When an entire global financial system collapses, it is reasonable to expect some bickering over the ultimate fixing of things. Rumors of dissention and talk of stimulus-paved roads to hell made everyone squeamish going into the April summit of the G20 group of large and industrialized nations in London. French President Nicolas Sarkozy even threatened to walk out on the whole thing if he didn’t get his way.
The French were perhaps right to be nervous: they were taking a somewhat socialist stand, declaring that unregulated shadow banking and offshore tax havens were at the heart of the financial crisis and had to be either controlled or eradicated. They were doing it in a city at the center of the shadow system, and at a summit chaired by British Prime Minister Gordon Brown, a man recently described by the Financial Times as “one of the principal cheerleaders for the competitive international deregulation of international financial markets.”
But Gordon Brown had already announced his intention to lead the global crackdown on tax havens as a first step toward global financial recovery. German Chancellor Angela Merkel had long backed France in calling for regulation of hedge funds, the poster boys of shadow banking charged with fostering the crisis. And, to Sarkozy’s delight, everyone kept their promises at the G20.
“Major failures in the financial sector and in financial regulation and supervision were fundamental causes of the crisis,” read the summit’s reassuringly clear communiqué. World leaders agreed to regulate all systemically important financial institutions, including hedge funds and those located in tax havens, under threat of sanctions for noncompliance. “The era of banking secrecy is over,” they concluded, as close to united as anyone could have dreamed.
But unity that looks good on paper is always more difficult to achieve in reality. The lingering questions post-summit are the same ones Sarkozy may have pondered on his way to London: will leaders from countries made rich from offshore banking follow through to shut it down? What is at stake, and what will the globally coordinated regulation everyone agrees is necessary actually look like? Not surprisingly, there are no easy answers.
Nature of the beast
Over the years, trillions of dollars in both corporate profits and personal wealth have migrated “offshore” in search of rock bottom tax rates and the comfort of no questions asked. Tax havens and other financial centers promoting low tax rates, light regulation, and financial secrecy include a long list of tropical nations like the Cayman Islands as well as whole mainland economies from Switzerland to Singapore.
Tax Justice Network, an international non-profit advocating tax haven reform, estimates one-third of global assets are held offshore. The offshore world harbors $11.5 trillion in individual wealth alone, representing $250 billion in lost annual tax revenue. Treasury figures show tax havens sucking $100 billion a year out of U.S. coffers. And these numbers have all been growing steadily over the past decade. A Tax Notes study found that between 1999 and 2002, the amount of profits U.S. companies reported in tax havens grew from $88 billion to $149 billion.
With little patience left for fat-cat tax scams, the public is finally cheering for reform. Tax havens, it seems, have become the perfect embodiment of suddenly unfashionable capitalist greed. Unemployed workers and unhappy investors grow hot with anger as they imagine exotic hideouts where businessmen go to sip poolside martinis and laugh off their national tax burden.
Reformers have tried and failed in the past to shut down these locales. But analysts say 2008, the year the global financial system finally collapsed under its own liberalized weight, made all the difference. Not only are governments now desperate for tax revenue to help fund bailouts, but a recognition of the role offshore financial centers played in the system’s implosion is dawning.
Along with the G20 fanfare, economists and policymakers including Treasury Secretary Timothy Geithner have pointed to the shadow banking system as a root cause of the global crisis. They’re talking about the raft of highly-leveraged, virtually unregulated investment vehicles developed over the last 20 years: hedge funds, private equity, conduits, structured investment vehicles (SIVs), collateralized debt obligations (CDOs), and other wildly arcane investment banker toys.
While most of these innovations were born of Wall Street imaginations, few found their home in New York. Seventy-five percent of the world’s hedge funds are based in four Caribbean tax havens: the Cayman Islands, Bermuda, the British Virgin Islands, and the Bahamas. The two subprime mortgage-backed Bear Stearns funds that collapsed in 2007, precipitating the credit crisis, were incorporated in the Caymans. Jersey and Guernsey, offshore financial centers in the Channel Islands, specialize in private equity. Many SIVs were created offshore, far from regulatory eyes.
We now know that hedge funds made their record profits from offshore bases by taking long-term gambles with short-term loans. The risky funds were often backed by onshore banks but kept off those institutions’ books as they were repackaged and sold around the world. Regulators never took much notice: one, because lobbyists told them not to; two, because the funds were so complex that George Soros barely understood them; and three, because many of the deals were happening offshore.
Beneath regulatory radar, shadow bankers were able to scrap capital cushions, conceal illiquidity, and muddle debt accountability while depending on constant refinancing to survive. When the bubble burst and investors made a run for their money, panicked fund managers found it impossible to honor their debts, or even figure out how to price them as the markets crumbled.
