Andrew P. Morriss evaluates IFCs' competition on quality, discusses innovation and defends the need for more people to communicate the importance of IFCs.
International financial centers (IFCs) around the world play an important role in the world economy because they are different in important ways from large economies. This seems counter-intuitive to those unfamiliar with the mechanics of international financial transactions and jurisdictional competition. In everyday life, we expect larger markets to be the goal and bigger competitors to rule the roost and so it’s hard to understand why a smaller jurisdiction might have particular advantages over larger ones. After all, big stores like Wal-Mart seem to be outcompeting smaller high street stores. Throw in Hollywood’s use of locations like the Cayman Islands as a synonym for criminal activity and it becomes hard to escape the idea that financial centers must be up to something. Explaining why this popular image is wrong is hard work – making real financial transactions more compelling than Tom Cruise, Mafia lawyers and The Firm is a challenge. Everyone involved needs to take this task on, because if we don’t win the battle for how IFCs are perceived, we risk losing important tools that improve life for people around the globe. In almost 15 years of teaching and writing about the role of financial centers, and having taken students to the Cayman Islands, Guernsey, Hong Kong and Jersey to see the role IFCs play, I have found three key themes that help explain the ideas.
Competing on Quality
Everyone can understand competition and people recognize the difference between price competition for commodities and how firms selling more complex goods and services compete on both price and quality. This distinction is important to explaining the idea of ‘jurisdictional competition’, which is critical to understanding the role of IFCs. Jurisdictions compete to have people and firms bring their transactions to them. They do so because those transactions generate wealth, which makes the people living in the jurisdiction better off, which in turn generates tax revenues that fund everything from schools to hospitals to highways.
At this point, the critics of IFCs will agree that there is competition but they recognize only price competition. IFCs charge low rates of direct tax (often zero), so the critics contend that they’re undercutting larger jurisdictions on price and so costing the big jurisdictions their ‘fair share’ of tax revenue. This misses the crucial competition on quality.
How do jurisdictions compete on quality? First, they have regulators who understand the industries that they are regulating. I have attended the annual Insurance Managers Association of Cayman Captive Forum several times and the executives and lawyers for captives repeatedly mention how important it is that they have regular access to regulators who are versed in captive insurance as they think through their business decisions. Second, jurisdictions compete by having high quality legal systems, including excellent judges. UK Overseas Territories like Cayman, and Crown Dependencies such as Jersey and Guernsey, make considerable efforts to get top quality judges for their courts and are proud of the right of appeal to the UK Privy Council, giving litigants access to some of the finest trial and appellate courts in the world. Third, IFCs have clusters of top professionals, all located within a short distance of each other. The advice of excellent lawyers, bankers, accountants, fund managers, insurance managers and other financial industry professionals is readily at hand. Putting a business entity in a top quality IFC is like checking into a Ritz-Carlton hotel.
But what about those low or zero tax rates? Doesn’t that turn the Ritz into a cut-rate fleabag hotel? No. What critics never mention is the high level of indirect taxation in most IFC jurisdictions. For example, Cayman imports just about everything, including most food, because it is physically small and has little arable land. Import duties are high, serving as a quasi-consumption tax with low collection costs, since duties need only be collected at the airports and ports. Not only is a consumption-tax based system rational economically and cheap to operate, but the zero-direct tax regime makes the jurisdiction competitive as a neutral platform to collect investment.
There are 193 United Nations members today – why should we care whether there are a few more, or less? Do IFCs add anything to the mix? Absolutely. Their role in the global economy is quite different from larger, more diversified economies. If we didn’t have IFCs, the world economy would not function as well as it does.
Let’s think about two important types of transactions. Captive insurance (where the insured owns the entity that sells it insurance) plays an important role in lowering the cost and raising the quality of health care in the United States. Catastrophe bonds broaden the pool of capital available for reinsurance, cutting the cost of disaster insurance for homeowners and firms while giving institutional investors like pension funds a chance to diversify risk. Without jurisdictions like Bermuda and the Cayman Islands, the US captive market would be far less competitive. Structural innovations like portfolio insurance companies and the entire catastrophe bond market are the product of the competition among jurisdictions to attract business.
