One of the responses to the Credit Crunch of 2007-09 was increased pressure from large countries with large financial centres, on small countries with international financial centres.
These centres were characterised as tax and regulatory havens, detours designed to get round rules, sources of risk and generally uncooperative jurisdictions. The Cayman Islands, Turks and Caicos and British Virgin Islands received the brunt of these ‘attacks’ given their past tradition of private banking and bank secrecy. The use of Cayman-based corporate vehicles, by Republican, US Presidential Candidate, Mitt Romney, is seen by his opponents as an easy target. However, the attack on international financial centres goes far beyond bank secrecy or the Cayman Islands and it will lead to a dramatic change in the way all Caribbean financial centres operate, with some disappearing and others successfully positioning themselves to overcome these new challenges and grab the opportunities that will arise.
The Economic Role and Rationale of IFCs
The Cayman Islands, and other responsible Caribbean states should staunchly defend and develop their international financial centres for a number of reasons, not least because it makes strong economic sense. Small states have little other choice but to export ‘weightless’ professional services. With a few niche exceptions they cannot out-compete large states in agriculture or manufactures.
The most high-valued added weightless professional services are those that surround financial centres: asset managers, family offices, lawyers, accountants, asset-valuers, risk managers, financial educators and software developers. Finance can be scaled up without extra land and labour. The amount of labour and land required to manage US$1bn along a particular investment strategy is almost identical to the amount required to manage US$100bn along the same strategy but the fees are not discounted for large size. Indeed, they are often higher the more popular the fund is. The same cannot be said for agriculture, manufacturing or many of the labour intensive professional services like medical diagnostics or architecture. This flat supply curve of the finance industry makes it perfect for small states and - with their small public expenditures in absolute terms - allowing them to charge low marginal tax rates for financial business without these taxes representing a subsidy.
It also makes economic sense - seemingly perversely - for large economies to let international finance migrate to specialist small states. A large financial sector has a similar effect to the Dutch disease¹. It bids away talent from other sectors and pushes up wages across the economy to levels in which few remain internationally competitive. A large financial sector is more able to capture regulators and policy makers, to persuade governments of the need for bank bail-outs and for preferences or concessions. In short, a large financial sector distorts the real economy. It is far better located in well-regulated places where there is less ‘real economy’ to be distorted.
The Challenge to IFCs
Large financial centres exist in large states today and are the source of substantial revenues and patronage. They are not going to roll over and die. The path of international financial centres will be determined more by international politics than international economics. In the political arena, the only thing better than blaming ‘foreigners’ for taking ‘our’ jobs and taxes, is blaming foreign bankers. Large states will argue that IFCs beggar thy neighbours with permissive tax rates and regulation. They demand that small states harmonise tax and regulation in a way that will squeeze the breath out of them.
The attacks on certain IFCs are not without any justification. The quality of regulation in Cayman, Bermuda and Barbados, is not shared by all. Yet clients are not forced to go to an IFC and in general these attacks amount to a non-tariff barrier by large financial centres against competition from small states.
Evidence for this comes from the observation that the attacks are discriminatory. The largest so called ‘tax havens’ such as Delaware, Nevada and Wyoming are quietly left alone2. The attacks ignore the use of subsidies across a range of sectors that cannot be matched by small states, such as State support to the car industry3. Furthermore, these attacks are disproportionately harsh on small state IFCs given the relative lack of regulatory failure in these states. It is also a serious lapse of natural justice when conclaves of large countries appoint themselves as both judge and jury on the activities of non-members and proceed to apply strictures to those, while simultaneously resisting broad application of the same rules to themselves.
There is on the other hand no escaping that the drivers of international financial centres 20 years ago were competitive taxes and regulation - in the same way that the UK’s City of London captured the Eurobond market from New York through low taxes 40 years ago and the hedge fund and private equity market 10 years ago. Also, let it not be forgotten, ‘light touch regulation’ was London’s boast for over 10 years4. Whether the attacks on IFCs are justified or not, they have been made - and will continue to be made - given the fiscal challenges in developed countries. Low taxes and light regulation can no longer be the basis for growth or even survival of IFCs.
Critical drivers of IFCs going forward will be quality of regulation and people. This plays to the strength of some Caribbean states, but the reality will not be so straight forward. The large centres will argue that the IFCs must meet their standards, not withstanding the previous, monumental failure of these standards. This does not seem so unreasonable but the critical factor that militates against the incorporation of these standards is that they are not risk or size tolerant.
