New regulation in the financial sector: US and Europe

I reproduce in extenso RGE Monitor's Newsletter regarding new proposed financial sector's regulation in the US and Europe:

"As decided at the latest G20 meeting, authorities around the world are devising micro- and macro-prudential reforms in order to strengthen the resilience not only of single financial institutions but of the entire financial system by extending oversight to all important financial institutions, products, and activities.

The United States

In the U.S., the Obama administration introduced its widely anticipated regulatory reform proposal on June 17. Its five main components include:

1. The establishment of the Fed as systemic risk regulator and supervisor of “too-big-to-fail” institutions in return for Treasury permission requirement for extraordinary liquidity programs. The plan proposes creation of a “Council of Regulators” (formerly the President’s Working Group) chaired by Treasury but with advisory powers only;
2. The creation for the first time of a regulatory regime for all financial derivatives, as well as a requirement that the originator, sponsor or broker of a securitized vehicle retain “skin in the game” – i.e., a financial interest of at least 5% in its performance;
3. The creation of a new Consumer Financial Protection Agency with rules against predatory lending and transparency standards at the retail level;
4. A new resolution mechanism that allows for the orderly divestiture of any non-bank financial holding company whose failure might threaten the stability of the financial system, including investment banks, large hedge funds and major insurers such as AIG;
5. Adopting a leadership role in the effort to improve and coordinate global regulation and supervision.

The main points of contention in Congress are likely to include the scope of the new regulatory powers conveyed to the Federal Reserve in view of the arguably minimal use it made of its already existing regulatory powers in the run-up to the crisis. Equally controversial are the need and the powers of the new Consumer Financial Protection Agency. Furthermore, some policymakers and market participants are equally worried about the potentially stifling effect of too much regulation on financial innovation.

The European Union and Switzerland

Two days after the Obama plan’s introduction, on June 19, EU leaders reached agreement on a new framework for coordinated (rather than unified at EU-level) macro- and micro-prudential supervision along the lines proposed by Jacques de Larosiere and endorsed by the European Commission on June 9. Regarding the macro-prudential authority, the new European Systematic Risk Council (ESRC) will comprise EU central bank governors and will most likely be chaired by the ECB president. The Council will issue financial stability risk warnings and macro-prudential recommendations for action to supervisors and monitor their implementation. In contrast to the U.S. Federal Reserve, however, EU central bankers will not oversee and regulate systemic cross-border institutions directly. ECB vice president Lorenzo Bini Smaghi, in a June 19 speech, deplored this discrepancy.

The EU agreement also establishes a new micro-prudential authority at EU-level. In particular, the European System of Financial Supervisors, comprising three new European Supervisory Authorities, will help ensure consistency of national supervision and strengthen oversight of cross border entities. This will be accomplished by setting up supervisory colleges and establishing “a European single rule book applicable to all financial institutions in the Single Market.”

Importantly, the new EU-level supervisory authority will have binding decision powers in the case of disagreement between the home and host state supervisors, including within colleges of supervisors. EurActiv cites the following example: “If Italian and Polish supervisory authorities disagree regarding recapitalization of an Italian bank operating in Poland, for example, it would be the new EU-level authority that would settle the issue with binding decisions.” However, EU leaders are clear in their agreement that “decisions taken by the European Supervisory Authorities should not impinge in any way on the fiscal responsibilities of Member States.” This precludes any ex ante burden-sharing provision, a very controversial issue. As EurActiv explains: “Should a major financial institution fail, there will be no European competence to establish which countries will have to foot the bill and by what means. National interests are likely to prevail again on this issue.”

Up until now, then, an EU-wide resolution regime for cross-border banks remains unaddressed. While this is welcome news for Britain, which worked hard to confine any EU interference to a minimum, smaller EU countries as well as non-EU countries with large banking sectors have a problem.

Not by coincidence, Philipp Hildebrand, vice president of the Swiss National Bank, noted on a June 18 speech: "The lack of any clearly defined and internationally coordinated wind-down procedure contributes to a de facto obligation on the part of the state to provide assistance to these institutions." Small countries, in particular, will need to develop wind-down rules for crisis situations. One possible consideration, according to Hildebrand is to "split off those units of a bank that are important for the functioning of the economy and wind down the rest."

‘The rest,’ of course, might include foreign EU operations in need of domestic backing. In terms of pro-active regulatory interventions, the Swiss have been at the forefront with an overall leverage cap for their large institutions, an innovative ring-fencing framework for bad assets at UBS, and a risk-adjusted remuneration scheme at Credit Suisse (i.e., to pay top bankers based on the performance of the toxic waste they originated or acquired on behalf of the bank).

