It was once said that there are lies, damn lies and statistics, but when we look at the gross mischaracterisations that are targeted at offshore financial centres, and the Cayman Islands in particular as one of the more successful of these jurisdictions, we find that a good look at some facts is an excellent starting point for the debate and at the very least extremely good for morale.
What is fascinating about an objective and non-arbitrary analysis is that despite the negative publicity which is founded in the blame deflecting endeavours of certain G-20 politicians and regulators, that is to say regulators in the jurisdictions in which the core of the financial crisis was rooted, Cayman’s financial services industry paints a robust picture. Let’s look at the key statistics:
- Bank deposits and interbank bookings in the banking industry remain at US$1.8 trillion, down only some 10% from the 2008 high
- Mutual and hedge fund establishment is running at some 100 new registrations a month with an aggregate number of some 9,486 regulated funds, a drop of only 5% from the 2008 high (although it is fair to point out that gross assets under management have dropped from US$3.6 trillion to approximately $2.5 trillion, no doubt a reflection of the deleveraged marketplace in which hedge funds are currently operating
- In the captive insurance market, we remain strong competitors for Bermuda, steadily catching them with 789 captives holding approximately US$45 billion in assets under management
- It is only in the area of company incorporations where we see a decline of about 30%. This is where we see the true effect on decreased transactions reflected as a consequence from the lack of available credit. That being said, the total number of companies incorporated are in the region of some 90,000. The view from within the industry in Cayman is that the reduction of company incorporation numbers is largely due to the reduction in the number of structured finance transactions, which is directly attributable to the effects of the sub-prime crisis.
The reason I have dwelt upon these statistics at some length is not to simply cheer myself up. The real point is that throughout the financial crisis and no doubt because of the regulatory mechanisms in effect in the Cayman Islands, no Cayman bank or financial institution failed. No depositor in a Cayman Islands bank or financial institution lost money. There was no Bear Stearns in the Cayman Islands, no Lehman brothers in the Cayman Islands, no Northern Rock, and no Royal Bank of Scotland. Clearly, before we start to analyse what may be required in terms of enhanced levels of regulation we need to start with the recognition that regulation in the Cayman Islands worked effectively. And I will go on later to discuss why this is the case.
We have been bombarded over the past 12 months with various reports from regulators and others as they look to create, appeal to and reinforce public perception about what needs to be done on the regulatory front. We heard many of these issues discussed over the past two days at this conference.
After considering the reports and the various presentations, I wonder if I am alone in arriving at what seems to me to be the inevitable conclusion that there is a major disconnect between the suggested responses and a realistic analysis of what actually caused the financial crisis. Various experts have differed on attribution of the crisis causes, but the debate can be boiled down to two simple points. The first can be summarised as simply irresponsible bank lending practices driven by political motivation in the US, dressed up in the laudable objective that every American had a right to own their own home regardless of their ability to pay for it We know that the mortgage defaults in and of themselves were not enough – the disintermediation of risk through securitisation added accelerant to what was already a wild fire and transferred an inadequately evaluated risk around the globe. Secondly, that same disintermediation of risk could not have occurred without the repackaged assets having been branded AAA by the rating agencies. Many investors, including some European and Asian banks, who were clearly incapable of undertaking the very basic degrees of due diligence in support of their own balance sheets, relied solely upon these ratings.
We can also say that the method of set-off of derivatives as between one major wall street investment banker and another did nothing but obfuscate the aggregate value of the derivatives in issue, which only manifested itself when major counterparties like Bear Stearns and Lehman’s were allowed to fail because set off was no longer applicable. It is not for me today to comment on the moral issue here or the fact that AIG was not allowed to fail. The simple fact of the matter is that had AIG and others been allowed to go under the effect on the financial system would have been cataclysmic. If anyone doubts the foregoing analysis and many do, I will cite the very distinct practices applied by the big 5 Canadian banks and rest my case – and I am not saying that just because I am Canadian.
The point I really want to make in analysing the appropriate regulatory response is that if you accept the foregoing two reasons as the fundamental cause of the financial crisis, you will also have to accept the irony that the problems occurred in the banking industry which was already highly regulated in a jurisdiction which now leads the G20 and G8 debate on regulatory reform.