Although the largest occurrences of money laundering that have been uncovered so far have been through the large metropolitan centres5, it is small state IFCs that are required to make the largest proportional investment in AML. Through these non-tariff barriers the size advantage offered by finance’s scalability is neutered by the disproportionate cost small states have to pay to match the regulatory standards required by large states. In the year before the financial crisis, the UK’s FSA spent US$2bn on financial regulation annually and employed over 2,000 people - all to little avail, given that at one moment in 2008 the entire banking system was effectively guaranteed by the UK Government. Substantial expenditure and ticked boxes do not guarantee effective regulation but it does represent an effective barrier to entry for small territories.
The path currently being offered to small state IFCs is not a viable path. Even if an IFC had the resources to spend on the regulation of risks they are not vulnerable to, trying to imitate the large centres will always make them second best or worse in a world where customers have the ability and technology to access the best.
A Viable Growth Strategy for the Caribbean in the New Order
The only viable strategy for small state IFCs is a niche strategy. IFCs should identify sectors where there is a clear and credible advantage and focus on being world class in those niches. There are more opportunities in this space for the bold than might be imagined. While trading operations of investment banks need to be located next door to the trading operations of their competitors (so they can trade staff and share technologies and practices) and as a result are concentrated in a few financial centres in the world (New York, London and Singapore), the location of asset management firms is driven by their most important asset, their employees and their lifestyle location choices.
It is why asset management in the US, for instance, which used to be concentrated in Manhattan, Boston and Chicago has now branched out to Denver, Colorado, Newport Beach in California and Fort Lauderdale, Florida. It is why asset management is often in the ‘second’ less crowded, more ‘livable’ city of many countries such as Edinburgh in the UK, Munich in Germany, Geneva in Switzerland and Melbourne in Australia. Barbados could be a destination of choice for asset managers, especially with its proximity to major centres and good broadband connectivity.
There are important opportunities in regulatory fields as well. The primary purpose of financial regulation is to avoid systemic risk and to protect vulnerable consumers.
However, in an attempt to limit regulatory arbitrage within large and complex financial systems, or because regulators have been given many legitimate but not strictly financial-risk objectives, many of the activities which do not pose systemic or consumer risks are inappropriately regulated in the large centres.
International finance centres can identify these areas and offer specialist regulation that is neither light nor heavy but right-sized for the systemic risks involved in that activity. Bermuda is in effect trying to do just that and is a leading innovator in the world of captive insurance. The Cayman Islands, with stiff competition from Hong Kong, is trying to be the world-class specialist regulator of hedge funds. Jersey is a specialist in trusts and a number of related areas. To get this right, IFCs will have to take regulation so seriously that they are not in the game of imitation but in the game of innovation. This will require further investment, especially in the field of people and regulation. Those that do not make this investment now will see their financial centres wither away.
¹ The Dutch Disease is an idea which links the effect of financial and goods markets of a natural resource and the decline in the rest of the economy, see ‘The Dutch Disease’ (November 26, 1977), pp. 82-83, The Economist.
2 Wyoming, Nevada and Delaware, not only have minimal tax rates for international business, they do not require any proof of identification to set up a business and another 26 US States allow a LLC (limited liability corporate) to be set up without showing beneficial ownership. Inexplicably, they offer complete tax information exchange to any jurisdiction that wants it, it is just that they do not collect any tax information to share.
3 See, Persaud, B. (2002). The OECD Harmful Tax Competition Policy: A Major Issue for Small States, in International Tax Competition (ed) Biswas, R. London: Commonwealth Secretariat.
4 “…and now the determination of the financial services authority to extend their risk-based approach of financial regulation that is both a light touch and a limited touch”, UK Chancellor, Gordon Brown, December 2005, http://www.hm-treasury.gov.uk/1847.htm
5 In 2005, The Bank of New York settled with US regulators for US$38m regarding the largest money laundering scandal in history that broke in 1996. The illegal operation involved two Russian émigrés - one who was a Vice President of the bank - moving over US$7bn via hundreds of wires. Former President Noriega is being held in France for laundering drug money through Paris. In 2010, the Vatican Bank came under investigation for money laundering between Rome and Frankfurt.
Avinash D. Persaud is Emeritus Professor, Gresham College; Senior Fellow, London Business School, Visiting Fellow, CFAP, Judge Institute, Cambridge University; 2010 President, British Association for the Advancement of Science (Section F) and formerly a Governor, London School of Economics. Professor Persaud was ranked as the #2 public intellectual in the world on the financial crisis by an expert panel for ‘Prospect Magazine’ at the end of 2009. He is currently Chairman, Elara Capital PLC; Chairman, PBL; Chairman, Intelligence Capital Limited and Board Director of RBC Latin America & the Caribbean and Beacon Insurance. He was Chairman, Warwick Commission; Chairman, regulatory sub-committee of the UN High Level task Force on Financial Reform; Co-Chair, OECD EmNet; Member, UK Treasury's Audit and Risk Committee; Member, Intergovernmental task force on financial taxes and Member, Pew Task Force to the US Senate Banking Committee.