Trim the sails, hold a steady course

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The word of the day is regulation. How could it not be? The formidable PR machines of the EU and US governments tell us so. Basel III, we are told by a triumvirate of US regulators, provides a “more stable banking system less prone to excessive risk”. We need more regulation, tighter rules and stricter controls, all supposedly so that governments (the good) can protect their citizens from the risks taken by global institutions (the bad) and Wall Street banks (the ugly).   

But if protection and a desire to prevent a repetition were the real objectives we could anticipate that the US regulatory response to the financial crisis would have established some passing reference to two of its fundamental causes. Yet the framers of the Dodd/Frank Act did not see fit to restrict Fannie Mae and Freddie Mac’s ability to guarantee mortgages to un-creditworthy borrowers, nor to restrict the rating agencies in granting AAA ratings to the repackaged toxic waste that resulted.

In the political world therefore, it follows that actual causes of the crisis must have been elsewhere. Cue then the political attack on banker’s bonuses, hedge funds and private equity – a safer target than any attack that might cut across the laudable but blatantly populist and embarrassing objective that everyone should own a home, regardless of their ability to pay for it.

Michel Barnier, Europe’s Single Market Commissioner, has now unveiled his latest plans for regulating Europe’s financial markets. He will give Brussels new powers to end “abusive speculation” and “impose order” on Europe, including the City of London. “We want to know”, he states with imperious disregard for the regulatory time lag, “who is doing what”.

Very possibly he has in mind placing an EU regulator at the screen of every trader. The EU authorities are going to “look at every product”. “[They] can restrict leverage, or in exceptional circumstances even ban a product temporarily”, Barnier told the Daily Telegraph in early September. But, if we employ the Euro-regulatory double-speak translator, what Mr Barnier no doubt meant to say was “we cannot possibly prop up a totally bankrupt European fiscal Union if hedge funds are allowed to trade in the market place and price European sovereign debt at its true market value rather than the value we attribute”.

Thus we see hedge funds now targeted in Europe and subject to a regulatory response that will restrict leverage and require UK-based fund managers to receive 50 per cent of their remuneration after a deferred three year period, as if hedge funds or their bonuses had been instrumental in the European financial meltdown (we cannot but admire the speed with which the FSA, in an endeavour to appear ahead of the regulatory curve, applies the remuneration restriction in a broader and more stringent manner than any other Euro regulator).

But, the average leverage in the hedge fund industry is only around two, so the only possible conclusion we can come to is that it is the threat that hedge funds pose to the political aspirations of those driving a totalitarian federalist agenda that has to be curbed by this new regulatory regime.

Mr Barnier speaks also of the creation of yet another EU regulatory regime – a triad system covering markets, banks and insurance. And, due to the questionable strategy of the recent UK socialist government in pandering to EU regulatory aspiration over and above its duty to the citizens it represented, the UK will have no veto power over this body’s regulatory determinations for whatever reason they are arrived at, despite the fact that the City of London is the only globally recognised financial services centre in the EU. The UK will as a result, carry the same weighted vote in these matters as Latvia.

In the face of this regulatory tsunami and the almost universal bleating that presages it, many industry commentators have been falling over themselves in forecasting the demise of any jurisdiction which does not fall immediately into line with the new world order. But even if we automatically discount to zero the contributions of those who, in a way peculiar to the Irish, actually believe their own public relations, or indeed those whose job security and pensions are entirely dependent on the growth and administration of market-throttling regulation, we need to be highly analytical in our approach. So let us start with two undeniable truths.

First, what is proposed is not, in the main, global and second no financial institution failed in Cayman during the financial crisis. So we conclude an appropriate regulatory regime in Cayman worked exactly as it was supposed to. It is hard see in these circumstances why there should be a rush to apply the regulatory notions of jurisdictions with less than enviable records and whose regulatory responses avoid recognition of the real causes of the financial crisis.

But, the truth is a good deal more troubling than that. In his book Engineering the Perfect Storm, Jeffrey Friedman points out that ill-considered regulation contributed to the financial crisis. The risk weightings applied under the Basel Convention encouraged heavy investment in the mortgage backed securities market because in 2001 US banking regulators (the very same bastions of public protection) assigned $2,000 of capital for every $1 million of MBS as against $10,000 for every $1 million of commercial loans. The result was that banks owned 45 per cent of all subprime backed mortgages by 2005, secure in the knowledge that 95 per cent of these were AAA rated and accepted as such by the banking regulators. Thus does ill-considered regulation distort the marketplace and in the current example assume a direct causal relationship with the catastrophe that followed.

