Memorandum from Professor Ronen Palan
and Dr Anastasia Nesvetailova
There is a link between offshore finance and
financial stability. We believe that this connection lies in the
financial cycle and more specifically in the maintenance of illusion
of liquidity. The secrecy and opacity provided by the offshore
financial centres, and most crucially, the manipulation of ownership
which had developed due to non-existent, or in most cases, de
facto loose regulation of new financial entities and their
functions, facilitated the construction and maintenance of liquidity
illusions in the markets. In "good times" financial
actors seem prepared to take risks with such ambiguity, assuming
that tax evasion schemes are part of the rules of the game. But
the moment the mood in the market turns sour, as happened in August
2007, this creates an added dimension of fear as no one can be
sure who will honour debts of what are legally speaking, separate
entities. This was an important contributing factor in the current
crisis that began in August 2007. We believe, therefore, that
OFCs are an important element in the link between the illusion
of liquidity that preceded the current crisis, and the puzzling
disappearance of this liquidity, virtually overnight.
Thank you for this opportunity to share our
thoughts on some of the lessons of the current financial turmoil
1. In each and every financial crisis or
scandal over the past twenty years, the names of offshore jurisdictions
pop up. This is true for the crises in East Asia, Russia, Argentina,
firms like LTCM, Parmalat, Refco, Enron and most recently, Northern
Rock. Yet the link between the type of offshore financial centres
(OFCs) commonly known as tax havens and financial instability
has not been widely researched and is not well understood.
2. A minority of economists take the view
that OFCs have a positive impact because they increase competition
among financial centre and hence, the argument holds, increase
efficiency and innovation. This opinion, however, is never supported
by empirical evidence and remains by and large, a theoretical
proposition. The consensus nowadays is that tax havens are certainly
not enhancing financial stability; nor are they improving in any
ways the system of financial governance, but instead, are contributing
factors to instability and crisis. This view is represented by,
among others, the ad hoc Committee on OFC seconded to the Financial
Stability Forum (FSF). On the basis of research into the causes
of the East Asian crisis of the late 1990s, the FSF concluded,
for instance, that OFCs were not the major cause of the crisis,
but a contributing factor.
3. In this brief, we would like to draw
the attention of the Committee to an important, though scarcely
discussed, link between offshore finance and financial stability
(though this point has been raised by Tax Justice Network's submission
as well). We believe that this connection lies in the role OFCs
play in the cycle of financial liquidity. More precisely, we believe
that OFCs are an important element in the link between the illusion
of liquidity that preceded the current crisis, and the puzzling
disappearance of this liquidity, virtually overnight.
4. As members of the Committee may recall,
just a few months before August 2007, the mainstream view in financial
commentary maintained that the world economy was, in the words
of the Chairman of the Fed, Ben Bernanke, "flush with liquidity."
The IMF also has warned about inflationary dangers of the global
liquidity glut. A small minority of heterodox economists never
shared the sense of optimism. They warned that this apparent liquidity
glut was an entirely artificial construction that may end up in
a big crushas it did. These commentators include Head of
research and policy at the Bank of International Settlements,
Basle, Claudio Borio
as well as one of the co-authors of this submission.
This artificial nature of the liquidity boom, or what Hyman Minsky
called "Ponzi," or pyramid finance, is what has really
been at the epicentre of the boom of securitised finance.
5. How come the illusion of liquidity had
been sustained for such a long period of time?
We now believe that the answer to this question may to an extent,
lieand again we emphasise that OFC played a contributing,
not a principle factorin the grey area of financial innovation,
which today encompasses offshore financial facilities, regulatory
avoidance, speculation and outright fraud.
6. We suspect that the secrecy and opacity
provided by the offshore financial centres, and most crucially,
the manipulation of ownership which had developed due to non-existent,
or in most cases, de facto loose regulation of new financial
entities and their functions, facilitated the construction and
maintenance of such liquidity illusions in the markets. Financial
actors are perfectly aware of these manipulations, which includes
ambiguities in asset ownership and distribution and responsibility
for risk. Such ambiguities are used largely for tax purposes as
a way of transferring profit-making financial activities to zero
or near-zero jurisdictions and/or to obtain higher rating for
"innovative" financial instrument from the rating agencies.
