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Sidebar: Recommendations by the Warwick Commission
Finance Professor Avinash Persaud argues that international regulatory compliance is a game imposed by large financial centres designed to close down Caribbean financial centres.
Speaking at the Caribbean Regional Compliance Association’s conference in Trinidad and Tobago in March of this year, Persaud said the only way for Caribbean centres to survive is to find a regulatory niche, specialise in it and become vocal experts in effective regulation.
In a world that is more regulated and demands more investments into compliance systems and professionals, the countries that are required to make the biggest investments had essentially nothing to do with the financial crash. “I make the assertion that is unfair,” said Persaud, a consultant and senior fellow at the London Business School.
Persaud believes politicians are to blame for the financial crisis of 2008 because crashes are caused by booms and booms in turn are supported by poor regulation, poor monetary policy and poor fiscal policy.
If there was only one thing that could have been changed to moderate the crash and shallow the depth of the recession, it would have been a tighter fiscal policy in the US, he said.
“What we have seen is a failure of the US Congress to tighten its fiscal belt. Whether this is because the Democrat side doesn’t want to cut spending or the Republican side doesn’t want to raise taxes, we can debate what the causes are, but there is no debate that the US Congress has been unable to reach agreement on fiscal policy. And that was a major cause for the global imbalances and a major cause of pumping up this financial boom.”
But instead of blaming themselves politicians prefer the bad apple theory of financial crises.
“The bad apple theory says this crisis was not caused by bad policy but by bad bankers, bad instruments and bad jurisdictions. And the advantage of the bad apple theory is that politicians can respond, lock up the bad bankers, shut down the instruments and close down jurisdictions.”
This theory however does not make any sense because the financial crisis of 2008 was not the first financial crisis, said Persaud, echoing the findings of the book
“This is time is different” by Kenneth Rogoff and Carmen Reinhart. In their book Reinhart and Rogoff analyse financial crisis of the past eight centuries and explicitly state policy makers should take note of their findings that there were striking similarities between past crises and the financial crash of 2008. Persaud makes a similar case, claiming it is difficult to argue the crash was caused by one instrument, if this instrument did not exist in the previous crises.
In 2008, Persaud chaired the Warwick Commission on International Financial Reform, which rather than following the current route of calling for uniform global rules, advocated that in certain areas of finance an unlevel playing field both on a national and international basis has merit.
The Commission’s report ‘In praise of an unlevel playing field’ concluded:
“We need an unlevel playing field between countries as a result of the policy responses to economic cycles that are often less synchronised than they appear. We need to tilt the playing field within countries to reflect the unlevel capacity of financial institutions for different types of risk and to help risks flow to where they are best matched by risk capacity.
"We need a financial system that is robust to shocks, and that requires diversity, not homogenous behaviour derived from the blanket application of the same rules and standards on valuation, risk and trading.”
Ducking the fast ball
Persaud, a Barbadian said, if current regulatory compliance efforts were genuine they would focus on the fundamentals of a well run financial system.
Yet, the way the game is played is discriminates small financial centres because the largest bribery and corruption cases did not occur somewhere in St. Kitts or Trinidad and Tobago but in the US and the UK. If regulations were an honest response to money laundering we would see “concerns about Nevada and Delaware, states which are thin with proper regulation and oversight”.
Rather than following a risk tolerant approach, the game is about heaping the regulatory compliance cost on small centres that cannot distribute those costs among their smaller financial industries without going out of business, Persaud argued. “That is the game at stake.”
In his opinion it is not a game that can be avoided, as the sanctions that would follow can only lead to the same result. Choosing a cricket analogy he said:
“If we are facing bodyline, we can’t pick up the stumps and go away. We have to find a way of dealing with bodyline. We have to find a way to deliver the strokes that deal with this new form of bowling. And unless we do so, we will not have an industry in ten years time.”
The only alternative for small Caribbean financial centres is to become intelligent participants of the game by specialising in a niche and to invest in compliance in that niche.
