No loopholes

Simple, effective regulation should cover all financial activities, including transactions “over the counter” or “in the shadows”.

What’s the problem?

You and I don’t generally do bad things, even if they are not illegal. But companies are pretty much free to undertake whatever activities they want, wherever they want, as long as they don’t break the law. Financial firms can escape regulation by moving deals “over the counter” or establishing “shadow banks” or creating off-balance “sheet special purpose vehicles”. They can move activities to low tax jurisdictions or places where their activities can be kept secret. The more complex the law, the more loopholes there are to exploit.

 

What’s so bad about that?

The problem is that however often the rules are updated, financial firms will always be quick to find a legal way around them.

Before the crisis many firms had set up complicated schemes to hide risks, which turned out to be much riskier than we thought. Since then, shadow banking has grown bigger than ever is still largely unregulated.

Perhaps the best-known use of loopholes is tax avoidance, moving money and debts around between instruments and countries (often tax havens) to minimise the amount of tax they should be paying. Billions in taxes have been legally avoided – taxes that could be used to help with the energy transition or provide more of us with the things we need to live a decent life – to live well within limits. The same techniques are used to keep financial activities secret, providing a cover for money laundering and theft by some of the world’s biggest crooks.

 

What’s the alternative?

Closing the loopholes doesn’t just mean a new set of rules for financial firms to get around, it means changing the burden of proof so that activities are covered by default. Financial firms should have to do things in certain ways and in certain places, unless they can prove they have a good reason for doing otherwise. Only that way can we bring activities back out of the shadows so regulators and supervisors can see what’s going on, act if they need to and to ensure companies pay a fair tax bill.

 

How will it help?

Closing loopholes will help to prevent hidden financial stability risks from building up where we can’t see them, and reduce tax avoidance and other abuses.

For example the 600tnUSD OTC derivative market at heart of the 2008 financial crisis started because derivatives escaped from exchanges. Earlier all derivatives had to be on an exchange, that meant authorities could see exactly what was going on and control it if they wanted to. But once banks started doing derivatives outside exchanges the authorities lost control, they escaped through a loophole that became a gaping hole. A trickle soon turned to a flood and once the genie was out of the bottle they couldn’t put it back in – they never really managed to control derivatives markets again. After the crisis authorities started to try and reverse this by insisting that many derivatives went back through a sort of exchange called a central counterparty. This is a step in the right direction.

The ongoing cost of tax injustice is perhaps even more dramatic, measured in hundreds of billions of dollars a year in lost tax revenues. IMF researchers’ estimates suggest that OECD countries may lose 2-3% of their total tax revenues, and lower-income countries lose 6-13%. Closing the loopholes could provide essential funding to meet some of society’s biggest challenges.

 

What steps could we take to get started?

  • Make banks and financial firms apply for pre-authorisation of new services to ensure they do no harm and serve society. A bit like we do with medicines.
  • Build a safe corral: ensure all financial instruments are recorded and subject to regulation supervision. OTC does not mean beyond scrutiny and finance must come out of the shadows.
  • Reduce tax avoidance through public country-by-country reporting.
  • Continue to erode financial secrecy, especially through targeting tax haven jurisdictions.