But as we will see, in the case of tax havens/OFCs one can kill
two (or even more) birds in one go: tax avoidance and evasion
schemes can easily be used for other purposes as well. Offshore
entities can be used, for instance, with great ease for the purpose
of isolating ownership of offshore financial vehicles from their
onshore parents in order to obtain higher credit rating from the
rating agencies. This exactly what happened and eventually precipitated
the current financial crisis.
7. In "good times" financial actors
seem prepared to take risks with such ambiguity, assuming that
tax evasion schemes are part of the rules of the game. But the
moment the mood in the market turns sour, as happened in August
2007, this creates an added dimension of fear as no one can be
sure who will honour debts of what are legally speaking, separate
entities. To put it simply, no one knows for sure if, for instance,
Northern Rock will take the responsibility for the estimated £50
billion debts of what was assumed to be its offshore SPV, Granite,
because legally, Granite is a separate entity. Since this particular
relationship is replicated through the thousands and thousands
of SPVs set up in offshore world-wide, the problem is of systemic
8. To begin to understand the full scale
of the problem therefore, we would like to draw your attention
to the great ambiguities of language and terminology, often perpetrated
by those who benefit from this ambiguity. In this brief we will
be talking about three aspects of this ambiguity: The grey zone
between what is an "offshore financial centre" and a
"tax haven"; b) what does "financial innovation"
really mean; c) ambiguity about the meaning of "liquidity".
All three, as we show below, have been at the epicentre of the
current malaise on financial markets and specifically, of the
fiasco of UK's Northern Rock.
9. Due to the highly politicized debate,
and the association of tax havens with evasion, money laundering,
criminality and embezzlement, few tax havens carry the tag "tax
haven" with pride. In fact, most if not all deny any association
to tax, or tax havens, and seek to present their policies as benign
forms of Preferential Trade Regimes (PTRs). At best, or worst,
some tax havens are prepared to accept the less pejorative designation,
"offshore financial centers" (OFCs). Some of them may
indeed advertise their offshore business sector in their official
websites. As a result the term tax haven is no longer popular
and is increasingly replaced by the term OFC, particularly by
international economic organizations such as the International
Monetary Fund (IMF), the Financial Action Task Force (FATF), the
Financial Stability Forum (FSF) and so on. We believe this to
be a mistake. Tax havens and OFCs are two distinct phenomena.
They evolved for different purposes and at different historical
periods. Just as tax havens can serve also as flag of convenience
and may host, say, an export processing zone, they can also develop
an OFC sectoryet, tax haven and OFC should not be confused
one from the other.
10. The term "tax havens" gained
currency since the beginning of the 20th century. Tax havens were
used primarily, but not exclusively, for the purpose of tax evasion
and avoidance, including inheritance tax. They served, of course,
other purposes as well, including money laundering, capital flight,
and offered stringent secrecy provisions which proved attractive,
for instance, to less enamored couples seeking to avoid punitive
divorce settlements. OFC is a more recent development and the
term became current only in the early 1980s. OFCs began life as
financial centers specializing in non-resident wholesale financial
transactions, otherwise known as Euromarket transactions. The
original OFC developed in September 1957 in London. The market
became known popularly as "offshore" because it escaped
nearly all forms of financial supervision and regulations. As
an unregulated market, the market is global in reach and trading
take place among many OFC spread around the entire planet. The
world's most important OFCs are London, New York's International
Banking Facilities (IBFs) and Tokyo's Japanese Offshore Market
11. An OFC strategy, in fact, is a logical
extension of the tax haven strategy as both are the product of,
and benefit from, avoidance. Furthermore, the lack of regulation
or light supervision that characterizes of tax havens can easily
be used (or abused) for reasons for tax avoidance and money laundering
purposes as well. British banks and corporations, for instance,
realized early on the advantages of tax havens for Euromarket
operations and began to establish subsidiaries in Crown Colonies
as booking offices already in the early 1960s. They were followed
soon by North American banks that preferred the Caribbean havens.
