THE RESEARCH EDITION VOLUME 4, NUMBER 2 TAX JUSTICE FOCUS Shadow regulation and the shadow banking system Jim Stewart 1 EDITORIAL Not on my watch please The quarterly newsletter of the tax justice network Nicholas Shaxson and John Christensen 4 FeatuRES Financial flows – the big picture Phillip Sarre 6 In need of a fix Thomas Rixen 9 Making the link: tax, governance and civil society SHADOW REGULATION AND Oliviia McDonald 11 REPORTS THE SHADOW BANKING SYSTEM Offshore Financial Centres: Creating Turmoil John Christensen 13 The role of the Dublin International Financial Services Centre Tax Justice Netherlands Attiya Waris 14 BOOK REVIEWS The emerging financial problems in played by tax havens and offshore financial This shadow banking system has boomed International Tax as International Law global markets have been described centres with “light touch” regulation. This over the last decade or so, as a variety of Sol Picciotto 15 article focuses on their role in the crisis and new players have evolved or emerged in the as “the worst financial crisis since ANALYSIS looks specifically at the Dublin International international financial system. Some are hedge The language of offshore John Christensen 16 the Great Depression.” The crisis is Financial Services Centre (IFSC,) where many funds or investment banks, or more arcane Conduits or Structured Investment Vehicles ongoing, and it is uncertain how deep of the funds that have collapsed or have been PHOTO COMPETITION 17 (SIVs) which are artificial structures created or protracted it will be. in difficulties are located. by banks or other institutions, off their balance CALENDAR 18 A shadow banking system sheets. These players in the shadow banking here has been much analysis of this system behave rather like traditional banks – The Bank for International Settlements Editor: Nicholas Shaxson topic and various policy reforms have they borrow short-term money and then lend Contributing editor: John Christensen T been proposed: these include looking (BIS) in its 78th annual report identified one it again at longer-term maturities – but outside Design and layout: www.tabd.co.uk at the role of ratings agencies, mark-to-market of the main roots of the crisis. “How,” it asked, traditional regulatory structures. Instead of Email: info(at)taxjustice.net Published by the Tax Justice Network International rules, greater transparency, and especially “could a huge shadow banking system emerge taking deposits, like “normal” banks do, they Secretariat Limited reform of financial regulation.Very little has without provoking clear statements of official raise funds in other ways, such as by issuing © Tax Justice Network 2008 been written, however, on the role in this crisis concern?” commercial paper. For free circulation, ISSN 1746-7691 SECOND QUARTER 2008 VOLUME 4 ISSUE 2 TAX JUSTICE FOCUS “The shadow banking system has lain hidden for years, untouched by regulation, yet free to magically and mystically create and then package subprime loans into a host of three- letter conduits that only Wall Street wizards could explain.” Most of the activity associated with the so- The role of tax havens called ‘conduits’ (off-balance sheet vehicles) One important reason for the lack of official is regulatory arbitrage: it exists to avoid attention to the growth of the shadow restrictions placed on banks. Bank supervisors banking system was the extensive use of tax turned a blind eye to it. Bill Gross, founder of havens. the US financial firm Pimco, said this shadow banking system “has lain hidden for years, Historically, hedge funds were often domiciled untouched by regulation, yet free to magically in the Cayman Islands, Bermuda or the and mystically create and then package British Virgin Islands. However, competition subprime loans into a host of three-letter between financial centres on regulation conduits that only Wall Street wizards could (and tax) is considerable, and more recently explain.” European jurisdictions, notably the Channel Islands, Ireland and Luxembourg, have been Bank regulation exists for very good reasons. “streamlining” regulation, among other things, Banks must set aside cushions of capital to to attract funds. protect the banks against downturns and other unforeseen events, to prevent problems In Ireland, for example, if the relevant Taken in June, this photograph shows the Cayman-registered motor vessel Turmoil reflected in the front door of turning into systemic panics. Such panics are documents are provided to the regulator by Citigroup’s offices in Dublin. Investors are currently nervous about more than a trillion dollars parked by Citigroup in off-balance sheet vehicles. rare, but the collapse of Britain’s Northern 3 p.m. the fund will be authorised the next Rock last year was a clear example of one. day. A prospectus for a quoted instrument is a It was not especially the low-tax regime that Bear Stearns hedge funds incorporated in complex legal and financial document (a debt