William Cohan writes in his new book on the Bear Stearns collapse (House of Cards: A Tale of Hubris and Wretched Excess on Wall Street) that it took the brokerage three weeks working day and night to value illiquid securities when two of its Cayman-based hedge funds fell apart in 2007. In the end, the firm realized it was off by $1 billion from its original guesstimate, on just $1.5 billion in funds.
Mortgage-backed securities that once flourished in offshore tax havens are now the toxic assets that U.S. taxpayers are being asked to salvage through the trillion-dollar TARP and TALF programs.
This convoluted network of offshore escapades is what world leaders have vowed to bring under global regulatory watch in order to restore worldwide financial stability. To their credit, the crackdown on banking secrecy has already begun in a big way.
In February, secret Swiss bank accounts were blown open to permit an unprecedented Internal Revenue Service probe. Europe’s UBS bank has admitted to helping wealthy Americans evade what prosecutors believe to be $300 million a year in taxes.
Switzerland, the world’s biggest tax haven where at least $2 trillion in offshore money is stashed, has long refused to recognize tax evasion as a crime. Every nation has the sovereign right to set its own tax code, which is why regulators have had such a hard time challenging offshore banking in the past. The dirty secret of tax havens, as President Obama once noted, is that they’re mostly legal.
Under U.S. law, tax avoidance (legal) only becomes tax evasion (illegal) in the absence of other, more credible perks. In other words, a company is free to establish foreign subsidiaries in search of financial expertise, global reach, convenience, etc., just so long as tax dodging does not appear to be the sole reason for relocation.
The IRS will tax individual American income wherever it’s found, but finding it is often the key. To access account information in Switzerland, authorities had to have proof not merely of tax evasion but of fraud, which is what much white-knuckled investigation finally produced on UBS. In the wake of this success, and under threat of landing on the OECD’s new list of “uncooperative” tax havens, all of Europe’s secrecy jurisdictions-Liechtenstein, Andorra, Austria, Luxembourg, and Switzerland-have signed information-sharing agreements.
Following the blood trail, congressional investigators descended on the Cayman Islands in March to tour the infamous Ugland House: one building supposedly home to 12,748 U.S. companies. The trip was an attempt to verify some of the implicit accusations made by a Government Accountability Office report in January which found that 83 of the United States’ top 100 companies operate subsidiaries in tax havens.
Many of those, including Citigroup (which holds 90 subsidiaries in the Cayman Islands alone), Bank of America, and AIG, have received billions in taxpayer-funded bailouts. But the report failed to establish whether the subsidiaries were set up for the sole purpose of tax evasion.
Politicians are already patting themselves on the back for their success in tackling tax crime. Everyone is making a big deal of the new tax information-exchange standard that all but three nations (Costa Rica, Malaysia, and the Philippines-the OECD’s freshly minted blacklist) have agreed to implement in the wake of the G20 meeting. What leaders aren’t saying is that before it became a G20 talking point, tax information exchange was actually tax haven fans’ favored reform measure.
The first thing most offshore officials claim when confronted with criticism is that their countries are not, indeed, tax havens. Since the OECD launched a tax policy campaign in 1996, many of the offshore centers have been working to clean up their acts. A hoard of information-exchange agreements with onshore economies were signed even before Switzerland took the plunge. Geoff Cook, head of Jersey Finance, says Jersey’s agreements with the United States, Germany, Sweden, and others have long outpaced what banks in Switzerland and Singapore traditionally maintained. “Our only fear in this is that people wouldn’t look into the subject deep enough to draw those distinctions,” Cook said.
But analysts say the agreements lack teeth. To request information from offshore, authorities must already have some evidence of misconduct. And the information-exchange standard still only covers illegal tax evasion, not legal tax avoidance. More importantly, what is already evident is that these agreements don’t change much about the way offshore financial centers function. Offshore centers that agree to open up their books still have the luxury of setting their own regulatory standards and will continue to attract business based on their shadow banking credentials.
The G20 decided that shadow banking must be subjected to the same regulation as onshore commercial activity, which will also see more diligent oversight. Financial activity everywhere will be required to maintain better capital buffers, they said, monitored by a new Financial Stability Board; and excessive risk-taking will be rebuked. But the push for harmonized regulation across all financial centers revokes a degree of local liberty. Big ideas about state sovereignty and economic growth are at stake, which is probably what made Sarkozy so nervous about taking his regulatory demands global.
“People come here for expertise and knowledge,” argues head of Guernsey Finance Peter Niven, and he may have a point. Many in finance think it’s wrong to put all the blame on private funds and offshore centers for a crisis of such complex origins. Havens say stripping away their financial freedoms is hypocritical and shortsighted. “It’s really not about the Cayman Islands, it’s about the U.S. tax gap-and we’re the collateral damage,” said one frustrated Cayman Island official, adding: “Everybody needs liquidity and everyone needs money. That’s what we do.”