The result is a confusion between different type of OFCs. Booking
centers or what the IMF calls OFCs are "more lightly regulated
centers that provide services that are almost entirely tax driven,
and have very limited resources to support financial intermediation.
While many of the financial institutions registered in such OFCs
have little or no physical presence, that is by no means the case
for all institutions".
This submission is concerned primarily with the last two categories
of OFCs, tax havens and "regional" centers, both of
whom, we believe, thrive effectively as tax havens and secrecy
12. Having commenced operation in this way
in the 1950s and especially during the 1960s, the attraction of
this model became obvious. It was necessary that tax havens attracted
particular expertise to service the market they had attracted
for non-resident wholesale financial transactions. The expertise
required was that of accountants, lawyers and bankers. Once established
in these places these persons, almost all of them expatriate with
regard to the taxation looked for other markets to exploit using
similar "offshore" techniques, incorporating the absence
of nearly all forms of financial supervision and regulation. The
consequence was the expansion of the tax on points and evasion
market using the trusts, foundations and international business
corporations that they could sell based on the legislation that
they advised their tax haven posts to adopt. As such over time,
the OFC became something more than a Euromarket facilitator, it
became the combination of professional firms that supplied tax
haven clients with the structures for regulatory avoidance in
other jurisdictions that the tax haven had created.
13. These type of "OFCs" benefited
enormously from the emergence of the Euromarket. BIS statistics
of international assets and liabilities of banks show that some
tax havens are among the world's premier's financial centers.
The Cayman Islands in ranked sixth largest financial centre in
the world in terms of assets (sometimes fifth or even fourth by
some other measures), Jersey 16th and the Bahamas 17th. In fact,
if we add the onshore/offshore types of centers such as Switzerland
(7th), the Netherlands (8th) and Luxembourg (9th), then the list
of OFCs is dominated by tax havens. About 20% of all international
banking assets and liabilities are loated in such centers. Although
presenting themselves as financial centers, they are not.
14. Financial innovation is a tricky term.
On the one hand, much like in any other sphere of activitytechnology,
science, trade- innovation is a healthy component of economic
progress. It thrives at the juncture of competitive entrepreneurial
spirit, desire to minimise costs, raise efficiency and ultimately,
enhances social welfare. Credit cards, or internet banking, for
instance, have made our daily life both dynamic and conformable.
On the other hand however, innovation in finance, unlike in other
sectors of the economy, spurs from the financiers' constant drive
to escape regulation. Unlike in other spheres of economic activity,
the nature of finance, with its reliance on financial engineering
and globalisation of IT technology, has not only facilitated the
process of inventing new products and investment techniques -
such as securitisation or subprime loansbut transformed
it into a lucrative line of business. Increasingly, the spread
of this process has made regulatory avoidance (or "regulatory
arbitrage", as the literature calls it), the key channel
of innovation in finance.
15. This aspect of financial globalisation
is not new at all, although as a subject of study, it has escaped
the lens of mainstream economics ad political science. Some 20
years ago, the few students of financial innovation pointed out
that in financial markets, a great impetus to innovate comes from
"regulatory arbitrage"a desire to circumvent
existing regulations in taxation and accounting, without necessarily
breaking the law."
In his case study, Shah found that with the great help of investment
bankers and lawyers, companies are able to design sophisticated
schemes of regulatory avoidance. The regulators, the media and
analysts were unable to expose these practices publicly and restrain
such creativity. He writes: "overall | practicing creative
accounting is not that difficult, owing to the significant grey
area that exists between compliance with the rules and non-compliance
or evasion| The collusion between management, bankers, lawyers
and auditors suggests that there is an avoidance industry out
there which is capable of undermining the spirit behind accounting
regulations." Shah also noted that the self-regulatory nature
of UK accounting standard setting, and lack of explicit legal
status of financial supervision are fertile grounds for the practice
of "creative accounting".
