Finance and Economy

Tax Havens Jeopardise the Stability of the Financial Markets

The analysis and publication by journalists of previously confidential data from known tax havens – widely known as ‘Offshore Leaks’ – has excited media interest around the world. However, one important aspect was not addressed by the media: not only do tax havens lead to the loss of tax revenues and enable capital flight and money laundering, but they were also a major contributory factor to the financial crisis of 2007/2008 and continue to jeopardize the stability of the financial market.

Tax havens laid the groundwork for the rise of unregulated financial institutions (the so-called shadow banks), they facilitate the avoidance of regulatory and prudential supervisory requirements, and they substantially increase competitive pressures in favour of light regulatory systems. Every step towards the re-regulation of tax havens and shadow banks is a positive step in crisis prevention and in the protection of working people against the huge economic costs of financial crises.

A contested term with problematic associations

The term “tax haven” is problematic in itself, notwithstanding that it has now become firmly established in public discourse. For one thing, the term “haven” arouses in people positive associations with harbours, and suggests above all a place of refuge, an enviable shelter from the storm. In addition, the term is also problematic because it foregrounds only the aspect of taxation and fails to address the issue of the continuous avoidance of regulatory regimes by financial institutions, something which is made possible and facilitated in “havens”. Whereas tax havens are characterised by very low or even zero tax rates and by strict confidentiality rules regarding banking and tax data – used by non-residents to enable tax avoidance, tax evasion and money-laundering (Palen et al. 2010: 23ff) – as well as the refusal of, or only restricted exchange of, information with other states concerning such non-residents (Rixen 2009: 10), regulatory havens are characterised by weak financial regulation. This includes non-disclosure of ownership structures, a lack of interest in foreign companies on the part of regulatory authorities, and the possibility of avoiding capital requirements (Troost/Liebert 2009: 79). Financial institutions which have relocated to regulatory havens are typically owned by non-residents, and the financial sector there is bigger than is required for the financing of the domestic economy (Rixen 2009: 10).

From a geographical perspective, the use of the term regulatory haven as distinct from tax haven may seem irrelevant (and of course it also fails to solve the problem identified with regard to the positive associations of the term “haven” itself), since states or territories are often simultaneously tax and regulatory havens. But distinguishing between the terms is necessary both for analytical reasons and with regard to possible policy initiatives: combating regulatory havens requires measures that explicitly address the problem of the avoidance of regulatory and prudential supervisory requirements – such measures may be different from those required to combat tax evasion and avoidance. Inadequate regulation of financial market participants and tax exile or avoidance are “two sides of the same coin” (Troost/Liebert 2009: 75), and must be recognised as such if they are to be effectively opposed.

Tax and regulatory havens in Europe

The Tax Justice Network has produced a list of the least transparent financial locations (tax and regulatory havens) (TJN 2011). Top of the list is Switzerland, followed by the Cayman Islands, Luxembourg, Hong Kong and the United States. This demonstrates clearly that tax and regulatory havens are not restricted to palm-fringed exotic islands, nor are they always full nation-states. Two of these locations, it is worth noting, are European states, and the Cayman Islands are a British Overseas Territory.

The United States, too, is among the top five, because individual territories within the United States (e.g. Delaware) can be classified as tax and regulatory havens. Some regulatory havens in Europe have also recently – that is, since the onset of the financial crisis – reduced regulatory requirements in order to attract financial institutions or to lure them away from other havens. In Ireland, for example, the financial crisis did not bring about a rethink: the Financial Act (2010) makes the transfer of investment funds to Dublin easier. Funds are registered for operation on the next working day in Ireland if the documentation is submitted by 3 pm. Due to their size and complexity, it is virtually impossible for the documents to be thoroughly inspected by the close of business (Stewart 2010: 2).