Predictably, reform critics warn that responding to the global crisis with “too much” regulation will stifle economic growth, something they know world leaders are quite conscious of. “International Financial Centres such as Jersey play an important role as conduits in the flow of international capital around the world by providing liquidity in neighbouring (often onshore) financial centres, the very lubrication which markets now need,” wrote Cook in a recent statement.
Overall, attempting to move beyond paltry information exchange to implementing real regulation of shadow banking across national jurisdictions promises to be extremely difficult.
Part of the solution starts at home. Offshore enthusiasts might be the first to point out that the Securities and Exchange Commission never had the remit to regulate onshore hedge funds because Congress didn’t give it to them. Wall Street deregulation is often cited in Europe as the base rot in the system.
But demanding more regulation onshore won’t do any good if you can’t regulate in the same way offshore. A serious aspect of the tax haven problem is a kind of global regulatory arbitrage: widespread onshore deregulation over the last 20 years came alongside an affinity for doing business offshore where even less regulation was possible, which in turn encouraged tax haven-style policies in countries like Britain, the United States, Singapore, and Ireland, all fighting to draw finance back into their economies.
President Obama has long been a champion of both domestic and offshore financial reform, and a critic of the deregulation popular during the Bush years. But for global action to happen, Obama needs Europe’s help (not to mention cooperation from Asia and the Middle East) and no one knows how deep Gordon Brown’s commitment runs. It is only very recently that Brown transformed himself from deregulation cheerleader as chancellor of the exchequer under Tony Blair to global regulatory savior as Britain’s new prime minister.
In an interview late last year, Tax Justice Network’s John Christensen predicted Britain could become a barrier to reform. “Britain, I think, will become increasingly isolated, particularly in Europe where the City of London is regarded as a tax haven,” he said. When British manufacturing declined, the City of London became the nation’s new breadwinner. It grew into the powerhouse it is today largely by luring business away from other centers with the promise of adventurous profit-making and mild public oversight.
The City now funnels much of its business through British overseas territories that make up a big faction in the world’s offshore banking club. Many offshore officials have accused Britain of making a show of tax haven reform to deflect attention from its own dirty dealings onshore.
Other obstacles to reform could come from Belgium and Luxembourg, which each hold important votes at the Basel Committee on Banking Supervision (a leading international regulatory voice) and the EU. Neither country has shown much enthusiasm for Europe’s reform agenda. And no one will soon forget that China nearly neutered the G20 communiqué when it refused to “endorse” an OECD tax haven blacklist that would allow Europe to chastise financial activities in Hong Kong and Macau.
Still, the regulatory tide is strong and rising; even global financial heavyweights may find it unwise or simply impossible to swim against it. For perhaps the first time since the end of World War II, the world appears open to the kind of global cooperation necessary to facilitate global integration in a socially responsible way.
But the tiny nations that have built empires around unfettered financial services will surely continue to fight for their place in the sun. Some may go the way of Darwinian selection. Declining tourism is already crippling economies across the Caribbean. But many more are optimistic about their ability to hang on. Guernsey is pursuing Chinese markets. Jersey claims business in private equity remains strong. Bermuda still has insurance and hopes to dabble in gambling. Many offshore say they welcome the coming reforms.
“We look forward to those challenges” said Michael Dunkley, leader of the United Bermuda Party, noting that Bermuda, a tiny island with a population of just 66,000 people, is not encumbered by big bureaucracy when it comes to getting things done. Whatever new regulations come up, he said: “Bermuda would be at the cutting edge of making sure it worked.”
Accusations of capitalist evil aside, one can’t help but admire their spirit.
Rachel Keeler is a freelance international business journalist. She holds an MSc in Global Politics from the London School of Economics, and is currently dabbling in East African investment analysis while soaking up the sun in Nairobi, Kenya. Her recent work has appeared in the Financial Times and Ratio Magazine.
Published by Dollars and Sense
SOURCES: Willem Buiter, Making monetary policy in the UK has become simpler, in no small part thanks to Gordon Brown, Financial Times, October 26, 2008; G20 Final Communiqué, “The Global Plan for Recovery and Reform,” April 2, 2009; Tax Justice Network; Martin Sullivan, Data Shows Dramatic Shift of Profits to Tax Havens, Tax Notes, September 13, 2004; William Cohan, House of Cards: A Tale of Hubris and Wretched Excess on Wall Street, March 2009; U.S. Government Accountability Office, “International Taxation: Large US corporations and federal contractors in jurisdictions listed as tax havens or financial privacy jurisdictions,” December 2008; Organisation for Economic Co-operation and Development. “A Progress Report on the Jurisdictions Surveyed by the OECD Global Forum in Implementing the Internationally Agreed Tax Standard,” April 2, 2009; Geoff Cook, Response to Financial Times Comment, March 5, 2009; William Brittain-Catlin, How offshore capitalism ate our economies-and itself, The Guardian, Feb. 5, 2009.