16. The nexus between the two elementsthe
self-regulation of the financial industry, and the ambiguity that
exists at the juncture between law and new financial practices,
created a grey zone for competitive financial innovation, or,
more accurately, regulatory avoidance. Thriving in this grey area,
innovation has produced a skewed structure of the financial system
itself. When interest rates are low, financiers are looking for
other ways of making money: through commission fees, tax evasion,
"creative accounting", and outright fraud.
17. Among the many factors supporting this
skewed structure of finance, in this brief, we focus on the role
of regulatory avoidance in the shape of offshore finance or tax
evasion, and the role of liquidity illusions in sustaining the
bouts of financial speculation. These elements have been at the
epicenter of the Northern Rock fiasco in the UK in late 2007,
and are representative of more general trends in the financial
18. Many recent financial crises including
that in East Asia as well as scandals associated with dot com
bubble, Enron, World Com, Parmalat and to some degree, Northern
Rock and the 2007-08 subprime crisis have been blamed, at least
in part on the opacity of current accounting practices and the
use of tax haven affiliate entities for either fraudulent or opaque
purposes. Opacity is benefiting those who are, as one of the directors
of Enron is reputedly quipped: "the smarter man in the room".
The small investor, by definition if not the stupidest in the
room, at least the one least equipped to handle complex and rapidly
changing information. Opacity is used and abused in effect to
shift risk from big financial institutions to society at large.
Of course, scandals and frauds not only cheat investors, they
leave many workers without pensions and jobs, and have contiguous
effects on the entire economy that ultimately bears the resulting
risk without enjoying the risk premium that created it.
19. The offshore entities that seem to have
caused most of the problems are the special purposes vehicles
or entities (SPVs, or as they are called sometimes SPEs). SPVs
raise severe prudential problems. SPVs hit the headlines following
the collapse of Enron. A congressional committee investigating
the Enron affairs emphasized that Enron's fraud was organized
through 3,000 SPVs. Enron set up over 800 registered in well known
offshore jurisdictions, including about 120 in the Turks and Caicos,
and about 600 using the same post office box in the Cayman Islands'
(Congressional 23). It appears that Enron's offshore SPVs were
set up primarily for tax avoidance purposes, although they served
to hide debts as well. To be fair, despite headlines reports,
neither the Powers report, nor the congressional hearings have
demonstrated that conclusively offshore structures were palpably
more poisonous that the onshore ones in the Enron case.
20. SPVs are often described as asset
holding vehicles, they are used to park and isolate high-risk
assets. These entities are subsidiaries of large companies normally
established to serve as a risk management tool, such as when financing
large projects. They are used primarily, or so it is argued, to
reduce the cost of bankruptcy, but due to weaknesses and ambiguity
in accounting they are used for other purposes as well. Financial
institutions also make use of SPVs to take advantage of less restrictive
regulations on their activities. Banks, in particular, use them
to raise Tier I capital in the lower tax environments of OFCs.
SPVs are also set up by non-bank financial institutions to take
advantage of more liberal netting rules than faced in home countries,
reducing their capital requirements.
21. Tax havens have made it exceedingly
easy to set up offshore SPVs but crucially they do not have the
resources, especially in terms of people, to perform appropriate
due diligence on what are very sophisticated financial vehicles.
For example, the Cayman banking system holds assets of over 500
times its GDP. Jersey holds resources of over 80 times its GDP.
It seems obvious to ask whether such small jurisdictions can allocate
sufficient resources to monitor and regulate such colossal sums
of money. A recent report by the UK's National Audit office has
clearly suggested that they do not.
As we all know now, after its demutualization Northern Rock became
a bank and commenced an aggressive expansion path which resulted
in its 2006 audited accounts showing that it raised just 22% of
its funds from retail depositors, and at least 46% came from bonds.
22. For the following we are grateful for
research conducted a tax expert, Richard Murphy. Murphy demonstrates
that those bonds were not issued by Northern Rock itself, but
by what became known as its "shadow company". This was
Granite Master Issuer plc and its associates, which was an entity
owned by a charitable trust established by Northern Rock. After
the failure of the company it became clear that this charitable
trust had never paid anything to charity and that the charity
meant to benefit from it was not even aware of its existence.