Moreover, the Irish supervisory authorities have made it clear that they consider themselves responsible only for financial institutions headquartered in Ireland. Funds are therefore scrutinised neither by the regulatory authorities before registration nor by the supervisory authorities afterwards (Troost/Liebert 2009: 79). In Luxembourg, the largest and most important location for investment funds in Europe, a new law means that approval is granted in advance for new funds as long as the regulatory authority is informed within a month of their establishment (Stewart 2008:2). Since 2006 the Channel Island of Jersey has allowed the establishment of new foundations administered via a trust but wholly owned by the founder (Murphy 2008: 38). In September 2007 it was announced in Jersey that hedge funds with over one million dollars in deposits would in future no longer need to worry about permission to register, external auditing or data publication.

The shadow banking system is considered to have been a major cause of the financial crisis and in many cases links to regulatory havens could be demonstrated.

Shadow banks: market participants in tax and regulatory havens

The shadow banking system and regulatory havens are distinct but closely-related phenomena. Participants in financial markets use so-called shadow banks to bypass domestic regulation. Although it is true that shadow banks can, in principle, also be set up outside regulatory havens, the majority of them are found in tax and regulatory havens (Rixen 2009: 17). Troost and Liebert (2009: 76) maintain that before the financial crisis the emergence of the shadow banking system and the threat it posed to financial market stability were not noticed in part because this occurred almost entirely in tax and regulatory havens.

Put simply, the term shadow banks is understood to mean those financial institutions that carry out bank-like activities without being regulated like banks. Though there is no universal definition of a shadow bank, special purpose vehicles, credit-financed hedge funds and money market funds are in most cases regarded as shadow banks. The shadow banking system is considered to have been a major cause of the financial crisis and in many cases links to regulatory havens could be demonstrated. The collapse of the Northern Rock bank, for example, was triggered by the special purpose vehicle Granite, which was quoted in Jersey and officially belonged to a charitable foundation of Northern Rock. The German regional banks, too, established the majority of their off-balance-sheet special purpose vehicles in regulatory havens, which made effective supervision impossible for the German authorities: Sachsen LB in Dublin, the IKB in Delaware and West LB, too, had subsidiaries in Ireland. In 2006 Sachsen LB’s Irish companies employed only 45 people but generated almost all the group’s profits (Stewart 2010: 14ff). In the USA, almost the whole of the 700 billion dollar aid package was allocated to the shadow banking sector (Ricks 2010:4).

A threat to financial market stability

The financial crisis has renewed interest in the effects of tax and regulatory havens on the stability of the financial system. International organisations, regulatory and supervisory authorities and the European Commission have investigated the risks posed by the shadow banking system to the stability of the financial markets, and have identified it as one of the main causes of the financial crisis (EK 2012, FSF 2000).

However, the fact that the shadow banks are predominantly based in tax and regulatory havens is not mentioned. Despite this, it is clear that the risks identified as being posed by the shadow banking system for financial market stability are also associated with tax and regulatory havens and are at the least intensified by them. In the first place, the significant growth in assets and liabilities in tax and regulatory havens increases the risk of contagion effects. This is where the tax dimension and the financial market dimension mesh: on the one side, loan capital interest in “high-tax countries” can be set off against taxes, while the profits generated thereby are collected and distributed tax-efficiently in tax havens; at the same time, regulatory havens and shadow banks enable loan capital limits to be bypassed and increase the growth of the debt ratio. Secondly, tax and regulatory havens facilitate the growth – presumed, in the absence of data – of the off-balance-sheet activities of the financial institutions.

No financial market participant in public ownership or receiving state support should be permitted to continue to operate in tax or regulatory havens.

This means that transactions are shifted to legally independent, non-consolidated firms which nonetheless continue to be closely connected. By this means, risk exposures are concealed and not covered by a sufficient level of equity capital. Thirdly, tax and regulatory havens hinder the global monitoring of financial markets, as national supervisory authorities are dependent for the inspection of legally independent subsidiary companies in regulatory havens on the willingness of the local supervisory authorities to cooperate. Fourthly, regulatory havens foster competition over lower supervisory and regulatory standards, a “downwards regulatory spiral”. The existence of tax and regulatory havens enables economic interest groups and financial market participants to promote a reduction in regulation on the grounds that it will secure or increase domestic competitiveness (Rixen 2009: 19). Finally, the danger of bank runs is also increased because when crisis conditions develop within the financial system, the consciously fostered lack of transparency, especially concerning ownership structures, further weakens trust in individual shadow banks acting in the market and in the financial system as a whole.

