Global challenges & opportunities

| 02/07/2009

We are passing through some of the most turbulent times the financial services industry has ever seen. This applies to the industry onshore and offshore and around the globe. We are also in an era of heightened initiatives both international and domestic that are rapidly changing the shape of the industry.

The financial crisis has significantly added to the momentum.

Reports of the impending death of the offshore industry are exaggerated (pace Mark Twain). I believe there will continue to be a place for high quality offshore financial centres (OFC’s), unless (unlikely I think) the world is prepared to go back to the days of strict exchange controls and restricted global trade and investment. Assuming I am correct, there will also be a place for high quality banks and service providers in those OFC’s.

Let us first consider what is behind all this activity. It is a question of who will control the world’s capital. And the old guard (the G7-8-9) is fighting hard to maintain the status quo under the guise of propriety, integrity and transparency (being the latest favoured buzzwords).

Most major jurisdictions publicly support open and competitive global markets between which capital can freely move. There is a growing body of academic studies that argues that OFCs can and do enhance competition in onshore markets and facilitate foreign investment into onshore jurisdictions that might not otherwise be made due to domestic constraints in those jurisdictions. After all, the funds do not remain in the OFC’s. Their domestic markets are far too small and undeveloped to absorb the capital flows.

In reality, many jurisdictions that claim to support free markets principles and the unrestricted flow of capital do so only as long as this system works in their favour. Behind the façade, they actually pursue self interested financial imperialism and protectionism.

For example, in financial services and products and in facilitating the global allocation of capital, OFCs pose a major competitive and potentially uncontrolled threat. Thus, the UK and the US in particular are not keen to see OFCs thrive too much, but they have traditionally recognised that, for their own financial service industries and multinationals to be competitive, they must allow them to use OFC domiciled structures. Further, they recognise that such structures are also often the conduit for valuable inward investment from foreign investors. This traditional position is now under serious pressure as politicians appear to see more downsides than upsides in the continued symbiotic relationship between onshore and offshore

Other major European nations with growing and unfunded entitlement programmes and ageing populations fear loss of capital to OFC’s and reduced tax revenues. And they wrongly see OFC’s (as opposed to their own domestic policies) as the cause. So, while voicing their commitment to open markets for (their own) financial services and products, they continue to impose burdensome and anti competitive regulation on OFC’s and to raise barriers to their residents investing in or using OFC financial products or services. Again, protectionism in all but name, despite protestations to the contrary.

The international standard setters mandated to execute the various initiatives are the creatures of and funded by the very same major countriesthat have no real interest in a level playing field open to OFC’s or to anyone else threatening to deprive them of control of the world’s capital.

Let us now look briefly at the various important international and domestic initiatives that are underway or threatened. These initiatives have been significantly energised by broad political support at the highest level in the major economies of the world as a result of the financial crisis. At the very top are the G8 and the G20 policymasters leapfrogging each other every few months in producing macro statements, followed up by often overlapping reports. In no particular order of merit, the more significant are as follows. 

The G8 is about to issue a report laying out the “big picture” framework for global standards such as corruption, banking, corporate governance, taxation, financial markets and executive pay.

The OECD has for over ten years been pursuing its global tax initiative, that has been chameleon like in its changes during the period. Having been beaten back (principally by the Bush Administration) on tax harmonisation (i.e. everyone should adopt French and German tax rates), the programme is presently focused on tax information exchange and transparency. In concert with (or under the direction of their political masters) the G20 and G8, the OECD has recently been playing the “name and shame” card to remarkably good effect.

OFC’s are scrambling to sign up at least 12 double tax agreements or tax information agreements (TIEA’s) that meet the OECD standards and thus secure a place on the favoured white list (although it is not clear what specific reward that actually brings). Cayman missed making the white list by a narrow margin (having been slow to build on both its early TIEA with the USA in 2002 and its implementation of the automatic reporting under the EU savings directive in 2005), but has recently signed with the UK, Ireland and the seven Nordic countries, pencilled a draft with the Netherlands and with more to come, and adopted locally enacted unilateral measures that will allow it to exchange tax information with designated countries (currently 12 countries have been so designated).

