Popular discussions of financial regulation often presuppose a binary regulatory framework between strict (good) jurisdictions and lax (bad) jurisdictions. IFC critics argue that IFCs are lax jurisdictions. This view is overly simplistic as it fails to account for differences among IFCs. As a result, it misses the effectiveness and efficiency of IFC regulatory frameworks. A more textured understanding reveals the important contributions IFCs make to strengthening global financial regulation.
The Need For Multidimensional Regulation
A lax-strict axis might explain simple regulations. Knowing the allowable maximum rate of interest can determine compliance with usury caps. Most financial regulation, however, is not so straightforward. For example, the degree of flexibility offered a captive insurance company in designing its investment strategies varies depending on the types of risks being insured, the amount of capital, and the level of risk shifted to the reinsurance markets. Such multidimensional transactions make lax-strict comparisons meaningless because of the multiple regulatory tradeoffs required. High volumes of complex transactions increase regulatory efficiency by providing regulators with experience at balancing the tradeoffs. This enables market specialisation, as with Bermuda in reinsurance and Cayman with medical malpractice captives.
Additional dimensions are needed to properly evaluate the effectiveness of regulatory frameworks and whether the costs imposed produce the desired policy outcomes. Consider the anti-money laundering (AML) regime in the United States, which imposes a duty to report “suspicious” transactions. US depository institutions filed more than 1.1 million reports of such transactions in 2019. This appears “strict” – financial institutions report a large number of transactions driven by the fear of penalties if they failed to report a transaction later found to be part of a money laundering operation. However, to determine the effectiveness of this “strict” AML regime, we need to know how many successful money laundering or other criminal prosecutions resulted from this reporting, the value to the government of conducting those prosecutions (did they disrupt major criminal networks or merely flag recording violations by otherwise legitimate parties) and the overall cost/benefit of AML reporting to both the government and the private sector.[i] Without such information, labelling the AML regime as “strict” or “lax” does not evaluate its effectiveness.
Moreover, financial markets evolve too quickly for effective regulation based on a single dimension. Reflecting on the 2008 global financial crisis, former Bank of International Settlements (BIS) general manager and chief executive officer, Malcolm Knight noted that a persistent governance challenge in financial regulation was the constantly innovating nature of the financial services industry. Because these innovations often alter the structure of the financial system, “new risks arise that are not well understood by investors or the financial institutions that develop them, with the prospect that severe financial stresses may arise and not be managed effectively”.[ii] The 1960s US Interest Equalization Tax was a “strict” regulatory scheme intended to prevent foreign borrowing in US capital markets; the development of Eurodollar and Eurobond markets rendered it irrelevant. As Herring and Litan noted, “When U.S. bank customers found they could not roll over their certificates of deposit in U.S. banks at the market rate of interest, many simply transferred their deposits to Eurobanks—often shell branches of their American banks but located beyond the reach of interest-rate ceiling regulations”.[iii] The financial innovation quickly made the strict regime irrelevant.
IFCs On The Regulatory Cutting Edge
IFCs are a major source of new products and legal structures in the global finance industry. This provides IFC regulators with a head start in understanding the potential risks and stresses these innovations impose on the existing regulatory framework. Their regulatory responses help guide global responses. For example, IFCs were among the leaders in licensing corporate and trust service providers and have quickly adapted more general licensing regimes for legal vehicles to innovations such as the development of special license classes for Insurance Linked Securities (ILS) vehicles.
While IFCs’ financial product innovations are readily recognised, their developments in regulation are equally important. Given the importance of reputation to sustain a strong financial services industry, IFC regulators have more “skin in the game” than do regulatory bodies in larger economies. A single Madoff case could be fatal to a small jurisdiction’s reputation. Large economies such as the United States, European Union, or China might weather multiple regulatory failures and Ponzi schemes, and similar disasters recur without investors doing more than shrug. As Nassim Nicholas Taleb has argued, “skin in the game” is an important creator of appropriate incentives in finance and IFC regulators have much more at stake than do large economy regulators.[iv] IFC regulators and professionals understand that a healthy financial sector depends on their effective regulation, track-record, and reputation.