Its sole purpose was, in fact, to form a part of Northern Rock's
financial engineering that guaranteed that Northern Rock was legally
independent of Granite, and that the latter was, therefore, solely
responsible for the debt it issued.
23. This was, of course, a masquerade, and
one that was helped by the fact that the trustees of the Granite
structure were, at least in part, based in St Helier in Jersey.
When journalists tried to talk to Granite employees they found
there were no such employees in Jersey, of course. In fact, an
investigation of Granite's accounts showed it had no employees
at all, despite having nearly £50 billion of debt. The entire
structure was acknowledged to be managed by Northern Rock, and
therefore (and unusually) was treated as being "on balance
sheet" by that entity and was therefore included in its consolidated
24. This is by no means unusual. We include
here an abridged version of a table drawn by the Irish economist,
Jim Stewart who studied the Irish Financial Service Centre (IFSC).
The table shows very clearly that many of these financial affiliates
in the Irish "financial centre" are "brass plate"
type companies used most probably for tax avoidance purposes.
In fact, although the IFSC has assets about six times Irish GDP,
it employs directly only 4,500 people! Such information is valuable
and rare. Due to opacity and intentional secrecy we are unable
to provide similar data with regards to say, Luxembourg or Singapore,
let alone Bahrain, Cayman or Jersey.
Name of ultimate parent company
|Name of Affiliate
|Albany Inter. U.S.
|A1 fin. service (Swizerland)
|Airbus, fin. ser (Netherlands)
|Analog Development, U.S.
Int. finance (Netherlands)
|BBA finance (Luxembourg)
|Boston Scientific, U.S.
|Bost. S. Int. Fin (Netherland)
|Tyco Inter. Bermuda
|Bristol-Meyers Squibb, U.S.
|BR. Mey, Sq. Int (Switzerland)
|Cisco Systems, U.S.
|Cisco Fin Int. (Bermuda)
|Coca-Cola holding (Cyprus)
|CNH, Capital (Netherlands)
|IBM, Int, fin. holding (Netherlands)
|Eli Lilli, U.S.
|Kinsale Fin. (Switzerland)
|Prizer, Services (Isle of Man Pfizer int bank, Europe (Isle of Man)
|Polygram int. (Luxembourg)
|Sea Container, Bermuda
|See Container, fin. (Bermuda)
|Black & Decker, U.S.
|Black & Decker, int. (Netherlands)
|Volkswagen, inv. (Cayman)
|Xerox leasing (Jersey)
|General Motors, U.S.
|Sigma-Ald. serv (UK)
|INGKA, Holdings, Netherland
|IKEA, Invest. (Netherlands)
The dilemma this created for Northern Rock was apparent.
Granite was used to securitize parcels of mortgages on the money
market through bond issues. When the money market lost its appetite
for that debt in August 2007 Northern Rock's business model failed:
it could no longer refinance the debt and as a result had to support
Granite in meeting the obligations it had entered into with its
bondholders, even though the company was notionally independent.
25. The same confusion arose as to whether the company
was onshore or offshore. In practice it included elements of both.
And, when Northern Rock was nationalised the House of Commons
held late night debates
on whether this meant that Granite was also nationalised. The
issue was never resolved. No one seemed to know whether a company
wholly managed by a state- owned enterprise but notionally owned
by a charitable trust registered in a tax haven was under state
control, or not. Despite that, the government had little choice
but extend its guarantee to the Granite bond holders.
26. The Northern Rock/Granite fiasco is an embarrassment.
More significant is the confusion created by structures about
ownership and risk. SPVs are often "orphaned" from their
parent (through the artificial use of charitable trusts in the
case of the UK) to break nominal control. This structure is however
commonplace throughout the offshore world and has been widely
used with regard to the securitisation of sub-prime mortgages.
