It is no surprise that the move towards more onerous anti-money laundering and information exchange procedures has significantly increased transaction costs for everyone in the finance industry. The concerning new development is that the costs are beginning to outweigh the benefits and that regulation is hurting legitimate as well as illegitimate users of the financial system indiscriminately.
This is putting increasing pressure on financial centres that are struggling to comply and remain competitive in the current economic environment, which presents challenges to our perception of competition and free markets. In this respect, our liberal market economy is under pressure like never before and regulation is to blame.
For some time, the financial industry and the surrounding world has accepted the influx of regulation as a necessary consequence post-crisis, in order to ensure stable, transparent and sustainable financial markets that won’t crash and burn at the expense of tax payers. The primary focus has been to uncover illicit activities such as money laundering, tax evasion and fraud, by enforcing stricter reporting criteria, banning certain types of financial activity and boosting client protections.
Regulators argue that this can provide enough insight and oversight to ensure that we never see a repeat of the magnitude of the financial crisis, which to a great extent was caused by irresponsible loan and product practices in the US and within other major international banks. The goal is also to bring in billions of dollars from untaxed money that is being hidden around the world and can seriously boost the high deficits seen in countries like the US.
Bank deposits in Jersey, December 2013
However, very few people have dared voice that regulation can go too far and that not all the rules may be beneficial in the long run. Not to discount that regulation does an important job at keeping our markets safe and stable, research has now proven that the costs of compliance are seriously outweighing the benefits of financial regulation. At least that is the argument of Professors Richard Gordon and Andrew P Morris, who recently wrote the paper Moving Money: International Flows, Taxes, and Money Laundering, which offers a series of critical insight into the consequences of our current regulatory regime.
In a recent interview with World Finance, Geoff Cook, CEO of Jersey Finance, described the recent years regulatory developments, as “a tsunami of regulation, particularly for the banking and asset management sectors,” which have been hardest hit. Legislation such as the AML, FATCA and AIFMD all require a slew of resources and as part of compliance, billions of pieces of data are now floating around the world, at a staggering cost.
“Regulation has increased in recent years in order to ward off future problems and we have been an early adopter of these policies, because it is really in our best interest to comply. That said, we must consider the costs of regulation. Does it actually have the intended effect?” said Cook, adding that so far, regulation has had “no significance on crime prevention” and that such laws tend to impact clients most, as costs eventually end up on them, reducing gains from investments.
According to Gordon and Morris, this increase in regulation could have significant implications for economic growth, while providing little evidence of any real benefit from the new measures in terms of improved tax revenues or reduced illegitimate funds flows. Recently, US authorities rejoiced when estimates showed that FATCA would generate $880m in revenues a year, as a result of lost income from tax evasion.
Ironically, this is a drop in the ocean compared to the billions spent on FATCA compliance, and as the professors point out, this begs the question whether such regulation actually benefits the public and states enough, to warrant the implementation of such far-reaching regulation. Only a few people have dared question the regime, but surprisingly, the cost dynamic is now being reviewed by the G8 and G20, while the OECD has put out recommendations for the streamlining of data collection on a global basis, in order to limit the costs of transparency.
This has become particularly pertinent as it’s become apparent that developing countries with fledgling financial sectors and small regulators aren’t able to cope with the regulatory burden. “A consequence of all this has been that a lot of firms are pulling out of developing countries because its impossible to gauge the risks associated with doing business there and whether or not they’re actually complying. That could potentially stunt economic development in some parts of the world, which I think is quite problematic,” said Cook.
Research has now proven that the costs of compliance are seriously outweighing the benefits of financial regulation
Financial centres buckling
A key concern in this is that the mounting compliance costs are becoming too much for the world’s financial centres. Offshore entities like Jersey have been able to cope well with regulation, as it was an early adopter that engaged with regulators during the evaluation and consultation processes. Its own legislation already bared down hard on financial crimes and has since 1998, forced anyone with knowledge of tax evasion or illicit criminal activities to report such issues or otherwise find themselves legally liable. According to Cook, “the only sustainable strategy was to adopt regulation” and as such, Jersey Finance has seen a steady growth in compliance heads.
However, for others, compliance is less than easy, says Cook, and while fewer financial hubs might be good news for some, it’s damaging to the free markets and general competition in the financial sector.
“It is an inevitability that there will be fewer offshore jurisdictions in the future. Jersey can cope and absorb the costs of regulation, but smaller jurisdictions with less employees, smaller regulators and with a lacking legislation, will find it difficult to comply. Of course, that’s levelling the playing field for jurisdictions like Jersey, which has seen its costs increase significantly, while others haven’t invested in compliance up until now and therefore had an advantage.
“But this is problematic for overall competition,” said Cook. The professors even go so far as to argue that the regulatory burden being put on small financial hubs is unfair. “There are real issues of respect for sovereignty that must be addressed. Today’s international financial institution regulation is dominated by a few rich or large countries. If we live in a world where international relations require respect for the sovereignty of all jurisdictions, the shifting of costs from large, wealthy jurisdictions to small ones, is illegitimate,” said Gordon and Morriss.
Interestingly, a recent report on shell companies and secret bank accounts, tested the compliance of OECD countries in comparison to offshore hubs, and found that major regulatory issuers such as the US, were among the worst sinners in the world. Professor Sharman from Griffiths University proved that it was incredibly easy to circumvent prohibitions on banking secrecy, forming anonymous shell companies and secret bank accounts in 17 instances, of which 13 occurrences happened in OECD countries.
In the UK, it took a sole 45 minutes to establish a company without providing identification, issued with bearer shares (which have been almost universally outlawed because they confer completely anonymous ownership). Shockingly, the study concluded that G20 countries had much more lax regulation than tax havens did.
“In this respect, it is frustrating that the regulation doesn’t seem to discriminate between financial centres who already have strong measures in place, as opposed to those who have an obvious intake of illicit activities”, said Cook. “It is important to us to inform people about IFC’s because of the mounting concerns about tax evasion and money laundering, which we don’t want to be associated with. Regulation doesn’t discriminate between financial centres, but I think its necessary for it to do so, because we believe that we are better run than others”.
To this end, the professors noted that the best IFC’s already have very effective systems and skill sets in these areas and that they may well be able to adapt to the new regimes more rapidly and with fewer costs than their on-shore counterparts – who also face huge compliance costs. Still, the concern remains that regulation has fundamentally changed the face of financial business and in particular, is making it impossible for small IFCs entirely dependant on their tax haven status to continue attracting financial services.
With many developing countries using special economic zones as a driver for growth, and small Caribbean nations building the majority of their GDP from financial services, it is problematic that these nations could be forced to abandon the sector and thereby, economic development. More importantly, the impact this will have on overall competition should be a prime concern for a world that is largely built on liberal economic principles.