Recent statements from the OECD and leading members now make it clear  that simply signing 12 agreements is not necessarily sufficient. The requirements now seem to be agreements with the major players, effective implementation and satisfactory peer review of implementation. And possibly even moves to sign multilateral agreements. All this may further delay Cayman’s promotion to the white list.

IOSCO (the international organisation of securities commissioners) has recently published six high level principles with respect to hedge funds, that in particular recommend that all hedge funds and/or managers/advisors and prime brokers and banks that lend to hedge funds should be subject to registration, there should be regular reporting to regulators to protect against systemic risk and better cooperation between regulators. I doubt that the IOSCO principles will be overly problematical for the major offshore hedge fund domiciles such as Cayman.

IAIS (the international association of insurance supervisors) is now actively working on the first common rules on solvency requirements (margins etc) for international insurance and reinsurance companies. It may be early days but is a sign that the insurance regulatory environment is at long last going global.

The Basel Committee on Banking Supervision, having only recently finished Basel II, is busy working on what will probably be called Basel III to apply the lessons coming out of the recent crisis. There will be much focus on the issue of on and off balance sheet transactions and structures, related capital requirements, risk management and stress testing. I do not see this as troubling Cayman’s banking industry (other than increased compliance costs).

The UN held a summit to tackle the global economic crisis last week. The communiqué specifically stressed the need for transparency, cooperation in tax matters and combating illicit financial flows.

The UN and the World Bank are actively pursuing a (welcome) programme the StAR project) to assist developing nations stamp out official corruption and to trace and recover stolen assets in financial centres (onshore and onshore).

Lurking in the wings are the other usual players such as the IMF, the Financial Stability Group (essentially the G20+) and the FATF (Financial Action Task Force, as subset of the OECD), expanding their oversight and assessments and developing new policies and rules as they go along.  

The international activity is complemented by proposals in the US, UK and the EU for domestic/regional legislation to limit and make the legal use of offshore centres by individuals and corporations increasingly difficult, burdensome and costly and to enhance the regulation and taxation of onshore hedge fund managers and, if they can find a way to do it, the offshore funds themselves. Both the UK and theUS also wish to punish so called vulture funds that prey on poor countries’ debt.

 The EU proposes that the automatic reporting of interest income EUSD (savings directive) be greatly expanded to include different types of income and gains and cut through provisions to the beneficial interests behind companies, partnerships and trusts.

The US proposes to tighten up the QI (qualified intermediary programme) to prevent perceived abuse by US taxpayers hiding behind offshore vehicles, to expand the reporting requirements by US taxpayers regarding offshore accounts and investments and to limit the ability of US multinationals to utilise OFC’s to defer US taxes and to manipulate transfer pricing.

All the various current proposals are still very fluid with much lobbying and backroom negotiation before the fat lady sings.

So why do OFC’s take any notice of these issues? Why not ignore them and carry on a before? This is not a sensible long term option for those OFC’s that wish to participate in global financial markets. And uncertainty and delay are not good for the reputations of or quality business retention and development by OFC’s. So let us look at some of the things that are happening.

Heightened threats of meaningful sanctions (e.g. increased withholding taxes) against non compliant OFC’s and those that use them.

The UK Revenue has just released for comment a proposed code of conduct for UK banks under which they will (voluntarily) commit to meeting the spirit and not just the letter of UK tax laws. It aims to limit the banks’ use (for themselves and their clients) of offshore structures that do not support genuine commercial activity and that, while legal, offend the spirit of UK tax laws as intended by Parliament.

The European Investment bank (EIB) is reviewing its lending policies so that loans will not be signed with entities domiciled in jurisdictions that do not meet international standards on tax information exchange.

US citizens working overseas are finding it increasingly difficult to open, operate and maintain normal banking relationships. Banks are finding the compliance costs and risks are not worth it.

A number of publicly quoted non-financial companies domiciled in Bermuda and the Cayman Islands and with strong US connections (so far principally reinsurance and oil services companies) have already elected to transfer their domiciles to jurisdictions with established (and protective) double tax treaty networks and attractive corporate tax regimes. To-date Ireland and Switzerland have been the preferred domiciles.

There is anecdotal evidence that some international financial institutions are becoming concerned about the heightened reputational issues raised by their conducting business through or with offshore jurisdictions and certainly with those not on the whitelist. Some of Cayman’s key competitors have been ‘whitelisted” and are ramping up their marketing on this basis. Hopefully, this will be a short lived.

