Professor Michael Mainelli, Executive Chairman, The Z/Yen Group
Jan-Peter Onstwedder, 3i
Professor Avinash Persaud, Intelligence Capital
[An edited version of this article first appeared as "Mid-Shore Trips For Capital Ships", Journal of Risk Finance, Volume 10, Number 4, pages 410-413, Emerald Group Publishing Limited (September 2009).]
"A capital ship for an ocean trip, was the Walloping Window-Blind;
No wind that blew dismayed her crew or troubled the captain’s mind."
(Charles Edward Carryl, 1885)
Political leaders continue to seek scapegoats for the Credit Crunch - greedy bankers, incompetent regulators, dopey rating agencies, useless accountants, hysterical journalists. There are victims, "us", so someone with suspect motives must have caused the harm; we just need to name them. During the Great Depression, H L Mencken wrote of "morons" blaming the "machinations of werewolves assembled in Wall Street" [H L Mencken, Baltimore Evening Sun, 15 June 1936]. As with any crisis, the Credit Crunch has multiple causes, but the populace need the distraction of simple ‘guilty’ verdicts.
As with all bullies, political leaders like scapegoats who don’t fight back. Sadly, off-shore centres are easy targets and risk joining the cast of Templars, Bavarian Illuminati, Rosicrucians or Cathars, that routinely feature in conspiracy theories. Convenient tar-and-feathering of off-shore centres not only diverts analysis from root causes, but irresponsibly impedes repairs. Evidence for off-shore centres causing the Credit Crunch is weak and contradictory. Flawed domestic regulation in the USA, the UK and other OECD countries led to the effective collapses of Bear Stearns, Fannie Mae, Freddie Mac, Lehman Brothers, AIG, Northern Rock, Bradford & Bingley, RBS, Lloyds and HBOS, just to name a few. Off-shore centres didn’t regulate these. If the off-shore blame is deserved, perhaps one should cast London as an off-shore centre, gaining from USA Eurodollar tax difficulties in the 1960’s, from avoiding USA Glass-Steagall banking regulation in the 1980’s, or from USA regulatory ineptitude on Sarbanes-Oxley in the 2000’s, and then watching its tripartite regulatory regime turn out to be ineffectual.
If reformers can move past mud-slinging, intelligent use of off-shore centres might accelerate useful reforms to the global financial system. Out of the world’s 221 sovereign states and dependent territories in 2009, 67 have a population of less than 1 million (30%), such as the Bahamas, Guernsey, Isle of Man, British Virgin Isles, or Gibraltar. Off-shore centres have used their constitutional independence to develop legislation, regulation and tax vehicles that attract non-resident business. Many have used their comparative advantage to create world-class expertise in international financial services. The most enduring off-shore centres offer ways of transacting essential but regulatorily complex wholesale finance transactions, e.g. reinsurance in Bermuda.
Off-shore centres have four roles, long-term finance, regulatory simplicity, tax mitigation and secrecy. Off-shore centres are famous for two of their four roles, tax mitigation and secrecy. Secrecy is easily attacked – why do you have something to hide? When looked at from a stable country, this seems a cutting question, but there are many legitimate reasons to desire secrecy. When looked at from an unstable country, secrecy can mean being less vulnerable to extortion or kidnap, or more able to consider positive reforms. Still, secrecy can too easily correlate with criminality, particularly where money laundering is involved. One solution is what Bermuda, Barbados and other responsible off-shore financial centres do, have information agreements that allow competent authorities to share essential information responsibly, without risking legitimate people. There are many small states that need to attain these essential levels of transparency, but so too do many larger states.
Tax mitigation, as with all things to do with tax, is more complex. Off-shore centres act as "way stations" that facilitate complex international trade and investment flows. Imagine a Japanese company that builds and sells products in Britain, the USA, Turkey and Japan. If the holding company is based in an off-shore financial centre, corporation taxes on earnings will be paid in the British, US, Turkish and Japanese subsidiaries before they arrive in the holding company. Taxes on dividends are then paid by the shareholders when they repatriate their dividends home. There are no taxes in the "way station" because the money is in transit. Taxes are paid at the beginning and end of the journey, just not along the way.
Now imagine that the Japanese company is sold to Chinese shareholders and ceases trading in Japan. Where should taxes be paid? Again, the company’s operational subsidiaries should pay corporate tax in each jurisdiction and the Chinese shareholders should pay Chinese income and dividends taxes. Without the off-shore centre, taxes will be paid not just in the US where some activities take place, or in China where the investors are, but also in Japan where no activity or investors reside. Excessive taxation reduces the returns from international operations and trade. The off-shore centre acts as a tax "way station" that facilitates international trade and investment. Taxes are paid at the beginning of the journey where the activity takes place and when the investors are at the end of the journey, but not along the way. Tax mitigation (legal) can too easily become tax evasion (illegal), particularly where secrecy is too highly guarded.