But do we find in the regulatory response a tacit recognition of this fundamental? I think not. What we find is Mr. Gordon Brown when addressing the US congress asking the rhetorical question “Would the world not be a safer place if jurisdictions like the Cayman Islands were outlawed?” The universal acclaim to which this question was met belied the fact that the Cayman Islands financial services industry had remained robust throughout the crisis. As an exercise in blame deflection this performance surely deserves some form of Oscar or at least a nomination for best fictional screenplay.
But we are of course all familiar with the pejorative descriptions of offshore financial centres. The expression “tax haven” which cunningly suggests that tax evasion is still an issue for the offshore financial centres notwithstanding the extensive range of tax treaties and proactive reporting under the EU Savings Directive and various other tax information exchange agreements. The expression ‘tax loophole’ is the one preferred by US politicians, which is used to cloud the fact that lawful tax avoidance rests exclusively within the tax legislation of the US and is exclusively within the purview of the onshore politicians concerned. Cayman Finance has had occasion to write directly to President Obama and Senator Dorgan to make these blindingly obvious points directly.
No doubt a major part of the problem has been a historic failure on our part – the offshore jurisdictions unfairly targeted, to make our case and tell our story. But we do so now. And we do so on a regular basis.
Not only are the public misrepresentations of offshore tax transparency unfair to those jurisdictions who have entered into and continue to enter into full transparency treaties, it is equally unfair to Joe Public who is misled into believing that the solution to gross onshore government over-expenditure and climbing domestic tax revenues lies in some mythical offshore pot of gold in the possession of a leprechaun sitting at the end of a hypothetical rainbow. What we do know as fact from the tax transparency initiatives that have been in place in Cayman for the past decade is that tax evasion is an insignificant component of our financial services industry.
And now we find ourselves in the same boat when it comes to the issue of regulation. The EU AIFM Directive (which I will call the directive) seeks to blame hedge funds for the financial crisis, although that logic is wholly flawed. Although there are still some 1200 unreconciled amendments and therefore no final version to comment on, the Directive as it stands quite reasonably suggests that any investment manager trading in the EU on behalf of a non-EU hedge fund should be subject EU trading and risk regulation. It quite unreasonably seeks to say that non-EU domiciled hedge funds should be precluded from being marketed in the EU.
Thus we see, in the same way that politicians vainly suggest (at least as so far as the Cayman Islands are concerned) that domestic deficits will be funded from offshore tax evasion — flawed analysis of the causes of the financial crisis and flawed political regulatory responses will lead to unintended consequences.
It has apparently not occurred to European politicians (although the rappateur M. Gauzes has been told by Cayman Finance directly) that restricting the investment objectives, risk profile and leverage of an EU fund manager will cause the investing public and the pension funds that represent them to suffer with a less competitive rate of return. And all this in circumstances where no one has seriously argued that hedge funds were instrumental in the financial crisis. And therein lays the root of the problem. Nobody and certainly not in the Cayman Islands has the slightest concern about the application of a global regulatory solution to a specific regulatory failure or to a systemic risk that ought to be properly regulated. But, what is actually occurring is a territorial and piecemeal approach by way of regulatory response which has failed to deal adequately with the causes of the problem. It is a staggering fact that the current financial regulatory reform bill working its way through the US senate and congress does nothing whatsoever to address the core of the financial meltdown – specifically the dangerous lending practices of Freddie and Fannie. And now the regulatory response from Europe is to exclude institutional investors who have undertaken their due diligence and who have received perfectly satisfactory 15% or more annualised returns from Cayman hedge funds from investing in those hedge funds.
You may well ask whether we should be concerned about the directive in the Cayman Islands and the answer is not unduly since the Cayman Islands has an institutional product that was not authorised to market itself cross-border to the public in any event. And, no institution whether in Europe or elsewhere in a global financial environment needs to invest in a Cayman hedge fund from within Europe. The Directive in its current form may well dis-incentivise investment into Europe at a time when Europe needs all the help it can get.
