya shows that if central banks behave in ways that align with domestic banks’ interests, other central banks also soften their stance, producing a race to the bottom.

Morrison and White found that when capital is mobile, this actually benefits the weakest regulator at the expense of stronger oversight. Haufler and Maier revealed that when governments internalise consumer and taxpayer risks, the strategic incentives reverse: rules are tightened in a way that imposes negative spillovers on other countries, generating upward pressure and a non-cooperative race to the top. 

For misconduct risk, the direction of competition matters less than the fragmentation it creates. Divergent standards, uneven enforcement and unstable rule trajectories give banks room for regulatory arbitrage.

In high-pressure, high-status financial environments, an individual’s conduct is affected as much by group identity and loyalty as by formal rules.

Top-down reforms

Several reforms would materially strengthen the current global regulatory system.

First, comprehensive whistleblower reform is needed. Dyck, Morse and Zingales find that employees, journalists, regulators and other non-traditional actors detect the majority of major corporate frauds in the US. Our own work demonstrates that without whistleblowers, identifying misconduct in more opaque markets is largely impossible. Yet protections, incentives and follow-up mechanisms remain uneven. Five EU countries, including Germany, have recently been fined for failing to transpose the EU Whistleblower Directive, underscoring that even basic safeguards remain incomplete.

A second priority is building cross-border enforcement infrastructure. Regulators need joint investigative teams, interoperable evidence-sharing tools, and clear expectations for cooperation in cases involving offshore structures, cryptoasset markets, or cross-border tax schemes. IOSCO and the FSB have repeatedly emphasised the need for deeper supervisory cooperation, while regulatory competition discourages countries from sharing information or aligning enforcement practices.

A third area needing reform is supervisory blind spots, including in private markets and technologically complex domains. Supervisors lack timely, granular information because critical data sits in fund complexes, special-purpose vehicles and bespoke financing chains. Similar gaps affect cryptoasset and tokenised finance markets, as well as AI-driven trading systems. Addressing visibility requires enhanced reporting obligations for large private market managers with material links to banks, systematic data collection and supervisory tools capable of tracing flows across both traditional and digital markets. Integrated stress testing would help map how shocks propagate across entities and jurisdictions. Without such measures, supervisors remain accountable for risks they cannot observe, let alone contain.

Instigating ethical behaviour from the bottom up

Even if these reforms were rolled out tomorrow, misconduct still originates inside organisations, and supervision and enforcement are, by design, reactive. A large literature shows why this gap matters. Our own work shows that even in opaque environments with almost no surveillance, insiders act strategically and weigh detection risk as carefully as they weigh expected profit. People routinely override formal rules out of loyalty to peers or expectations. Even with institutional codes of conduct and strict protocols, misconduct persists.

A sustainable response must therefore combine top-down authority with bottom-up discipline. Firms need to redesign incentives and decision environments so that misconduct becomes irrational. This means:

• pay tied to long-term sustainable performance, with deferral and clawbacks that carry consequences when misconduct emerges
• promotion pathways that reward challenge, escalation and contribution to control and risk functions
• rgular checks that identify teams where everyday behaviour no longer aligns with stated organisational values
• reviews that pinpoint products or processes where the incentives encourage risky behaviour and controls are not strong enough to counter it
• clear authority for compliance and risk teams, rather than a mere advisory role, and
• systems and products designed so decisions can be easily understood and traced, rather than buried in opaque models or booking structures.

The common thread is clear: culture, incentives and the day-today decision environment shape conduct more powerfully than rulebooks. Bottom-up mechanisms scale in ways that regulators cannot, operating continuously in real time in the places where misconduct actually arises.

Misconduct risk is endogenous

Financial regulation can be tightened or softened, but it cannot remove the conditions that allow misconduct to take hold. Misconduct is not accidental. It emerges from incentives, behaviours and institutional design. The current shift toward lighter-touch oversight raises risk not because rules weaken, but because incentives, expectations and organisational signals subtly change, making boundary-pushing a rational adaptation.

Reforms at the top remain essential, but the most important defences reside within firms. Avoiding the next dividend arbitrage or LIBOR scandal requires a twin commitment: credible external deterrence and deliberate internal design. Without both, the question is not whether the next scandal will emerge, but rather when and in what form.