The comparative advantage of off-shore centres is displayed in how they ‘signal’. In biology and economics, animals and people convey information about their abilities and intentions by ‘signalling’. Off-shore centres advertise their stability, their freedom from interference and their dependence on financial services, using such signals as credit ratings, legal codes or funds under management. The key message of these off-shore signals is that, unlike financial centres with large domestic economies, off-shore centres won’t do something stupid, e.g. radically change the tax code or impose onerous regulation at short notice. Off-shore centres walk a tight-rope across a chasm of claims on the one side that they are both capable of rapid change, and on the other side that they are havens of stability. For example, off-shore centres simultaneously claim that they can change legal codes rapidly when laws impede sensible decisions, yet also avoid hasty legislation when larger nations are senselessly reacting to domestic calls for action. Unlike larger economies, financial services are so important to off-shore centres that they must keep their balance.
A more integrated perspective of comparative advantage emerges from the argument that savvy off-shore centres enable longer-term financial planning. ‘Long finance’ structures, i.e. structures that can endure for a generation or two, benefit from avoiding the capriciousness of larger nations’ domestic agendas. A large nation can change tax rules or ownership rules at short notice. Well-regarded off-shore centres have achieved a reputation for avoiding hastily-enacted changes that would harm their own self-interests.
The current financial crisis suggests that large states have a comparative disadvantage in global finance. They seem unable to combine wholesale and retail financial regulation without incurring booms and busts. Nor are they paragons of virtue. It’s easy to sling mud back, though audience interest is low. Tens of billions are involved in one of the biggest cases of corporate corruption that surrounds BAE Systems (formerly British Aerospace), listed in the UK. The largest amounts of recorded money laundering took place through London, Zurich and New York, and there is no shortage of large nations’ banking sleaze. The comparative disadvantage of large states indicates that there may be a way to aid global financial reform through off-shore centres. In its simplest expression, large economies will never be able to regulate wholesale and retail properly, so push problematic wholesale financial activities towards designated off-shore centres, "mid-shore financial centres".
For example, larger nations’ banks could be controlled more simply by segregating wholesale and retail transactions. For all transactions where the hedges against market risk can be calculated using recognised exchanges and multilateral trading platforms cleared through a regulated clearing house, regulators would assess the residual risk, apply a small multiple and make that the regulatory market risk limit for the bank. If exchanges can similarly trade and clear simple credit products (not portfolio products sensitive to default correlation), the framework extends to regulatory credit risk limits as well. A bank can choose the risk it runs, up to that risk limit, and the exact hedges it wants to use, as long as the risk can be measured. Market and credit risk are now directly related to customer business. Exchanges would have an incentive to develop more useful hedging products, while the use of clearing houses means the risk in the system is closer to the transparent net exposure than to the gross exposure.
Regulation would force ‘proprietary’ trading by banks to mid-shore centres. This is one elaboration of ideas that limit retail banking to ‘utility banking’ and put ‘global finance’ elsewhere, just here it’s specific physical locations. Competition amongst mid-shore centres should create centres of excellence that have a better chance to get regulations and risk-reward balances correct than any single country. Mid-shore then becomes a known high-risk, high-reward zone, rapidly evolving regulatory structures that suit wholesale finance. Since global finance brings economic benefits, albeit at great risk, the possibility of keeping the benefits at lower risk is worth pursuing.
The idea of turning off-shore centres from convenient scapegoats to central participants in controlling global finance is interesting. Clearly, there are complexities. Despite the unpopularity of global finance, no large country will voluntarily give up its international banking companies and be at the mercy of mid-shore banking titans, out of reach and not responsible to anyone. As a consequence, mid-shore centres would have to be subject to an international legal system with enforcement powers, including criminal prosecutions.
Mid-shore global finance companies are likely to be profitable, possibly extremely profitable. No country will entertain the thought of powerful, mid-shore finance companies playing a substantial role in its economy without far better disclosure of transactions, profitability, risks and reserves. Politicians would have to level with the public that these centres exist to keep larger national retail finance safe. Claims of unfair competition would have to be countered in part by pointing out that these mid-shore companies ultimately contribute to the local economy, via taxes, but over time. Purposely taking the riskiest parts of global finance and putting them in a few jurisdictions will require thought about the role of a ‘lender of last resort’, if any. One could even speculate about a mid-shore currency, perhaps similar to Bernard Lietaer’s Terra, backed by physical commodity reserves in relation to the real economy. If mid-shore centres worked in Terras, or financed international trade in Terras, offering price risk management and ‘cash management’ in Terras, perhaps they’d acquire more legitimacy?
In summary, today’s off-shore centres contain good and bad, from money launderers and tax evaders to long-term planners and legitimate but complex wholesale financiers. Off-shore centres should continue to exist because on-shore regulators haven’t created sensible wholesale finance regulations and are subject to bouts of rapid regulatory change in response to domestic crises. Credible off-shore centres have moved well beyond primitive secrecy to build reputations based on tax mitigation, longer-term stability and regulatory simplicity. If larger nations separated retail and wholesale regulation, leaving wholesale to mid-shore centres, the comparative advantages of large and small could help achieve a more stable global financial system.
"It’s fun to charter an accountant
And sail the wide accountancy,
To find, explore the funds offshore,
And skirt the shoals of bankruptcy."
("Accountancy Shanty", Monty Python, The Crimson Permanent Assurance, 1983)