The other point we may take well under consideration is that the International Monetary Fund in their report prepared for the June G20 summit in Toronto stated and I quote “it is important to ensure that the financial system regulatory reforms in advanced economies do not have unintended adverse effects on financial flows to developing countries or their financial sector management. Vigilance is needed to avoid financial protectionism.” The report then goes on to say “G20 leaders can boost market confidence by renewing their commitment to refrain against protectionist measures. An even stronger signal would be a collective pledge to unwind the protectionist measures that have been put in place since the onset of the crisis.” The IMF is calling out for more open trade and less protectionist measures because it is a fact that restricting international capital flows, and restricting tax competition hurts the poorest people in this world the most.
By all of this I do not mean to say that we are adverse to regulation in fact, rather the contrary. I simply mean to say that there is a massive disconnect between the high sounding principles which emanate from high sounding institutions on the issue of regulation and the reality. For example, if we look at the banking industry, we see a global regulatory framework in Basel 1 and Basel 2 that applies across the board. And that is how it should be. The notion that some countries can apply a Tobin tax whilst others do not shows no understanding whatsoever of a competitive marketplace.
But I will make the point again that even in the case of a global banking regulatory framework, it was US banking regulation that failed. It could very well be argued that what is needed is not new regulation, but a proper application of existing regulation.
The same could be said for hedge funds. Certainly the hedge fund manager with the assets under management allocated to it must be regulated in accordance with the jurisdiction where it undertakes its business activity. But prior to the crisis, the SEC did not regulate hedge fund managers trading in the US at all. So if what is now proposed is that hedge fund managers be regulated, that seems entirely sensible and logical, provided it can be argued that there is a global system of hedge fund regulation in place (and there is not).
It can only be the case that the hedge fund must be regulated through the hedge fund manager in accordance with the laws in the jurisdiction in which it trades. If that were not the case we would have an illogical situation if we were to have a fund with four different hedge fund managers trading in four different jurisdictions. Thus far it is only in the area of banking where we have a global regulatory system represented by the Basel accords. It is for the G20 and other to first establish the global systems with regards to fund management, private equity, derivatives, structured finance, insurance and indeed all areas of financial services before there can be meaningful talk about global regulation. As matters stand, the rhetoric of the international bodies is well ahead of the substance.
In the meantime, we in the Cayman Islands would be first to say that the issue should be a focus on transparency. The Cayman Islands has full IOSCO membership and therefore full regulator to regulator disclosure. Is there really value then in the EU suggesting that that form of IOSCO agreement will not be acceptable for the purposes of establishing regulator to regulator disclosure under the AIFM Directive? Clearly this is simply political posturing undertaken in the name of regulation. Is the EU really saying that the IOSCO regulation is really inadequate and if it is, should it be allowed to do so? Clearly if transparency is established in accordance with the requirements of an international body, that should be sufficient, otherwise we run the risk of recreating under the regulation banner the same fiasco that arose with respect to tax transparency when the OECD for political reasons refused to recognise the Cayman Islands unilateral tax transparency mechanism and then insisted on the precisely same thing introduced under a bilateral mechanism.
It is important that regulation is not used in this way as a cloak to shield the hidden agenda of onshore jurisdictions who are more interested in protecting their domestic economies from tax competition and to use the terminology of tax evasion and lack of regulation as weapons of choice. The recurrent suggestion that there exists “dark pools of capital” that exist in some unregulated or unspecified manner in jurisdictions such as the Cayman Islands is the purest nonsense. Transparent offshore financial centres like the Cayman Islands ensure that capital is efficiently deployed and given that tax evasion is off the table, operate by ensuring that funds are fully invested in accordance with the rules of onshore markets, whether these are in the US, Europe, Asia or South America or wherever. It is a mistake both for tax transparency and regulatory purposes to conflate the Cayman Islands and other transparent offshore financial centres with jurisdictions like Switzerland and Liechtenstein which have until recently relied on secrecy and non-disclosure.
What we anticipate and welcome is a true level playing field and no, despite what we heard yesterday from the OECD, we have not yet arrived. It should not be the case when regulation is required in the Cayman Islands to a more restrictive and onerous standard than is applied in G20 jurisdictions. Think back to the anti-money laundering legislation that was required to be applied retroactively to every pre-existing Cayman client. But that was not a standard that was required in the US, UK or continental Europe. If those who seek to apply regulation globally are to have credibility such regulation must be part of a global standard. And it must be applied in a non-prejudicial and non-arbitrary manner across all jurisdictions. Regrettably what we are seeing thus far by way of regulatory response falls short on both points.