Paper to be presented at the International Schumpeter Society Conference 2010 on

INNOVATION, ORGANISATION, SUSTAINABILITY AND CRISES

Aalborg, June 21-24, 2010

Financial Innovation and the Financial Crisis

Jim StewartTrinity College Dublin

jstewart@tcd.ie

Id: 374

ISS SCHUMPETER Conference 2010

Innovation, Organisation, Sustainability and Crises

Aalborg University, Denmark, 21-24 June 2010

Financial Innovation and the Financial Crisis

Jim Stewart

School of Business, Trinity College, Dublin

Email: jstewart@tcd.ie

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Financial Innovation and the Financial Crisis

“The message of Schumpeter for our times is that market-oriented economic development requires two analytically distinct sets of entrepreneurs; the innovators in product and process and the innovators in finance.” Hyman Minsky (1990)

Innovation plays a key role in economic development, through the development of new products, new processes and in increasing productivity. The focus of this paper is on innovation in the financial sector. Some have argued that financial innovation has a key role as a source of economic growth. The financial crisis has also drawn attention to the role of financial innovation in introducing instability and deep recession. This paper in particular examines one financial innovation - referred to as the shadow banking system, the essential feature of which is that it was either unregulated or subject to light touch regulation. 1. The contribution of Minsky The dominant paradigm in dealing with the current financial crisis is to reduce Government expenditures. This is the proposed ‘solution’ to the Greek crisis is an example (see the IMF conditionality programme available at http://www.mnec.gr.). Portugal Spain, and other countries have also announced programmes to reduce government expenditures including wage cuts. Commentators often cite Ireland (Barkham, 2010) as a role model in dealing with the financial and economic crisis. Yet in the week these announcements were made and following the recent intervention in Greece, stock markets fell. Commentators writing in the financial press generally support these policies, but at the same time report fears that retrenchment in European countries may result in a double dip recession (Oakley, 2010). Some economists for example, Stiglitz, Krugman, argue that the policy prescriptions from Keynes are the most appropriate response to the current crisis. But as argued by Minsky Keynesian arguments neglect the role of finance in causing cycles. Minsky argues that Keynesian economics as largely implemented does not take sufficient account of finance, because the role of finance was implicit rather than explicit in the General Theory. Minsky argues that .. implicit in the analysis in the General theory is the view that a capitalist economy is fundamentally flawed because “the financial system necessary for capitalist vitality and vigor………. ..contains the potential for runaway expansion, powered by an investment boom”. (Minsky 1975, pp. 11-12). Minsky states:-

“..in a boom the ingenuity of bankers is directed at turning every possible source of temporarily idle cash into a source of financing for either real operations or financial position making”. (Minsky, 1975, p. 143).

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“This expansion is ended because accumulated financial changes render the financial system fragile so that not unusual changes can trigger serious financial difficulties”. (Minsky, 1975, p. 12).

Minsky argues that ‘booms and busts’ are an inherent feature of every economiy where financial innovation is driven by market forces. (Minsky, 1009, p. 60). The General Theory had much to say about uncertainty. Skidelsky (2009, p. 84) states “uncertainty pervades Keynes’s picture of economic life”. A situation of certainty is often assumed in financial and economic analysis, as in the standard Fisher-Hirschleifer analysis of investment decision making (Stewart, 2000). If a framework based on probabilities is developed this is almost always done in the context of assuming events follow a normal distribution. Keynes however assumes “the view of the future is subject to sudden and violent changes” (Minsky p. 67). Uncertainty leads to volatility in investment even though production relations are stable (Minsky p. 68), and quotes the famous statement by Keynes that “When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done” (Minsky p. 90). Minsky argues policies pursued by governments have led to a fragile financial system, and the real economy behaves in quite a different way with a fragile financial system. It is much more prone to cycles. The fragility of the financial system is related “to the extent to which units are dependent upon refinancing their positions in long assets in smoothly functioning short-term financial markets” (Minsky, 1975, p. 163). Minsky argues the problem is that Keynes never explicitly developed a theory of the boom and the crisis and he never articulated a model or an explanation of how the liability structure of firms, banks, and other financial institutions evolve. It is not sufficient to advocate Keynesian type policies, or indeed other policies without analysing the role of finance in the current crisis. 3. The Key Role of Financial Innovation In his Nobel lecture Merton (1997, p. 108) identifies innovation as “a central force driving the financial system towards greater economic efficiency”. Merton in this lecture emphasised financial innovation resulting from academic research in finance via the development of options and derivatives. Merton argues that ‘contracting technology’ has increased risk sharing, lowered transaction costs and reduced information and agency costs (Merton, 1997, p. 88). The development of derivative securities has allowed very diverse financial systems to become much more integrated and helped create the ‘global economy’ (Merton, 1997, p. 89). Apart from the development of markets devoted exclusively to trading options and derivatives, the development of these new products has had an impact on new firm formation, for example firms specifically dedicated to trading strategies using these new instruments. More fundamentally trading in derivatives markets has become an integral part of the operation of financial institutions such as

