Regulatory Effectiveness in OFCs

Offshore financial centers (OFCs) provide significant competition for onshore jurisdictions on tax and regulatory measures.[1] Not surprisingly, onshore jurisdictions are unhappy about this competition. In an effort to delegitimise their competitors, onshore politicians1 sometimes claim that OFCs are engaged in a “race to the bottom” in financial regulation – harming the world economy by undercutting important regulatory schemes. Such complaints come from all sides of the ideological spectrum – liberals and conservatives in North America and Europe unite in denouncing lax regulation and low taxes in OFCs. To correct this problem, the OECD countries (and the OECD) campaign for international “best practices” on everything from tax rates and information exchange, to regulatory practices.

The claim that OFCs are lax regulators has two weaknesses. First, it ignores differences between OFCs and onshore jurisdictions that influence the effectiveness of regulatory measures, such as their relative need to protect retail investors and the effectiveness of informal constraints. Second, leading OFCs deploy resources that are comparable to leading onshore jurisdictions by many measures. While better data would be welcome, we believe that leading OFCs do well in fair comparisons with leading onshore jurisdictions.

Creating a Fair Comparison

One significant difference between onshore and offshore regulators is what they seek to accomplish. Most onshore financial regulators have mandates to protect retail investors; by contrast, OFC regulation is designed for institutional investors. Securities law expert Prof. Donald Langevoort notes that “The [US] Securities and Exchange Commission thinks of itself as the investors’ advocate, by which it means retail investors[.]” To protect those investors, the SEC mandates extraordinarily costly disclosure that many analysts believe inhibits innovation in financial markets. A jurisdiction with a different focus for its regulatory infrastructure will necessarily allocate resources differently as well.

These measures often provide little protection to investors. For example, Apple’s regulatory filings routinely disclose that it “competes in global markets that are highly competitive and characterised by aggressive price cutting.” Requiring firms to repeatedly state the obvious does little to protect investors. Moreover, US regulators in particular have proved remarkably ineffective at preventing even massive financial frauds like Bernie Madoff’s, Enron, or Worldcomm. Structuring a regulatory regime differently is not a decision to have lax regulation; it may reflect different regulatory goals and differences in the effectiveness of regulatory strategies across jurisdictions.

A second difference between OFCs and onshore regulators stems from their incentive structures. Onshore economies like the United States, United Kingdom, France or Germany offer large financial markets. Investors and businesses seek entry into such markets for the opportunities they offer despite regulatory burdens these jurisdictions impose. OFCs, on the other hand, offer only their legal regimes and service providers. There is limited scope for major investment in small economies like the Channel Islands, Cayman Islands, BVI, or Barbados. These jurisdictions offer access to clusters of service providers and make sophisticated business structures available to meet the needs of sophisticated investors. OFCs have pioneered the segregated portfolio company, the VISTA trust, and captive insurance precisely because they depend on mobile capital. Many of these entities may require fewer regulatory resources to adequately regulate. VISTA trusts, for example, are innovative because they include features that make it more likely, not less, that the trustee will follow the settlor’s wishes. This reduces the need for regulation.

OFCs do not “race to the bottom” because such a race risks their reputations as legitimate jurisdictions. Once gone, such reputations are hard to rebuild. Because of its size and attractiveness to investors, the US economy and SEC can survive a Madoff scandal in which the regulator demonstrated stunning levels of incompetence. No OFC could survive a similar scandal; the Stanford International Bank scandal caused Antigua to lose business as a financial center, despite the fact that it was also a failure of the US regulatory system. The stronger reputational constraints imposed on OFCs thus serve as a powerful mechanism to promote regulation aimed at safeguarding their reputation.

OFCs’ small size relative to onshore economies also provides an advantage in administering regulatory agencies. Large economies must rely on costly formal checks and balances to constrain regulators. Smaller jurisdictions, such as OFCs, are able to avoid these costs by substituting informal constraints such as personal monitoring and moral suasion for formal institutions. Corruption is harder to hide where government regulators are well known to their neighbours than in a nation of 300 million. Moreover, smaller jurisdictions appear better able to hold their officials to account. No American SEC employee lost his or her job as a result of the agency’s failure to prevent the Madoff fraud. In contrast, the Antiguan regulator who failed to catch Allen Stanford not only lost his job but was arrested.

These factors suggest that a simple comparison of inputs across regulators – the primary basis for much onshore criticism of OFCs – will fail to adequately capture differences. Indeed, these factors point towards the conclusion that OFCs may have significant structural advantages in regulating the financial industry relative to large onshore jurisdictions.

Comparing Regulators

Cross-jurisdictional regulatory comparisons are made difficult by the complex nature of modern business structures. Consider BVI and Delaware, the leading OFC and onshore jurisdiction for business entities. BVI has more than 450,000 registered entities; Delaware more than 850,000. But Delaware’s include over half of the Fortune 500 companies, while BVI’s are generally smaller. One might therefore expect Delaware to have a more complex regulatory task than BVI. Yet the Delaware regulator, the Secretary of State’s office, is a far less sophisticated body than BVI’s in many respects. Headed by a political appointee with little to no financial industry experience, the Delaware Secretary State oversees a wide range of non-financial activities, including arts funding and veterans’ affairs.

If we simply count regulators per capita, an admittedly crude measure of regulatory resources, we find that OFCs compare well to onshore regulators. (To compile these numbers, we contacted leading onshore and offshore jurisdictions in 2010-11. More details are available in our forthcoming Virginia Journal of International Law article cited earlier.)

Table 1: Financial Regulators per Capita