attracted funds to Dublin, but other features: the Cayman Islands announced considerable In the shadow banking system, institutions instrument issued by Sachsen Bank ran to 245 Ireland ticks certain boxes for funds and the losses. Bear Stearns had two investment were able to sidestep this kind of regulation pages) so it is unlikely it could be adequately regulators in their home countries, including funds and six debt securities listed on the and borrow money against much smaller assessed between 3 p.m. and the normal close the fact that certain EU directives apply, and Irish Stock Exchange, and it also operates capital cushions than traditional regulators of business (5 p.m.) Even worse, Luxembourg being within the Euro currency zone is also three subsidiaries in the Dublin IFSC through would accept. As a result, systemic risk has a new law stating that as long as the highly attractive. Perhaps most alluring of all, a holding company, Bear Stearns Ireland Ltd., increased dramatically. “Perhaps,” the BIS fund manager “notifies” the regulator within however, is its “light touch regulation.” for which every $1 of equity financed $119 report said, “it is simply that no one saw any a month of launch, the fund can enjoy pre- of gross assets – an exceedingly high (and in pressing need to ask hard questions about authorisation approval. The Financial Times Bear Stearns is so far the biggest institution most circumstances dangerous) ratio. the sources of profits when things were going has noted that the Luxembourg regulator to have collapsed from this credit crunch. so well.” does not “scrutinise promoters”. Problems emerged in June 2007 when two (Cont’d) 2 SECOND QUARTER 2008 VOLUME 4 ISSUE 2 TAX JUSTICE FOCUS Where is the regulator? “ ‘financial innovation,’ Box 1: How, and by whom, was Bear Stearns Ireland Ltd. regulated? The accounts state that the EU Directive on Financial Regulation 2006/48/EC), states in the current crisis Irish group and subsidiaries are regulated by Art 21: Irish Financial Services Regulatory Authority. appears to have The host member state should be responsible for the supervision of the liquidity of the EU directives seem clear the host country motivated by opaque branches and monetary policies. The supervision of market risk should be the subject of – Ireland in this case – has responsibility for close cooperation between the home and host member states. regulation. (See Box 1.) shifting of risk, Yet despite the location of managed funds Art. 22 and substantial operations in Ireland, the and avoidance of The competent authorities of the host member state, should be able, in an emergency, to Irish regulator does not feature in any verify that the activities of a credit institution comply with the relevant laws, etc. media analysis or discussions relating to the regulation.” insolvency and subsequent take-over of Bear Stearns. In an interview, the Irish regulator considers his remit is to ‘Irish banks’ – that Box 2: is, banks that have their headquarters located in Ireland. Four German banks with funds quoted in Dublin ran into difficulties in the subprime crisis – Bayern LB, IKB, Sachsen LB and West LB. One of these banks, IKB Bank, sustained Nineteen funds reported as facing difficulties losses of €2 billion from an off balance sheet conduit called Rhineland PLC with funds in the sub-prime crisis, have been identified quoted in Dublin. as located at the Dublin IFSC. Almost always, the IFSC link is not discussed. There is an Eventually the German government was required to provide the bank with €7.8 billion exception, however: the case of four German in state aid. Sachsen bank required emergency funding of €17.3 billion because of liquidity banks (see Box 2). Between them, they difficulties with a Dublin based subprime fund called Ormond Quay and received state required state aid from the German taxpayer aid of €2.8 billion. totalling €16.8 billion as a result of the losses from the shadow banking system. And yet none of the accounts or prospectus for any of the years examined mentioned regulation or the Irish regulator. Within Ireland the Financial Regulator has been quoted Some people argue that financial innovation as saying that they have no responsibility for entities whose main business is raising and associated with risk management has been a investing in funds based on subprime lending. major source of economic growth, particularly in the US. But “financial innovation,” in the This stance has been repeated by commentators in the media. The Financial Times, for current crisis appears to have motivated example, blamed the difficulties faced by German banks exclusively on the state-owned by opaque shifting of risk, and avoidance of banks and the structure of the German banking industry. regulation. Jim Stewart is Senior Lecturer in Finance, Trinity College, Dublin. 3 SECOND QUARTER 2008 VOLUME 4 ISSUE 2 TAX JUSTICE FOCUS NOT ON MY WATCH PLEASE editorial We are living through a period of consequences.