Why reregulation after the crisis is feeble: Shadow banking, offshore financial centers, and jurisdictional ‘competition’

Prof. Thomas Rixen

Prof. Thomas Rixen, who has written a lot about tax ‘competition’ (aka tax wars) in the past, has a new article looking at similar dynamics in the area of financial regulation. Entitled Why reregulation after the crisis is feeble: Shadow banking, offshore financial centers, and jurisdictional competition, it points out that the shadow banking sector, many of whose players were implicated in the global financial crisis that erupted almost a decade ago, is heavily entwined with offshore financial centres.  Typically, this involved banks sponsoring off-balance sheet vehicles, located in places like Cayman or Luxembourg: these supposedly took risk off the banks’ books, but then returned to haunt the banks when they blew up, causing widespread economic disaster. Rixen:

“Most shadow bank entities are incorporated offshore and enjoy the tax and regulatory privileges offered by these places. It was, therefore, warranted to target OFCs after the crisis – one of the most immediate and publicly discussed policy reactions of the G20. However, the regulatory response toward OFCs and shadow banking falls short.”

He then examines why. The core point he makes, perhaps, is that while the world has engaged seriously (if imperfectly) with tax haven issues such as financial secrecy, it has hardly even slapped the wrists of the tax havens for their role in these activities. He puts it bluntly:

“I submit that the regulatory reaction largely serves a symbolic purpose to acquiesce popular sentiments without having actual effect.”

Politicians can be seen to “do something” about tax havens by cracking down on secrecy, but this obscures large and powerful malign forces, which we’ve written extensively about.

The key reasons for this failure to act seriously, he argues, are firstly ‘jurisdictional competition’ – a fear of putting into place serious safeguards for fear that the often abusive activity will flee to more friendly climes – and secondly, what we are TJN call ‘state capture’ – where financial interests effectively control the policy-making apparatus, particularly in small jurisdictions. And of course a key component of that capture is this ‘jurisdictional competition’ – the ‘don’t regulate us too much or we’ll flee to Geneva or Singapore’ cry that we hear all the time, in country after country.

Rixen’s key contribution, in academic terms, is to bring the problem of jurisdictional ‘competition’ to centre stage, in terms of explaining why it’s so difficult to regulate this stuff.

“While the existence of such competition is, of course, well known to international political economists working on financial markets, it has not been discussed as the main factor in the literature on regulatory reform after the crisis.”

This is big stuff, of course. As Rixen puts it:

“The Financial Stability Board (FSB 2012a, pp. 8–9) estimated the shadow banking sector at around $67 trillion at the end of 2011, which is about 25 percent of the global financial system.”

That’s ‘trillions’ with a ‘t’.

As an aside, he adds:

“While there is no generally accepted definition of an OFC, in this paper the term refers to states or dependent territories which intentionally create regulations and tax rules for the primary benefit and use of those not resident in their geographical domain. Regulation and taxation are designed to circumvent the legislation of other jurisdictions.”

That is completely consistent with an informal way we at TJN sometimes talk about these places, boiling down the phenomenon to two words: ‘escape’ and ‘elsewhere.’ Take your money or your activities elsewhere, to escape the rules.

We could go on: there’s plenty more in here, but the main purpose here is to flag this piece of research.