Northern Rock was, in fact, a relatively clean case compared to
many, and yet when it failed it exposed uncertainty on how to
deal with the resulting situation on the part of almost every
regulator who approached the scene, and the ambiguity remains
even after Northern Rock has been nationalised by the UK government.
27. What is clear is that the uncertainty this created
significantly contributed to the problems that the failure of
this bank caused. Moreover, what is also clear is that if the
bank had been unable to issue debt in this way it was highly likely
it would not have failed. The opaqueness of the arrangement, partly
offshore for that very purpose, guaranteed that the risk within
it was hidden from regulators and others for a considerable period.
The result was serious financial, political and economic instability.
28. It is amazing how quickly a widely shared belief
in new and better ways of managing risk can unravel as a grandiose
scheme of exuberance, greed and fraud. In winter 2007, Northern
Rock was valued at £5 billion; in February 2008, its shares
dropped to 90p per share, pulling the value of the company down
to $380 million. On 18 February 2008, the UK government announced
the decision to nationalise the bank. Northern Rock, along with
other high-profile victims of the financial crisis, was exposed
as an element in a convoluted chain of securitisation techniques,
centred on the sub-prime mortgage industry in the US, and spread
globally. At heart, Northern Rock suffered from a crisis of liquidity.
As the global crisis unfolded, it became apparent that the very
idea of a subprime mortgage market was nothing but a grandiose
Ponzi scheme, while the process of securitisation in fact concealed
a myriad of risky, bad loans, packaged and distributed in sophisticated
ways. As the securitisation boom came to a halt in the summer
of 2007, observers left and right started to argue that securitisation
practices had never really discovered new ways to manage or optimise
risks; they merely hid them. If the real foundations of financial
heath were never there, why and how so many dubious debts were
29. Some eight years ago, just as the securitisation
bubble was beginning to be inflated, one of the big investors
warned about specific liquidity risks faced by his own firm. Although
the firm's securitisation strategy had been based on the assumption
that CMOs will be more liquid than their underlying collateral,
the properties, he forewarned that this assumption is far too
short-sighted, and over-relies on the market's shared sentiments:
as a guide to market discipline, we like the expression, "sure
they're liquid, unless you actually have to sell them!"
30. How come then, that against the warnings of history
and even some market players, the bubble of dubious quality debt,
packaged and offloaded to obscure third parties, was widely perceived
as a liquidity glut? The answer, we believe, lies in the interplay
of three elements: First, it was the notorious moral hazard factor
and the idea that big banks are the public frontier of global
finance and they will never be allowed to go bust. Second, it
was the collective belief in the tradability of securitisation
products shared by market players and therefore, a certain state
of mind regarding the liquidity of the markets and products. And
third, it was the legitimation of these debt instruments offered
to the markets by the credit rating agencies. Each of the above
contains a complex set of problems, the second and third, however,
are also linked to the question of OFC.
31. During periods of economic optimism, much like the
periods of stress, it seems that it is the herd instinct of investors,
each of whom is keen not to lag behind the competitive regulatory
arbitrage of others, that sustains the market liquidity. Typically
in this game, it is not the rationale of cost minimisation or
efficiency that informs the decisions and actions of securitisation
officers, but commission fees, the spirit of the herd, and sheer
exuberance. In this herd-driven process of financial innovation,
the usual trends of a bubble, or Ponzi pyramid, prevail: the under-valuation
of risks, especially the liquidity risk; the aggressive expansion
of new borrowings; and in many cases, the use of quasi-legal investment
techniques and outright swindling.
32. Crucially, two elements in the current regulatory
paradigm have aggravated the latest bout of liquidity illusion
and risks inherent in it. Firstassociated primarily with
financial deregulationhas been the sophistication of new
products, for instance synthetic structures, which have eroded
the transparency of the markets, both in relation to supervisory
bodies, but also, importantly, at the level of counterparties.
The prevalence in the securitisation spiral of obscure institutions
such as hedge funds, private equity firms, the secretive sovereign
wealth funds and offshore accounts suggests that anyone who is
attempting to find out what precisely is held on which books,
and how much is owed and to whom, belongs to an old and forgotten
age of narrow banking and is hopelessly obsolete.