Similarly, investment funds require legal entities to hold their investments. Institutional investors and high net worth individuals want well-regulated investment environments rather than free-for-alls, but they also don’t need the type of regulation that are provided to smaller, individual investors. Innovative jurisdictions that can cope with everything from blockchain to derivatives facilitate creating such vehicles for investors.
What makes IFCs better competitors than their larger counterparts is that they don’t have to worry about simultaneously encouraging innovation and protecting vulnerable individuals from villains twirling pencil thin mustaches. IFC regulators can be nimble in ways that the US Securities and Exchange Commission can never be. Moreover, IFC regulators tend to have broader enforcement powers than large country regulators. US financial regulation is divided among multiple agencies at both federal and state levels and, to prevent abuse of power, regulators are constrained by important limits on their authority and their speed. By contrast, IFC financial regulators tend to have broader powers and fewer constraints. IFC governments don’t have to worry as much about restricting their regulators, both because they can keep a closer eye on the regulators and because everyone, including the regulators, knows that behaving abusively toward their customers will drive away business.
IFCs also play a crucial role in reducing the frictions in the world economy that slow growth. Sadly, much of the world doesn’t have legal systems that encourage growth. Where investors lack access to well-crafted business organizations laws, they will form fewer businesses. A key role for IFCs is to provide a location for investors from multiple jurisdictions to form business entities, with the IFC chosen because of the quality of its legal system. For example, Jersey trust law is well established, built on commonly understood principles, and kept up-to-date by the legal community working in tandem with the Jersey government. Jersey ‘exports’ its laws, by allowing the organization of business trusts there that will oversee economic activity elsewhere. The investors reduce the risk that their fellow investors or the trustee will cause problems by using Jersey law. Indeed, Jersey should be using the slogan ‘Exporting the Rule of Law Since 1204’! One needs look no further than failing states like Venezuela to see the need for a stable business law environment.
If we want the world’s economy to continue to have the benefit of the advantages IFCs bring to the table, how do we win the argument against the combination of Hollywood and IFC critics’ complaints about ‘lost’ tax revenue? Everyone involved, but particularly IFC governments and the industry, need to do (at least) three things.
1) Develop the data to back up the claim that IFCs are good for the world economy. The gold standard in this regard are the reports commissioned by Jersey Finance, Jersey’s Value to Britain (2nd edition, 2016) and Jersey’s Value to Africa (2015). These reports document the incredible impact of investments through Jersey and into other jurisdictions. Showing that Jersey-based investment supported almost 250,000 British jobs, brought £14 billion in investment into the UK, and led to £5 billion in tax revenue to the UK Exchequer demonstrates in a tangible way the importance of a financial center’s facilitation of investment into a jurisdiction. We need more reports like these from more jurisdictions.
2) Tell the story of how IFCs raise the quality bar in financial transactions. Regulators in IFCs have impressive credentials – much more impressive than many onshore regulators. The Delaware Secretary of State, a key corporate law player in the United States, oversees a department that – in addition to its corporate law duties – is responsible for almost twenty different agencies in fields ranging from the arts to veterans affairs. Similarly, talk about the impressive quality of the professionals who work in IFCs.
3) Connect the big picture to people’s lives. There are people in the United States who have free health care because charity hospitals saved money on their insurance needs due to Cayman captives. There are people in the UK who have jobs because of Jersey investment. There are thousands of such stories – and these need to be told to put a human face on the statistics about what IFCs mean to the world economy.
As the father of two amazing daughters, I want them to live their lives in a world where economic growth is the norm. IFCs play a critical role in making that possible. Getting the word out about that makes a difference.
Andrew P. Morriss Andrew Morriss is the Dean of Texas A&M University School of Innovation. Prior to this position, he was the Dean of the Texas A&M School of Law, the D. Paul Jones & Charlene A. Jones Chairholder in Law at the University of Alabama, the Ross & Helen Workman Professor of Law at the University of Illinois, and the Galen J. Roush Chair in Law at Case Western Reserve University.