Small financial centres can identify a specialty niche and do it well to global standards, Persaud said. In contrast, the application of all global standards across the board would mean that small financial centres will be weighed down by the cost of doing business, make them uncompetitive compared to large financial centres and ultimately shut them down.
This “copy and paste approach” to regulation won’t work, said Persaud. “Take the Financial Services Authority of the United Kingdom. 2,000 employees, $2 billion spent on regulation and they still miss the biggest financial crisis. How can small states tick the same number of boxes as the regulators with $2 billion of resources? Impossible.”
Only when small financial centres invest in these niches, develop better regulation and become advocates in the debate over effective regulation of particular industries and the right compliance, will they be able to survive.
The examples of Bermuda which is world class in insurance regulation and the Cayman Islands which is world class in hedge fund regulation show that it can be done, said Persaud.
It would also involve winning the intellectual arguments and investing into advocacy, for example by creating a Regional Institute of Regulation and Compliance.
Identifying areas of poor regulation
In the past the regulatory default position has often been ‘best practice’, ie what was commonly done.
“But that is actually a copout,” said Persaud. “The default position should be, how does this fit in with the principles of why I am regulating? And we have to move back to that.”
While it is easy to focus on copying common practice, it is much more difficult to recognise that regulation aims at a moving target and that what was good practice last year used in a different way in a different industry is bad practice today.
Persaud sees a genuine advantage for smaller states in detecting those areas of finance that are not regulated well. “There are issues of large aspects of finance today that are being poorly regulated, not too tight or too loose, just wrongly regulated.”
One such area concerns the long-term savings of insurance companies and pension funds, he said, because the regulators are captured by the banking lobby rather than the asset management lobby.
The resulting disproportionate focus on banking has led to a banking approach to financial regulation and supervision that does not necessarily makes sense for those who are managing long-term money.
“A bank which has short-term funded money must use mark-to-market in accounting, must manage short-term liquidity issues, short-term solvency issues. For a fund investing for 20 years, a surplus fund that pays out in 20 years time, mark-to-market accounting and short-term measures of liquidity make no sense.”
This is only one of many regulatory aspects, which would be better regulated by small financial centres that are able to develop innovative effective regulation, according to Persaud. These centres will then be able to attract pension funds to be domiciled there if they are going to be regulated in a way that makes sense in terms of systemic risk, institutional risk and market risk.
Regulators do not have to be behind the curve as far as effective regulation is concerned, but they need to frequently update regulation every three or four years, Persuad said.
“If you have regulation that is 15 years old on the statutory books then you can imagine that the bankers had 15 years of applying their intelligence and incentives to finding ways of getting around it.”
Essentially this requires regulators and supervisors to understand the principles and objectives of regulation, who they are trying to protect and who they are not trying to protect and to have the confidence in their understanding of the industry and the effective way it should be regulated.
“If our regulators do that, they have all the powers they need today to observe behaviour and to decide whether they have to make an intervention or not.”
While this may involve talking to the industry, the regulators should not be beholden by the industry, because too close a relationship will lead to cases like CLICO in Trinidad and Tobago and Stanford in Antigua.
Moving away from tax efficiency
The only avenue for financial services in Caribbean financial centres is that in ten years time the industry will be based on the foundations of regulatory innovation and world class expertise.
Although the financial industry developed in the Caribbean mainly on the basis of tax efficiency, Persaud believes in the future “the very genetic foundation of this industry has to change” and has to be about something else, if it is going to survive.
“If our industry is built on tax efficiency it is dead. The G20 will not allow tax revenues to be siphoned off into international financial centres.”
In addition to world class regulation in specialised areas, Caribbean financial centres will have to refocus on other issues, such as lifestyle and location for example to be able to attract asset managers to live in the region.
“But if we think we can ignore this, that we can just add more compliance officers and that somehow we will survive, then we are not living in the real world.”