33. Second, the overall mode of financial governance
has contributed to a great homogenisation of investment techniques.
Here, the collective reliance on value-at-risk (VAR) models of
valuing risks, investment practices based on the "originate
and distribute" principle, and the exercise of supervision
and monitoring based on the "bottom-up", soft-touch
principle of financial regulation of the 1990s and 2000s, have
only exacerbated the crisis potential of the illusions of liquidity
in the markets. The "originate and distribute" model
of lending has reduced incentives for banks to screen and monitor
the potential borrowers, and the credit risk has been under-priced.
The models do not differentiate between onshore and offshore entities
or products. At the same time, the CDO market (whose value exceeds
$10 trillion) proved to be opaque and inefficient. It seems to
have been used to "transform old accurately priced debt instruments
into new ones that are overvalued".
34. The fiasco of Northern Rock shows that dispersing
the risk off the books and onto third and fourth parties does
not eliminate it; in most cases, it actually aggravates it. When
the "good times" end, the illusion of liquidity sustained
by markets' shared belief in continued prosperity, reinforced
by benign endorsement of financial experimentation by public authorities
quickly turns into a systemic crisis of unpayable debts. Which
is what happened in August 2007, and continues to unravel at this
time. All this, it appears, is the outcome of a long-running problem
of "artificial liquidity", or liquidity illusions that
had underpinned the boom of structured finance and have become
a product of financial innovation.
35. But however exuberant, canny or short-sighted financial
engineering might be, illusions of prosperity, including the liquidity
illusion, can only be sustained over periods of time if there
is some credibility given to new instruments. In other words,
something was needed in the markets to sustain the collective
belief in the liquidity of bad debts and make the complex structures
of IOUs "worthor seem to be worthmore that
the sum of its parts". That something was the credit rating
agencies. Here, two processes have been at play: the so-called
"vehicle finance", driven by regulatory avoidance, manipulation
of legal ownership of assets, and creative accounting mentioned
above; and secondly, the engineering technique of layering securitization
structures. Credit ratings agencies have been pivotal to both.
36. First, from the very beginning of the securitization
boom, a central concern to ensure the marketability of securitized
debt (or as most people mistook for liquidity) is to enable the
rating agencies to analyse and grade the credit risk of the assets
in isolation from the credit risk of the entity that originated
the assets. In other words, credit rating agencies required legal
confirmation that the securitized assets represented a so-called
"true sale" and were outside the estate of the originator
in the event the originator went bankrupt.
According to Baron's such a removal of legal "home"
of assets it was absolutely essential for the approval stamp that
the risk was redistributed and taken away from the originators'
books. The primary purpose of such a transfer of ownership is
to prevent the seller and its creditors
from obtaining control or asserting a claim over the assets following
the seller's insolvency.
37. That is where are infamous special-purpose vehicle
(SPVs) come into the storyGranite. From the point of view
of financial prudence and stability, such a transfer means, for
example from Northern Rock to Granite, that once the assets have
been isolated from the insolvency risk of the originator, there
is no additional credit risk analysis required on the purchaser.
In other words, the purchaser of Granite's structured finance
product should not care about the state of Northern Rock, and
hence Granite's product can be analyzed and approved in isolation.
This was, of course, a sham and it is reasonable to assume that
the credit agencies knew full well that such separation of ownership
is most probably apparent and not real. Yet, they went "with
the flow" as long as, strictly speaking, the arrangement
could operate to suit their models and requirements.
38. We would like to stress that there was nothing to
prevent Northern Rock from creating its own structured risk and
selling it directly to third party. In this scenario, the rating
for such risk would have been lower and Northern Rock inevitably
would not have been able to get into such high leverage debt.
