House of Commons - Treasury - Written Evidence

Offshore Financial Centres - Treasury Contents

Memorandum from Professor Ronen Palan and Dr Anastasia Nesvetailova

EXECUTIVE SUMMARY

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 with you.

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."[297] 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 crush—as it did. These commentators include Head of research and policy at the Bank of International Settlements, Basle, Claudio Borio[298] as well as one of the co-authors of this submission.[299] This artificial nature of the liquidity boom, or what Hyman Minsky[300] 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?[301] We now believe that the answer to this question may to an extent, lie—and again we emphasise that OFC played a contributing, not a principle factor—in 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 proportions.

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.

DEFINITION PROBLEMS: THE CONFUSION BETWEEN TAX HAVENS AND OFCS

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 sector—yet, 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 (JOM).

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".[302] 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 spaces.

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.

FINANCIAL INNOVATION

14. Financial innovation is a tricky term. On the one hand, much like in any other sphere of activity—technology, 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 loans—but 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."[303] 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 elements—the 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 industry today.

NORTHERN ROCK AND ITS SPV, GRANITE

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.[304] 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 accounts.

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 Pre-tax
Profits
millions Gross
Assets
Millions Number of
employees

3Com. U.S. 3Com. (Cayman) $4.6 $153 0

Albany Inter. U.S. A1 fin. service (Swizerland) 3.0 euro 117 euro 0

Airbus, France Airbus, fin. ser (Netherlands) 0 E 2 0

Analog Development, U.S. Annalog Development

Int. finance (Netherlands) $11.6 $592 6

BBA, UK BBA finance (Luxembourg) 0 $433 0

Boston Scientific, U.S. Bost. S. Int. Fin (Netherland) $2.8 $312 0

Tyco Inter. Bermuda Brangate (Lux) $26.6 $907 6

Bristol-Meyers Squibb, U.S. BR. Mey, Sq. Int (Switzerland) E 15.1 E947 4

Cisco Systems, U.S. Cisco Fin Int. (Bermuda) $-109.0 $235 27

Coca-Cola, Greece Coca-Cola holding (Cyprus) 3.7 euro 2,179 euro 0

CNH, Netherlands CNH, Capital (Netherlands) -6.3 euro 94 Euro 49

IBM, U.S. IBM, Int, fin. holding (Netherlands) $50.2 $2,653 4

Eli Lilli, U.S. Kinsale Fin. (Switzerland) $32.9 $1,409 1

Pfizer, U.S. Prizer, Services (Isle of Man Pfizer int bank, Europe (Isle of Man) $33.6
$23.6 $6,501
$485 10
0

Vivendi, France Polygram int. (Luxembourg) $22.0 $3,919 0

Sea Container, Bermuda See Container, fin. (Bermuda) 0.5 euro 26 Euro 0

Black & Decker, U.S. Black & Decker, int. (Netherlands) $5.9 $888 7

Volkswagen, Germany Volkswagen, inv. (Cayman) 15.9 euro 566 Euro 7

Xerox, U.S. Xerox leasing (Jersey) 29.7 euro 645 Euro 0

General Motors, U.S. RFC (Ireland) $2.1 $108 0

Sigma-Aldrich, U.S. Sigma-Ald. serv (UK) £1.2 £645 0

INGKA, Holdings, Netherland IKEA, Invest. (Netherlands) SEK 53.7 2,052 SEK 1

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[305] 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.

MAKING BAD DEBTS LIQUID

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 made liquid?

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!"[306]

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.

HERD INSTINCT: LIQUIDITY AS A "STATE OF MIND"

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. First—associated primarily with financial deregulation—has 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".[307]

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.[308]

LEGITIMATING BAD DEBTS

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 "worth—or seem to be worth—more 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[309]. 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[310] 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 story—Granite. 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,[311] 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.

CONCLUDING REMARKS

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 matter—we 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