IFCs’ role in regulatory innovation was recognised by the 1998 UK Home Office review of the Crown Dependencies (CDs) (Jersey, Guernsey and the Isle of Man), the “Edwards Report”. Commissioned by an arm of the UK Government, not particularly sympathetic to IFCs, to review the CDs’ laws, systems, and practices for regulation as well as for the combatting of financial crime and cooperation with other jurisdictions,[v] the Edwards Report recognised that the CDs provided:
Innovation and flexibility. The offshore centres are sometimes better able than the larger centres to test out innovative financial products such as new insurance or investment vehicles. They can respond flexibly and quickly to the changing needs of international customers and markets. In the larger centres, the ramifications of change are typically wider.
Regulation. The offshore centres may also be able to lead the way in certain areas of regulation. Examples are the regulation of Trust and Company services providers.[vi]
More than 20 years later, IFCs are still providing “innovation and flexibility” and often “leading the way” in regulation. They continue to innovate and to lead because they are embedded in a densely layered set of networks through which ideas about laws, regulations, best practices, and solutions are spread.
Networks As Solution Sources
Internal IFC regulatory innovation and experience contribute to global and regional regulatory and policy bodies overseeing international financial regulation. One example is IFCs’ participation in the Basel Committee on Banking Supervision (BCBS). Created to address the regulatory weaknesses that led to the 1974 collapses of a German bank and an American bank caused by foreign exchange speculation, the BCBS did not initially include IFCs. However, in the 1980s Jersey States’ Economic Advisor Colin Powell brought IFCs and the BCBS together. Powell went on to forge “the longest and closest relationship between the BCBS and non-G10 regulators”.[vii] This collaboration gave the BCBS the benefit of IFC banking regulators’ experience and expertise.
Networks are important methods of generating and spreading solutions to problems. For example, the IFC-BCBS collaboration rapidly bore fruit in improving the international financial environment. In 1989, IFC regulators agreed to apply the Basel I standards to their banks; in 1991 Powell successfully advocated for more stringent standards, participation criteria based on effective banking supervision, and stronger sanctions against non-compliant regimes.[viii] Without IFC participation, it is unlikely the consensus-driven Basel process would have been able to move this quickly. Similarly, the Edwards Report acknowledged that the CDs “have taken a leading role in seeing to promote high standards in the offshore generally”. [ix] This included spearheading the development of the Offshore Group of Banking Supervisors (OGS), including the Group’s involvement with FATF processes, and development of the Offshore Group of Insurance Supervisors (OGIS) in 1993 (which later evolved into the International Association of Insurance Supervisors (IAIS)).
Although IFCs are small jurisdictions and so their regulators are smaller in absolute size than larger jurisdictions, their regulators are proportionate to the size of their financial sectors in terms of staffing per regulated entity.[x] IFCs invest in their regulatory bodies by recruiting internationally recognised experts. IFCs as jurisdictions are also deeply engaged with pan-jurisdictional bodies, ranging from interest groups like the IFC Forum to specialised organisations of regulators, such as the International Organisation of Securities Commissions (IOSCO) and the International Association of Insurance Supervisors (IAIS).