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banks because a derivative when purchased with the underlying asset may be equivalent to an insurance policy, which prevents the value of the asset combined with the option falling below the exercise price of the option. Merton does not discuss with the issue that derivatives also allow speculation where there is no economic interest in the underlying asset. Financial innovation has resulted in the securitisation of mortgage loans, collateralised debt obligations, and credit default swaps to name but a few. Some have argued that financial innovation, in particular financial innovation associated with risk management has been a major source of growth in particular for the US economy (Bernstein, 1996). Baily et al (2008), have argued that financial innovation such as securitisation has been an extremely positive innovation for credit markets” . In contrast Minsky argues that booms associated with financial innovation will inevitably lead to a subsequent collapse. Minsky states “Economies with financial innovations that are driven by market prospects are structurally conducive to booms and busts..” (Minsky, 1990, p 60). It is not surprising that Minsky has become one of the most quoted economists in recent economic policy debate (Kay, 2010). Hence a number of issues arise as follows: (1) What determines financial innovation and (2) is it necessarily the case that financial innovation is followed by collapse? This paper considers the causes of the current crisis in terms of financial innovation and in particular the emergence of the ‘shadow banking system’ with particular reference to the Irish Financial Services Centre in Dublin. The Causes of Financial innovation: Merton versus Miller Miller argues frequent and unanticipated change in regulatory and tax codes have been the main forces for financial innovation. This argument is supported by others for example, Calomiris (2002, p. 312-313) argues that “costly regulations” gives incentives for new financial products, services and intermediaries. In contrast Merton (1990b) argues that the forces driving innovation are:- (1) Demand to complete the markets; (2) lowering transaction costs (3) reduction in agency costs due to asymmetric information or incomplete monitoring. Merton and Bodie in their textbook state :-

"Generally, financial innovations are not planned by any central authority but arise from the individual actions of entrepreneurs and firms" (Merton and Bodie , Finance, Prentice-Hall, 1998, p. 33).

Some Examples of Financial Innovation followed by Collapse The successful innovation by Drexel Burnham Lambert in the ‘junk bond’ market in the US led to a large increase in the number of junk bond issues (from $1.3 billion in 1981 to

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$32.4 billion in 1986) and very large profits. The innovation was to provide an underwriting service and a market for junk bonds, enabling a much wider spread of investors to purchase ‘junk bonds’ (Milgrom and Roberts, 1992, pp. 485-489). The subsequent collapse led to the bankruptcy of Drexel Burnham Lambert, the jailing of several of the key players (Boesky, Milkin, Drexel), and partly explained the problems with the Savings and Loan Associations3 . Long Term Capital Management was probably the best known managed fund specialising in arbitraging between different markets and is an example of a firm whose strategy was based on academic research in finance. The key innovation by LTCM and similar financial firms was to develop trading strategies which involved identifying and separating the option component of a financial instrument. In 1995 and 1996 LTCM earned net returns for investors of 40%, and a return to LTCM of 63% and 57% respectively (Dunbar, p. 170). In 1997 LTCM had total equity of $4.72 billion, assets of $129 billion, liabilities of $124.5 billion, and a derivatives position of $1.25 trillion (Dunbar, 2002, p. 191). However by September 2008 LTCM losses amounted to $4.6 billion and the New York Federal Reserve Board organised a capital injection by other financial institutions and the eventual liquidation of LTCM. The fund was liquidated in 2000. The development and collapse in the value of debt based on subprime mortgages and in the value of various forms of financial instruments (ABS, CDO, SIVs) and subsequent losses at banks and other financial institutions has resulted in the most widespread financial crisis since the great depression. One early estimate by the IMF was that losses on loans and securities would amount to $1400 billion for banks, (Financial Times 13/11/08). This estimate was raised to €2200 billion in January 2009, €2400 million in April 2009 and remained unchanged in September 2009 (IMF Global Financial Stability Report various issues). These estimates exclude losses on derivatives as they are regarded as transfers of wealth from one party to another. Banking losses were estimated to amount to $3400 billion (IMF October 2009). One reason for these large losses by banks, is that they issued securities such as collateralized debt obligations (CDOs) but then failed to sell these bonds but rather kept them as investments .

