Shadow banking: why tax havens increase financial risks

From a 2013 paper by Thomas Rixen, another set of arguments why tax havens have helped generate financial risks. The paper itself argues that financial regulatory competition – core TJN fare – is much overlooked. He focuses on:

“an aspect that has so far been under-analyzed in the post-crisis literature – state or jurisdictional competition for financial activity as a serious obstacle to regulatory reform.”

And in the paper he notes five ways in which tax havens, or secrecy jurisdictions (he uses the term Offshore Financial Centres, or OFCs) generate financial risks:

“OFCs increase financial risk in at least five ways.

First, given their lax incorporation rules, they make it easier to register SPVs.

Second, as a result of lax oversight and lack of cooperation with onshore jurisdictions they enable onshore financial institutions to hide the risks involved in their offshore subsidiaries from regulators.

Third, the low or zero taxes lead to higher profit margins and, thus, increase the incentive for risky behavior.

Fourth, and related, by using SPVs in tax havens certain quality requirements on credit to be securitized could be avoided (OECD 2009, p. 48).

Fifth, the tax advantages offered by OFCs foster the debt bias of investments. As interest payments can be deducted as costs, whereas dividend payments cannot, most tax systems advantage debt over equity financ- ing. This effect is exacerbated by the low or zero tax rates in OFCs; the interest payments lower onshore tax burdens, and the profit can be accumulated tax-free offshore.7 Overall, this increases the propensity to take on credit and to work with ever higher leverage ratios in investments.8 The tax bias toward debt conflicts directly with financial regulation, which tries to lean against debt (cf. IMF 2009).

Taken together, these features of offshore finance increase investment profit margins and make the shadow bank strategy more attractive. To some extent, OFCs feed the shadow banking system.”

Some of these are points that we’ve made before, but we did want to point to this paper. And there are some major feedback loops here, which we’ve remarked on before, and not just in the area of financial regulation:

“The international and domestic forces against reform reinforce each other: the competitive pressures at the international level make governments more susceptible to the arguments of business interests; and these argu- ments are more credible because of the existence of jurisdictional competition.”

For a whole lot more on this huge but under-explored area, click here.


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