Shadow banking: why tax havens increase financial risks

“OFCs increase financial risk in at least five ways.

First, given their lax incorporation rules, they make it easier to register SPVs.

Second, as a result of lax oversight and lack of cooperation with onshore jurisdictions they enable onshore financial institutions to hide the risks involved in their offshore subsidiaries from regulators.

Third, the low or zero taxes lead to higher profit margins and, thus, increase the incentive for risky behavior.

Fourth, and related, by using SPVs in tax havens certain quality requirements on credit to be securitized could be avoided (OECD 2009, p. 48).

Fifth, the tax advantages offered by OFCs foster the debt bias of investments. As interest payments can be deducted as costs, whereas dividend payments cannot, most tax systems advantage debt over equity financ- ing. This effect is exacerbated by the low or zero tax rates in OFCs; the interest payments lower onshore tax burdens, and the profit can be accumulated tax-free offshore.7 Overall, this increases the propensity to take on credit and to work with ever higher leverage ratios in investments.8 The tax bias toward debt conflicts directly with financial regulation, which tries to lean against debt (cf. IMF 2009).

Taken together, these features of offshore finance increase investment profit margins and make the shadow bank strategy more attractive. To some extent, OFCs feed the shadow banking system.”