We think that most of us would agree that this would have been
the prudent thing to do. We can entertain another prudent scenario,
namely, that Northern Rock still uses its SPV, Granite,
but that the rating agencies do not accept the proposition that
Granite is in fact an independent entity. But while Northern Rock
acknowledged its close relationship with Granite, in principle
such an approach is futile because of the great ease creating
opacity and secrecy in offshore jurisdictions. A third prudent
scenario would demand a certain premium of risk on offshore entities,
so, for instance, they can never obtain a full AAA rating. Again,
a prudential measure that anyone who has ever looked carefully
into the practice of the offshore world is likely to agree with.
Each of the three prudential measures discussed above would have
certainly slowed down the flow of artificial liquidity and would
have made things better in this financial crisis.
39. Today's financial system seems to be less about intermediating
between savers and borrowers, and much more about the ability
to trade risks, In such a system thriving on product and institutional
innovation, risk analysis is required by credit ratings agencies,
and it is in this task that according to most observers, credit
agencies have failed most scandalously. Relying again, on new
ways to float a series of bonds and putting less risky ones on
top of the tranch, ratings agencies found a way to reward AAA
ratings to obscure pyramids of dubious quality loans. According
to the existing paradigm of financial regulation, risk analysis
is also the task of the bankers and financiers themselves, and
this is where they failed quite miserably. But now the liquidity
glut the Bernanke was so worried about disappeared so quickly
that central banks around the world collectively intervened by
injecting US $3.5 trillion (!), of which net estimated at about
$ 1 trillion.
40. It is difficult to legislate against such negligence
or regulate it out of the system (whether the regulators have
done their job, or even tried to do their job is a different matterwe
believe they did not). What is clear, however, that OFCs are not
making the task of easier to either. To the tax regulators they
claim to be highly regulated financial centres' to the financial
regulators they claim to be merely legitimate form of low tax
countries. Frankly, we see not advantage whatsoever in the continuing
existence of these type of financial centres.
19 June 2008
Bernanke, B., 2005, "The Global Savings Glut and the U.S.
Current Account Deficit", available from www.federalreserve.gov;
Bernanke, Ben, 2007, "Global Imbalances: Recent Developments
and Prospects", available from www.federalreserve.gov Back
Borio, C., 2000, "Market liquidity and stress: selected issues
and policy implications", in BIS Quarterly Review,
November, Basle: Bank for International Settlements. Borio, C.,
2004, "Market distress and vanishing liquidity: anatomy and
policy options", BIS Working Paper no. 158, Basle: Bank for
International Settlements, July. Back
Nesvetailova, A., 2007, Fragile Finance: Debt, Speculation
and Crisis in the Age of Global Credit, Basingstoke: Palgrave. Back
Minsky, H., 1986, Stabilizing an Unstable Economy, New
Haven, Conn.: Yale University Press. Minsky, H., 1991, "Financial
Crises: Systemic or Idiosyncratic", Working Paper No.
51, Jerome Levy Economics Institute, Bard College, April. Back
The boom lasted for at least four consecutive years: 2003-07. Back
IMF, 2000, Offshore Financial Centers. IMF Background Paper.
Prepared by the Monetary and Exchange Affairs Department, 23 June
Shah, A., 1997, Regulatory Arbitrage Through Financial Innovation",
Accounting, Audit and Accountability Journal, 10:1, 85-104. Back
The National Audit Office: Foreign and Commonwealth Office Managing
risk in the Overseas Territories, November 2007, available from
Kochen, N., 2000, "Securitization from the investor view:
meeting investor needs with products and price", in L. Randall
and M. Fishman, eds., A Primer on Securitization, London
and Cambridge, MA: MIT Press. Back
Onado, M., 2007, "Lessons from the credit crunch", The
Financial Regulator, 12:3. Back
For a more detailed discussion see Nesvetailova, A., 2008, "Liquidity
Illusions and Global Financial Architecture", IPEG Working
papers No, 35. www.bisa.ac.uk Back
Baron, N., 2000 "The Role of rating agencies in the securitization
Process", in L. Randall and M. Fishman, eds., A Primer
on Securitization, London and Cambridge, MA: MIT Press. Back
Including an insolvency official of the seller. Back
We suspect for tax avoidance, shifting profitable part of the
business to low tax jurisdiction such as Jersey. Back