Participation of IFC regulatory staff in these bodies has a larger impact in a small jurisdiction than the homeopathic impact that participation of large economy regulators does on their home jurisdictions. IFC regulators often have high levels of industry experience, giving them deep knowledge of industry practices and connections, while comparable large jurisdiction regulators have less international and relevant private sector experience. IFC regulators have careers that span multiple jurisdictions, giving them an invaluable multi-jurisdictional network and perspective. For example, all ten directors of the Jersey Financial Services Commission have significant professional experience in other jurisdictions, and include a former UK Financial Secretary, a former Central Bank of Ireland regulator, former CEOs of multi-jurisdictional firms, and multiple members with experience in European institutions and multinational regulatory bodies.[xi]
IFCs bring to the table the expertise of this dense network of governments, regulators, and professionals in ways that larger jurisdictions cannot. For example, trust and company service providers have gone from an industry dominated by small, single jurisdiction businesses to one with large, multi-jurisdictional service providers, which are often publicly traded companies, such as JTC and CITCO. Keeping up with a rapidly evolving industry is difficult for large jurisdictions, where legislative and regulatory programmes might be decades in the making. Moreover, part of what makes the spread of ideas for new products – whether a segregated portfolio company or the purpose trust -- possible is that jurisdictions are connected through the international regulatory framework for the financial system as well as through private sector networks.
The IFC experience demonstrates the importance of depth in the regulatory system to cope with the regulatory demands of new financial products and services. IFCs provide that regulatory depth in ways that larger jurisdictions do not. Although seemingly counterintuitive – surely bigger regulators’ larger staffs and resources have room for deeper expertise – the apparent contradiction is resolved by IFCs’ greater “skin in the game” and ability to leverage their participation in dense networks of regulators, service providers, and multinational institutions.
While IFCs benefit from the international connections and networks that the global regulatory framework provides, the ultimate beneficiaries are consumers of financial products and services and the regulatory framework as a whole. IFCs provide a necessary interaction between the market and regulators that addresses immediate needs and develops the capacity and structure to meet future needs at a tolerable cost and effective level of regulatory complexity. Recognising this relationship and fostering its development will be important to address the anticipated higher rate of innovation and resulting complexity in financial products and services to come. It is time to shift the regulatory conversation away from simplistic lax-strict comparisons to focus on improving the robustness of the overall global framework. IFCs have much to offer in that conversation.
[i] See Richard Gordon & Andrew P. Morriss, Moving Money: International Financial Flows, Taxes & Money Laundering (with Richard Gordon), 37 Hastings Int’l & Comp. L. Rev 101 (2013).
[ii] Malcolm D. Knight, Reforming the Global Architecture of Financial Regulation the G20, the IMF and the FSB, CIGI Papers No. 42 (September 2014): 1 available at http://eprints.lse.ac.uk/61213/1/SP-6%20CIGI.pdf., at 14.
[iii] Richard J. Herring & Robert E. Litan, Financial Regulation in the Global Economy 20 (Brookings 1995).
[iv] Nassim Nicholas Taleb, Skin in the Game: The Hidden Asymmetries in Daily Life (2018).
[v] Andrew Edwards, Letter of Transmittal, UK Review of Financial Regulations in its Offshore Territories, 24 October 1998 available at https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/265705/4109.pdf
[vi] Andrew Edwards, Letter of Transmittal, UK Review of Financial Regulations in its Offshore Territories, 24 October 1998 available at https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/265705/4109.pdf; Edwards Report, Section 2.14.5.
[vii] Charles Goodhart, The Basel Committee on Banking Supervision: A History of the Early Years, 1974-1997 (Cambridge, 2011) at 417.
[viii] Goodhart, 417, 424, 480.
[ix] Edwards Report, Section 17.5, paragraph 201.
[x] Andrew P. Morriss & Clifford C. Henson, Regulatory Effectiveness & Offshore Financial Centers, Va. J. Int’l L. 417 (2013).
[xi] The JFSC directors’ biographies are listed on the Commission website, https://www.jerseyfsc.org/about-us/directors/
Charlotte Ku is a Professor at Texas A&M University School of Law. Her specialties include international law and global governance. She has previously served as Professor and Assistant Dean for Graduate and International Legal Studies at University of Illinois College of Law, Acting Director of Lauterpacht Research Centre for International Law at University of Cambridge, and Executive Director and Executive Vice President at American Society of International Law.
Andrew Morriss is Professor of the Bush School of Government & Public Service and School of Law at Texas A&M University. Prior to this position, he was the Dean of the Texas A&M School of Innovation, 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.