Nick Shaxson ■ Not quite anywhere: shadow banking and the offshore system

Shadow-06-creative-commons-small, creative commons

A useful reminder about shadow banking from Anastasia Nesvetailova, Reader in International Political Economy at City University London. It begins like this:

“It takes me about two hours to assemble a team of finance geeks and lawyers to devise a product or a transaction that would bypass any new rule or regulation coming our way,” said a senior French banker to me in the midst of the financial crisis in autumn 2008.”

As we’ve remarked before, shadow banking is analogous to the offshore system of tax havens. It involves financial operations that has escaped the bonds of traditional banking regulation, or which have otherwise escaped the social contract. The concept of ‘escape’ brings us to the notion of tax havens. But it’s not just analogous to the offshore system: it is inextricably intertwined with it, as Nesvetailova continues:

“Over the past three or four decades, banks and financial institutions have developed what amounts to a parallel financial universe. Today, behind the facade of any major banking conglomerate, there is a plethora of entities, transactions and quasi-legal cells. Many of them are “orphaned” from the visible part of the bank by complex legal and financial operations and often embedded in offshore financial havens, yet they have become integral to the functioning of our banks.”

And it’s big – very big.

The Financial Stability Board (FSB) puts the global size of the shadow banking system at $71tn. This accounts for, roughly, half of total banking assets globally and a third of the world’s financial system.”

And it’s very Anglo-Saxon, with US and UK, accounting for nearly 60 percent of the system, according to one way of measuring it.

And, of course, it’s a problem. The banking system has come to depend on shadow banking: in a sense, it’s a fait accompli. But there are of course problems – and big ones. It identifies three:

  • Relying on long, complex and opaque structures of credit creation, many visible banks are able to enlarge their de facto size, often creating undetected leverage and thus, adding to the problem of “too big to fail.”
  • By netting several entities into opaque chains of credit intermediation, the shadow banking system amplifies the scope for regulatory arbitrage.
  • Relying and thriving on complexity, shadow banking obscures the sources and real dimensions of systemic risk in the financial system and aggravates the problem of non-transparency of finance.

Complexity, Gillian Tett argues, has become a social and even cultural tool of opacity, employed by financial elites in effort to isolate themselves in “silos of silence”. During the boom years and even in the wake of the crisis, professional jargon and heavy mathematics serve as barriers against transparency of the often controversial yet profitable business of financial innovation that too often, is akin to financial sabotage (Nesvetailova and Palan 2013).

In a separate paper, Nesvetailova and her colleague Ronen Palan explore the links between shadow banking and the offshore system, and they explain that

The two intertwined phenomena of offshore financial centres and shadow banking are now drawing the attention of global and national regulators. We suggest this attention should be guided by the insight that both are defined by the search for being not quite anywhere. . . .  the principle of not being recognised, registered, accounted for, taxed, regulated, detected or understood well, has been the engine behind the growth of the offshore economy.”

The article cites Richard Murphy of Tax Research, who challenges

“a major misconception about financial transparency is the assumption that the secrecy world is geographically located. It is not. It is instead a space that has no specific location.”

Nesvetailova again:

“while the idea of  “elsewhere”  has been paramount to the emergence of the global financial system and its key nodes,  the shadow banking system firmly linked together the notion of “elsewhere” and “nowhere” not simply for the conduct of financial transactions, but for the very process of credit creation as well.”

And, to finish:

“It is therefore quite likely that the next (and inevitable) bout of financial instability and crisis would involve a nexus of official and shadow banking systems.

Pessimists would remind us though that it takes a team of finance geeks and lawyers only a couple of hours to devise a product that bypasses any rule or restriction.”

The real risk is that so much of this is rent-seeking activity: extracting wealth and bringing forwards consumption into the present, at the expense of future generations.

Or, to put it more pithily: we will pay for this.

We have a large archive of other material on this broad subject, here.

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