The UK established new resolution powers for national institutions in the Banking Act 2009 in the aftermath of Northern Rock. Large and complex financial institutions, however, still await a comprehensive solution, a fact noted in Mervyn King’s June 17 speech. He noted that “one important practical step would be to require any regulated bank itself to produce a plan for an orderly wind down of its activities,” i.e. akin to making a will. That kind of information would also be a valuable input for the new EU cross-border regulators.

Alternative Investment and Derivatives Regulation

In the U.S., the President’s plan requires all advisers to hedge funds and other private pools of capital, including private equity funds and venture capital funds whose assets under management exceed some modest threshold, to register with the SEC under the Investment Advisers Act and provide sufficient information for effective systemic risk supervision. Similarly, under the EU Commission draft regulation, managers of hedge funds and similar ‘alternative investment funds’ that handle at least €500m (€100m for those using borrowed money) would have to be registered in trade repositories and provide information about leverage. For now, the draft law applies only to managers, rather than funds, because many funds are based offshore. After three years, the rules will get tougher for funds based outside the EU. Although the EU plan was under heavy attack by the industry, the latest U.S. backing should put any hope of a reversal to self-regulation to rest.

New rules in major financial centers also require all financial derivatives to be brought under the regulatory umbrella. As part of the U.S. plan, standardized credit default swaps (CDS) and other over-the-counter (OTC) derivatives will be required to clear through a central counterparty and trade on exchanges and other transparent trading venues. More customized products will be required to register with a central registry that makes aggregate data available to the public and detailed positions for regulators. In the European framework, the UK secured that the new EU supervision will not cover clearing houses for derivatives – an important objective for the City of London who is global leader in terms of trading volumes of derivatives."

I will have only one comment (besides the fact that I do believe that State regulation will sow the seeds of further and even more damaging crises - just look at the increasing indebtedness of States in the West for the past 40 years): the emerging markets' banking system is in much better shape and does not need to increase regulation. Interesting...

Source:

RGE Monitor's Newsletter: June 24, 2009
http://www.rgemonitor.com/

Tax Havens, Politics and Scapegoats (3/3)

Scapegoats

On the question of transparency, which seems to be central to discussions regarding tax havens, the OECD established a Framework for a Collective Memorandum of Understanding on Eliminating Harmful Tax Practice where:

Each party will ensure that its regulatory or tax authorities have access to information regarding beneficial owners of companies, partnerships and other entities organized in its jurisdiction, including collective investment funds, and to information on the identify of the principal (as opposed to agent or nominee) of those establishing trusts (settlors) and foundations under their laws and those benefiting from trusts and foundations.

Clearly, the State of Delaware in the US does not comply.

The very interesting study conducted by Bruce Zagaris, a Partner of the Washington based law firm Berliner Corcoran & Rowe, demonstrates the double standard applied:

Some U.S. states, such as Alaska, Delaware, and Nevada, have enacted asset protection laws to attract persons, especially foreigners, seeking protection from creditors. (…) Delaware has advertised that its new trust law ensures “confidentiality of information and records.”

At least two other states, Montana and Colorado, have offshore banking laws designed to attract foreign investors by offering tax exemptions, confidentiality, and ease of establishing accounts and doing business. (…) especially the fact that Colorado's was enacted in 1999, after the release in May 1998 of the OECD's initial report on harmful tax practices.

(…)

The state of Delaware also is trying to attract business based on its laws and reputation as a domicile where corporate debtors can quickly obtain bankruptcy.Virtually no OECD country requires corporations to keep ownership information on file with a central or other governmental authority on a routine basis, except for certain types of corporations, although the OECD HTC MOU requires the targeted countries to do so.

Interesting enough, On June 23, 2008, Brazil's Congress published Law 11,727/2008, which, effective as of January 1, 2009, will amend Brazil's transfer pricing regulations and expand the legal definition of tax havens. The surprising news in all of this is that it is widely believed that these changes were made specifically so that the exotic state of Delaware could be designated as a tax haven, or at least a jurisdiction with the characteristics of one.

Paul Mason, from the BBC, analyzed what happened at the G20 meeting in London regarding the OECD list. It appears that last minute negotiations occurred between Sarkozy, Hu and Obama not to include Macau in the grey list of the OECD. But, hold on, wasn't it the OECD that was establishing the list independently...? This BBC story is worth reading!

So, all countries attending the G20 meeting escaped in one form or another to be named and shamed, whilst the usual small countries were used as scapegoats for the crisis. Making the public (read the voter) thinking that tackling tax havens and putting them under the control of large deficit countries will solve the crisis, is ludicrous.

Clearly tax havens make tax hells losing tax receipts; this is however a drop in the ocean of accumulated budget deficits over the years from lax budget spending (voting bribery?) and poor public governance, governance hailed however by the very same politicians as the new Graal of the New World Economic Order (don't misread: I very strongly support governance in general and corporate governance in particular as well as I believe its lack of it is one of the roots of the financial crisis).