Policy implications and measures

Tax and regulatory havens do not bear sole responsibility for the financial crisis: the deregulation of financial markets was not restricted to the regulatory havens. But they made it easier for interest groups, politicians and financial market participants to call for lighter regulation in the home market and to link this call with the competitiveness argument. Moreover, stronger regulation at the global level as a result of the financial crisis – so long as it does not remain mere lip service – will further increase the incentive for financial market participants to shift into tax and regulatory havens.

As tax and regulatory havens are two sides of the same coin, and as tax and financial market aspects interact reciprocally, any measure taken to close tax havens (such as lifting banking confidentiality rules in Austria and Luxembourg) will also improve the stability of the financial system. But beyond that, measures are required which are directly and explicitly designed to counter the threat posed by tax and regulatory havens to the stability of the financial markets. One possibility is to include regulatory havens in a risk map (Issing et al.2009: 10ff). This would make it possible, for example, to set higher equity ratio requirements for financial institutions with connections in regulatory havens so as to take full account of the increased risks. Alternatively, financial institutions could simply be prohibited from doing business in countries with inadequate regulation. At any rate, no financial market participant in public ownership or receiving state support should be permitted to continue to operate in tax or regulatory havens. As regards shadow banks, the European Commission is working on a regulatory proposal currently still in the development phase. It is still too early for a proper evaluation of the proposed regulations – above all, one has to wait and see precisely what regulatory proposals are statutorily prescribed following the consultations with interest groups.

At any rate, the public must be informed of the dangers posed by the existence of tax and regulatory havens to financial market stability, and that every step towards re-regulation in finance policy is a positive step for crisis prevention. Because, sadly, the last few years have demonstrated strikingly that the huge economic costs of financial crises are borne predominantly by working people.

 

This article was originally published on Gegenblende.

References

Europäische Kommission (EK) (2012): Grünbuch Schattenbankwesen. Brüssel. [18.07.2012]
Financial Stability Forum (FSF) (2000): Report of the Working Group on Offshore Centers. Basel. [18.07.2012]
Issing, O./Asmussen, J./Krahnen, J.P./Regling, K./Weidman,J./White, W./Center for Financial Studies/Goethe-Universität(2009): New Financial Order. Recommendations by the Issing Committee. Preparing G-20, London, April 2, 2009. White Paper No. II. [18.07.2012]
Murphy, R. (2008): Tax havens creating turmoil. Evidence submitted to the Treasury Commitee o f the Ho use of Commons. London: Tax Justice Network UK.
Palan, R./Murphy, R./Chavagneux, C. (2010): Tax Havens. How Globalisation Really Works. New York: Cornell University.
Ricks, M. (2010): Shadow Banking and Financial Regulation. Columbia Law and Economics Working Paper No. 370.  [18.07.2012]
Rixen, T. (2009): Paradiese in der Krise. Transparenz und neue Regeln für Steuer- und Regulierungsoasen. Schriften zu Wirtschaft und Soziales, 4, Heinrich Böll Stiftung.
Stewart, J. (2008): Shadow regulation and the shadow banking system. In: Tax Justice Network (TJN) (Hg.): Tax Justice Focus. 1-4.
Stewart, J. (2010): Financial Innovation and the Financial Crisis. Paper präsentiert auf der International Schumpeter Society Conference 2010.
Tax Justice Network (TJN) (2011): Financial Secrecy Index 2011.  [18.07.2012]
Troost, A./Liebert, N. (2009): Das Billionengrab. Von Steueroasen und Schattenbanken. Blätter für deutsche und international Politik, 3, 75-84.

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Tax Havens Jeopardise the Stability of the Financial Markets

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