So we are assured that Basel III makes no such similar mistakes. Or are we? Commentators have already pointed out that none of Bear Stearns, Washington Mutual, Lehman Brothers, Wachovia and Merrill Lynch would have failed the increased Basel III capital adequacy ratios, having regulatory capital ranging from 12.3 per cent to 16.1 per cent. Thus, the much lauded Basel III would not have saved any of them. It may have assisted the regulators in their deliberations, if before deciding erroneously what supposedly constitutes “too big fail” they had accurately analysed what is meant by “small enough to succeed”.

No doubt the Cayman Islands cannot stand alone, howsoever flawed the regulatory responses. But as the Canadian banks showed in their rejection of the Tobin tax, there is a material distinction between regulation that is imposed globally, like the Basel accords in relation to the banking industry, and that which is purely regional like the European Alternative Investment Funds Directive. In determining in which jurisdictions Cayman vehicles may operate we accept absolutely that local regulation must apply to those who choose to operate within its ambit.

With that principle established, it becomes clear that such local regulation should only apply in that circumstance. Indeed the European Funds Directive supposes that outcome. If its application is technical we need go no further. If it is political, in that fund managers representing Cayman funds are excluded, we must first evaluate how many Cayman funds so trade. The answer by NAV is around 20 per cent but that number may in fact be declining, not increasing and it may not be worth prejudicing the operations of 80 per cent by seeking to apply the European solution across the board.

In all of this we need not take the words of the regulators as gospel. It is becoming increasingly evident that the market has a very distinct voice and is voting with its feet. The excellent and objective KPMG report “The Future of Alternative Investments” investigates the opinions of over 200 investment managers, administrators, institutional investors and service providers on the effect of the suggested increased regulation. It states in categorical terms:

“Anticipated regulation, driven by external forces that continue to blame alternative investments for the meltdown of the global financial system, is not wanted by the majority of investors, managers or service providers. The widely held view is that the industry did not cause or contribute to the credit crisis. Furthermore, investors believe more regulation will not produce any tangible benefits”.

The Report goes on to state: “Managers with assets of less than $100 million will find it increasingly challenging to run a long term business as a result from increased cost of regulation”.

The new regulation will ultimately stifle ingenuity and entrepreneurial opportunities. The survival of only larger operators will impede potential growth at the peril of UK and the US economies, which are regulating themselves out of a productive industry and the capital flows that are essential the recovery of their failing economies.

The Report makes clear that the effect of this regulation paradoxically will be to create a marketplace dominated by fewer larger institutions, none of which, it is supposed, will be “too big to fail”?

But the effect of localised or regional regulation rather than global regulation is equally perverse given the financial marketplace is not static. The exodus of fund managers and banks from London is now occurring as alternative offices are established in Switzerland, the most unlikely of unintended beneficiaries, and Hong Kong. Cayman too would be an excellent choice as a jurisdiction for relocation of investment management companies, but geography, life style issues and a regressive and short-sighted immigration policy have weighed heavily against it in the current circumstances.

But whilst we rue one missed opportunity for substantial development of the local financial infrastructure that an influx of fund managers would have brought, we must not lose sight of the fact that a Cayman hedge fund trading with a Swiss, Dubai, Hong Kong or Singaporean fund manager does so free of the restrictions of the new Euro-regulatory regime.

This means in turn that the Cayman hedge fund may continue to trade traditional hedge fund strategies and with traditional rates of return – which the Euro-based UCITS model will struggle to compete with, starved as it will be of the oxygen of leverage, a more liberal risk profile and the best-remunerated talent.

Cayman has trimmed its sails and held its regulatory course. As a jurisdiction, it has been able to lay justifiable claim to being a properly regulated, market-efficient jurisdiction. The opportunities for growth are in the BRIC countries, the Middle East, Asia and other emerging markets and we should tailor our regulation to be highly competitive in those places. European and American investors will not take long to realise that needless regulation imposed on them for reasons which relate to the aspirations of their politicians will render their businesses non-competitive, and that entrepreneurial spirit will continue to thrive in places that embrace it.

sails-SM