In addition, imagine what would happen to tax rates, if low taxation jurisdictions did not exit. Already, The US, the UK and Ireland announced an income tax increase; this is only the beginning of the tunnel. And why blaming countries that are managing their budget in a proper way and do not need punishing taxation?

What to conclude?

First, China showed once again its power on the international stage and will become more and more assertive
Second, Continental Europe is firing a bullet in its foot as usual: the reading of the OECD list is self explaining.
Third, the US and UK continue successfully to divert attention away from their backyard: do what I say and not what I do...
Fourth, the G20 meeting and the preceding negotiations about the OECD list showed the lack of transparency and governance from countries that insist on them, and discredited the OECD.
Fifth, Large countries found their scapegoats: small, well managed countries that offer high living standards to their populations; instead of following their path, they point the finger at them as responsible for the financial crisis (one of the two causes of the crisis was outlined by President Sakorzy in October as being tax havens - a joke! -).

Tax Havens, Politics and Scapegoats (2/3)

Politics

It seems that we are going towards the legitimation of the the strongest, biggest financial centers and tax havens while smaller countries and territories are stigmatized.

Indeed, the OECD found that its definition caught certain aspects of its members' tax systems (most developed countries have low or zero taxes for certain favored groups). Its later work has therefore focused on the single aspect of information exchange. This is obviously a flawed decision. This single criteria for defining a tax haven is inadequate and goes against common sense, but is politically expedient because it includes the small tax havens (with little power in the international political arena) but exempts the powerful countries with tax haven aspects such as the USA and UK.

For example one of the most permissive location for business is the State of Delaware in the US (where Joe Biden, the current Vice-President, was a senator). Let’s review it quickly:

• 43% of companies on the NYSE are incorporated in Delaware (over 400.000 companies i.e. +/- 1 company for 2.5 inhabitants and growing)
• Significantly low income tax levels (below 6%)
• No need to disclose the beneficial owner of assets (Delaware having passed the test of transparency, no jurisdiction should be included in the OECD list)
• Partnership taxation laws which make it favorable to non-US entities, typically allowing taxation at 0% where the partners are registered in non-US jurisdictions
• Anti-hostile takeover legislation and strong protection of companies’ management
  

If you want more detailed information, go to the State of Delaware official website

To summarize and according to the State of Delware web site:

"Corporations choose Delaware for the following reasons:

1. Ease of incorporating,
2. Business-friendly climate,
3. Fast services provided by the Secretary of State's Office and
4. Delaware's Court of Chancery. (Our Court of Chancery is well known for its ability to issue timely decisions on complex corporate matters, and its wealth of case law ensures consistent answers to corporate questions.)
If you form a corporation in Delaware, you are required to pay an annual Franchise tax to the Delaware Department of State for the privilege of incorporating in Delaware. Franchise Tax is based on the number of the corporation's authorized shares and costs a couple of tens of dollars."

Funny enough (well, not so funny) the Delaware Statutory Trust has been widely used for structured finance deals such as asset securitization.

Let’s review the politics during the G20 meeting and their interaction with the OECD list.

Tax Havens, Politics and Scapegoats (1/3)

Tax Havens

The G20, hailed as a success, was nothing more than a political gathering aiming at communication (see post "G20 summit and today's markets" April 2), the most for the French President, Nicolas Sarkozy, who threatened to walk away if he did not get what he wanted: tax havens MUST be scrapped since Sarkozy, in October 2008, identified them as one of the two causes of the financial crisis...

Here we are. The OECD published on April 2 a list of non or not co-operative enough countries or supposed to be. Funny enough, Uruguay, Malaysia and Philippines were on the black list: didn’t you know that these countries were tax havens? (they were moved, together with Costa Rica from the black list to the grey list on 7 April). Didn’t you also know that Hong Kong, Mauritius, Dubaï, Saint Barthelemy in the French West Indies or Delaware in the US to name a few were not tax haven?

Funny enough, the OECD makes a distinction between tax havens and other financial centers: are they tackling tax havens or something else? We will see this later on.

In any case, the credibility of the OECD has zoomed down to zero!

Remember, the fight against tax havens took a boost after 9/11; it was aiming at fighting more efficiently Al Qaieda and money laundering from crime in general.

Let’s go back to 1998 when the criteria where laid down by the OECD to pinpoint a tax haven. There are three criteria (the absence of a requirement that the activity be substantial was abandoned by the OECD in 2001):

1. No or only nominal taxes. Tax havens offer themselves, or are perceived to offer themselves, as a place to be used by non-residents to escape high taxes in their country of residence
2. Protection of personal financial information. This prevents the transmittance of information about taxpayers who are benefiting from the low tax jurisdiction.
3. Lack of transparency where one country can make it difficult, if not impossible, for other tax authorities to apply their laws effectively

In the next article you will discover how politics melted in.