Tuesday, July 27, 2010

Offshore City of London puffed up shadow banking

The IMF has produced a curious new working paper with the exciting title of The (sizable) Role of Rehypothecation in the Shadow Banking System, with a particular look at the role that the United Kingdom has played in this vast, dangerous unregulated market.

Please forgive the slightly wonkish nature of this, but rehypothecation is the practice that allows collateral posted by, say, a hedge fund to its prime broker (the investment banks or securities firms that provide lending and a bunch of other services to hedge funds) to be used again as collateral by that prime broker for its own funding. Rehypothecation is a form of expanding the off-balance sheet part of the financial system, by letting prime brokers use collateral that isn't really theirs to use, allowing further expansion of their balance sheets and injecting greater riskiness into the financial system as a whole. Off balance sheet financing was an essential ingredient in the conditions that brought the world to the edge of financial calamity recently.

Now all sorts of angles are interesting in this area. Two things they say are worth pointing out from the outset.

"there has been very little research in this area."

and, as a result of the studies by the authors Manmohan Singh (no, not the Indian Prime Minister but an IMF senior economist) and James Aitken:

"we show that the shadow banking system was at least 50 percent bigger than documented so far."

In other words, this matters a lot, and nobody has noticed.

But it's another angle we want to concentrate on here. It is this:

"In the United Kingdom, such use of a customer’s assets by a prime broker can be for an unlimited amount of the customer’s assets while in the United States rehypothecation is capped."

US banks have been receiving funding far beyond what prudential regulation suggests is safe, because although the United States put strong curbs on this practice, banks simply evaded them by going to the United Kingdom, which has a track record of allowing foreign banks to do what they would not have been allowed to do at home. The United Kingdom has been puffing up the size of the shadow banking system. And the IMF paper adds:

"Furthermore, there are no policy initiatives to remove or reduce the asymmetry between United Kingdom and the United States on the use of customer collateral."

The aim of this post is simply to add to the overwhelming weight of evidence that has accumulated that the City of London (pictured - the small red splodge in the middle of the pink London map), an offshore island within the United Kingdom, is in several respects the world's most important tax haven. We have already presented reams of evidence on this (see here, for instance, or here or here or here, for starters) and more evidence will be presented in the coming months - some of it which will be quite astonishing to people even in Britain.

TJN doesn't have a hard and fast definition of a secrecy jurisdiction or tax haven, but loosely we take these places to be jurisdictions that seek to attract business from elsewhere by providing opportunities to undermine or undercut the rules, laws and regulations of other jurisdictions. This is exactly what has been happening in this case. The United States instituted laws against the kind of opaque off-balance sheet abuse - so the banks went to the City of London to do it. As the IMF put it:

"the United Kingdom provides a platform for higher leveraging (and deleveraging) not available in the United States"

We now have a web page dedicated to highlighting the many and varied links between secrecy jurisdictions (or tax havens) and the latest financial crisis. We will be adding this post to it.


Anonymous Anonymous said...

I agree with you that the possibility of 100% repo of collateral is probably stupid and should be capped. Maybe it should be capped at zero percent.

Do you (TJN) not fear that spreading your efforts to all kinds of regulatory arbitrage may dilute your standing and influence?

Where is the "tax justice" in repo? How do you manage to jump from the fact (a mountain of numbers and transactions that noone has looked into before) to the conclusion "tax haven" or "secrecy jurisdiction"?

If neither the US nor the UK had any caps on repo in year one, and the US introduced caps in year two, would the UK then become a tax haven or secrecy jurisdiction, everything else equal?

I fear that TJN is on a slippery slope which in the end leads to that "tax haven" is just any practice one do not like.

We need TJN focused on taxes and secrecy established by law. This task is hard enough without straying off to any other battle worth fighting. Please?

4:50 am  
Anonymous TJN said...

Anonymous. You make an interesting point. It is a risk that plunging into these highly complex areas could lead to misunderstandings.

However, one of the central themes that TJN has repeatedly stressed is that the City of London is an offshore island inside the United Kingdom, and it provides services to other jurisdictions elsewhere that enable them to get around the rules and laws and regulations of those jurisdictions. Tax havens aren't only about tax - they are about secrecy, financial regulation, and much more. The links are there.

And to be fair, all of this economic and financial crisis business is ultimately a tax justice issue, not least because the processes underlying the crisis that allowed insiders to take the cream while shifting the risks onto everyone else, is an issue ultimately about ordinary taxpayers. And we do seek to articulate the interests and challenges facing ordinary taxpayers.

We are alive to the risk of spreading ourselves too thinly, but the issues are so vast and interconnected that if we were to operate on a policy of being frightened of taking on the big issues we would face big problems from a different angle.

12:31 pm  
Anonymous Relationship Banking said...

Turner said that no reform of global financial regulation will work without a thorough and appropriate response to the issue of shadow banks--institutions that perform functions similar to banks but are structured to avoid the regulation banks are subject to.

4:44 am  

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