On tax, shadow banking and the social contract

The Harvard Law School Forum on Corporate Governance and Financial Regulation (catchy name!) has a good post by Morgan Ricks, a former senior U.S. Treasury official looking at the shadow banking system. It is worth reading in full, but it's fairly long so we'll distil a handful of key points here.
As we've often noted before, the shadow banking system is not the same as the offshore/secrecy jurisdiction system, though there are huge overlaps and similarities. We'll get to what shadow banking is shortly - by way of some important points.

We are the Tax Justice Network and as such our focus is primarily on tax, but we do stray into discussing financial regulation, firstly because the recent global crisis has showed how lax financial regulation (typically abetted by secrecy jurisdictions) harms taxpayers around the world, and second, because many of our tax concerns have a counterpart, or mirror, in the field of financial regulation. Here's one way, as the post (and the longer paper it came out of) explain:

"Without a safety net, banking is unstable. . . . The apparent instability of banking has given rise to a standard policy response in the form of a social contract (a phrase borrowed from a marvelous speech [which TJN has blogged before] by Paul Tucker of the Bank of England.) That contract entails certain privileges that are unavailable to other firms: most notably, access to central bank liquidity and federal deposit insurance. These privileges amount to a safety net, and they stabilize banking. The social contract also imposes obligations—activity restrictions, prudential supervision, capital requirements, and deposit insurance fees. These obligations are designed to counteract the moral hazard incentives implicit in the safety net and protect taxpayers from losses."

The parallels with tax are quite obvious - the banks benefit from all sorts of privileges and help from society - and they need to pay for it by paying for it, through submitting to these important social obligations. And of course everybody in the game wants to enjoy the benefits of the social protection and assistance, and shift the costs onto the shoulders of everyone else. With tax, the prime form of escape has been to go offshore, whereas with financial regulation, the prime form of escape has been to go into the shadow banking system.

So what is "shadow banking?" We've discussed this before, but the article spells out a nice way to think about it:

"Historically, this social contract has been limited to depository banking—firms that take deposits and use them to invest in illiquid loans. . . . In recent years, however, this situation changed. A set of institutions emerged that performed the basic functions of depository banks, but without submitting to the terms of the social contract. Indeed, the very existence of many of these institutions has been predicated on being free from inconvenient constraints. Collectively, these institutions have come to be known as the “shadow banking” system."

In other words, these shadow banks have behaved like banks, but they are deemed not to be banks for the purposes of financial regulation. The shadow banks are the ones that escaped the social contract: the free riders on the backs of everyone else. The Bank of England allowed something like this to emerge in the mid- to late-1950s with some banking business, deeming certain forms of deposit-taking activities not to be resident in the City of London even though it quite clearly was in the City of London -- and this "innovation" exploded into the giant offshore Eurodollar (and, later, Eurobond) markets which are the beating heart of the offshore system today. More on that another day. Suffice to say that, as we recently noted in a post about the arcane business of rehypothecation (which Gillian Tett of the Financial Times wrote about a couple of weeks later, reaching pretty much the same conclusions as we did) the shadow banking system in many countries grew to exceed that in the mainstream system.

The point is that both the secrecy jurisdictions, and the overlapping shadow banking system, have been used for the purposes of escape: escape from tax, and escape from financial regulation (and, often enough, escape from criminal laws and various other obligations and restraints of society.) And this escape has been justified, all in the name of freedom for finance. Recent experience has shown us that this potential for escape is a very bad thing. This, and free-riding on the backs of everyone else, is what concerns TJN and this story helps re-iterate why we cannot focus only on tax and tax havens, but need to look at financial regulation too.

The Harvard paper goes on, a little more wonkishly, to look at policy responses to the challenges posed by the shadow banking system. The conventional view, they argue, is that the safety net should not be extended to it, because expanding the perimeter to include it will expand the moral hazard that underlay the recent crisis. Instead, the conventional view continues, is to pursue regulatory restrictions: expand the obligations, but not the privileges, of the social contract, and let market discipline do the rest. But the authors find this approach misguided: not only is it odd to give these firms obligations without the benefits of the social contract (much as one might like to bash the shadow bankers), but also it ain't necessarily going to cure instability, because runs and panics are not caused by the absence of market discpline: they are "the very manifestations of market discipline by short-term creditors."

Well, yes indeed. You need the safety net, and you need the obligations that come with it. How to square this circle? Well, the authors point to the obvious answer.

"If the objective is to ensure that all maturity transformation [TJN:that means lending long-term, and borrowing short-term, which is risky] takes place within the social contract, there is of course another alternative: We might disallow financial firms outside the banking social contract from engaging in maturity transformation—that is, preclude such firms from financing themselves in the money markets."

In other words, ban shadow banking.

In theory, why not? The normal banking system is perfectly able to provide the credit and savings and intermediation products that an economy needs. We don't need shadow banking: we have merely become addicted to it. And so it is with the secrecy jurisdictions: why not outlaw them, or outlaw anybody from doing business with them?

The answer in each case can be summed up in one word: politics. The vested interests are too huge, and they have us all too much by the throat, for us to be able to imagine a politician could simply shovel the whole lot into the garbage bin of history. For any chances of success, we need to outline a wide range of proposals, and keep going, day after day, chipping away at these escape routes, and try to find rough and ready ways of re-asserting our democratic sovereignty, bit by bit, push by nudge. Which is just what we are doing.