In light of this, let us now look specifically at what Cayman is doing. Cayman recently elected a new Government and approved a new constitution. With that has come a renewed commitment from the political leadership to support, enhance and protect the financial services industry and thus benefit the local economy. The list of what I think needs to be done is lengthy but an encouraging start has been made by the new Government.

Dedicated and focused political and executive leadership for financial services.

Increased actions and engagement to secure compliance with and effective implementation of relevant international standards and cross-border assistance through tax information exchange agreements and law enforcement and thus to secure due recognition of Cayman standing.      

Increased transparency in the private sector by enactment of holistic data privacy laws in place of the Confidential Relationships (Preservation) Law, by increasing the publicly available information regarding both regulated and unregulated entities and by increasing the statistical information published by the Monetary Authority and the Economics and Statistics Office.

Implement the Anti-Corruption Law and the Anti-Corruption Commission

More effective enforcement of our existing financial services laws and regulations by the regulators and law enforcement.

Better targeted and effective intelligence gathering, lobbying and media relations, particularly in key centres such as Washington, London, Brussels and Paris to influence political and media perceptions, opinions and outcomes

Develop better governmental contacts and business promotion in Asia, Latin America and the Middle East.

(Re)establish Government offices (with the right staff) in key centres such as Dubai, Hong Kong and Washington DC.

Strengthen the London office including the ability to cover Brussels, Paris and other key European jurisdictions.

Support think tanks, symposia and the research, publication and dissemination of quality academic studies analysing the beneficial impact of OFC’s on the world economy.

Encourage new financial and otherinternational businesses to establish in Cayman with  meaningful physical presences and also encouragement of much greater decision making and economic activity within the jurisdiction by the entities domiciled here.

Encourage wealthy people to take up physical residence, buy houses and invest locally.

Develop sensible and welcoming immigration policies to attract and keep the brightest and the best together with a well educated, motivated and participating local professionals and staff working alongside them.

So what might OFC’s such as Cayman expect for the future?

The pendulum is swinging against OFC’s for the moment. But unless the world goes back to the dark ages (unlikely), the rhetoric (even from the French and Germans) will reduce and some semblance of balance will return.

The world is full of global businesses and families. And their number and wealth (pace Bernie Madoff and Allen Stanford) should continue to grow over time. The real growth will be in the new BRIC worlds and not so much the traditional world of the G7,8 and 9.

Increased rates of taxation will make proper tax and estate planning for wealthy families even more important and also lead to greater demand for tax advantaged and good places to live where there is access to quality professional services and advice.

In tax matters,the rule of law requires the legislation to be clear. Broad anti-avoidance wording can go a long way towards discouraging too much envelope-pushing, but subjective statements like “paying your fair share” are on their own unhelpful in the extreme. The fair share is in the eye of the beholder. To be meaningful, the statement must be converted into legislation and regulations that can be understood and applied consistently by professional advisors, tax departments and courts.

Global economic competition inevitably means tax and regulatory competition. No-one has yet created the perfect tax or regulatory regime, so competing regimes (within broad agreed norms) are perfectly proper, just as there are many ways to make a safe automobile. Individuals and corporations are entitled legally to maximise their wealth. Indeed, corporations have an obligation to their shareholders to do so. Thus, legitimate tax and regulatory planning will always have a place. OFC’s with high standards of sensible regulation, appropriate transparency, cross border assistance arrangements and good infrastructure and providing quality value-added service have a valuable role to play in that scenario.

The challenge for OFC’s and their service providers will be to maintain their competitive advantage in the face of the inevitable increase in the cost of doing business. So I expect the required minimum net worth of clients and size of transactions will likewise increase. That may be no bad outcome.

Government controlled banks in the UK and the US may feel obliged to pull back from the offshore market; if so, that leaves greater opportunities for those banks and others that are not so constrained.

I do not believe legitimate quality offshore centres, such as Cayman, need suffer death by a thousand cuts; if the lessons are learned and applied, they can and will survive and thrive as (albeit reluctantly) accepted participants in the global financial world.

The above is a presentation given by Ridley in New York City on 30 June 2009 at the Stuarts Walker Hersant andRBC Wealth Management Forum.


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