More recently the development and growth of the Credit Default Swaps market has been blamed by some for exacerbating the crisis and more recently threatening the stability of members of the Euro such as Portugal and especially Greece (Rickards, 2010). Essentially the problem with these instruments is that they allow insurance but with no insurable interest. Innovative financing also enabled Greece to massage its true borrowing and at considerable cost in terms of fees to the Greek State (Hope et al. 2010). However there are also examples of financial innovation which are long lasting, have had a significant impact on financial systems, and while they may have contributed to financial instability have survived through time. Porta et al (1997) argue that the legal system has a considerable influence on the financial system and can in turn affects the choice between internal and external finance. More generally there is widespread

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agreement that there is a relationship between the financial system and economic growth. Several studies support and cite the contention of Schumpeter (1912) that the financial system is important for growth and innovation. 4. The causes of the Current Crisis There are many causes of the current crisis – perverse incentives, poor regulation including widespread belief that markets were efficient and rational in the sense of the ‘efficient markets hypothesis’. Financial innovation magnified these faults. A common assumption that financial innovation did not require change and innovation in financial institutions has a number of implications and may partly explain the subsequent crash. For example corporate governance issues are ignored. Financial crashes invariably reveal agency problems between management, equity owners and bondholders, between external validation agencies such as credit rating agencies and auditors, and between regulators and regulates. In the current crisis agency issues have arisen between credit rating agencies and bondholders and between credit rating agencies and regulators. The failure of financial innovation to be regulated and monitored in an appropriate way is seen by many as one of the causes of the current crisis. As noted above some have argued for example, Bernstein (1996) argues that financial innovation associated with risk management has been a major source of growth in particular for the US economy. Bernstein states:- “The revolutionary idea that defines the boundary between modern times and the past is the mastery of risk” (p. 1), and that “the normal distribution forms the core of most systems of risk management” (p. 144). In contrast Taleb (2007) describes the normal curve as an “intellectual fraud” (Taleb, p. 229) and argues that many characteristics of financial markets cannot be described by a normal distribution. Baily et al (2008), have argued that “financial innovation is a very positive force in our economy”, but add that it also creates problems (p. 7) and that financial innovators and regulators are in a race, and the regulators will always lose that race (p. 93), but it matters how much they lose by”. Schiller also warns against financial regulation that may stifle innovation and that regulators rather than discouraging complexity in financial products should promote “innovation-enhancing financial regulation” (Schiller, Financial Times 27/9/09). However many regulators and others see unregulated financial innovation as being a major cause of the crisis (Turner Review, pp. 47-49, Volcker, New York Times February 5, 2009). In addition many of the instruments created by recent financial innovation were administered in low tax financial centres/tax havens, resulting in an unregulated financial system. The conjunction of new financial products organised by financial firms located in low tax financial centres led to the development of a ‘shadow banking system’. The emergence of the ‘shadow banking system’ is central to the current crisis.

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5. Emergence of the Shadow Banking System In the crisis involving Northern Rock, the Financial Times argued that the greatest regulatory concern is:-

“.. .. ..the supervision of so-called “conduits”, off-balance sheet vehicles which borrow money, finance loans, and generally behave just like banks. Most of this activity is regulatory arbitrage – it exits to avoid the restrictions placed on banks – and supervisors appear to have ignored it. If there is to be reform then this is the place to start.” (Financial Times, Leader, The Right Response to Northern Rock, October 1, 2007).

The ECB in an analysis of the effects of the crisis on bank funding, states that one noteworthy feature was the large increase in banks off-balance sheet financing prior to the crisis, and continues that “many banks had financial vehicles that were not included in their balance sheets, but which made investment decisions for which their parent companies were liable” (ECB, p. 10). The Turner Report also notes the growth of the unregulated ‘shadow banking’ system (Turner Report, p. 21; see also Roubini, 2008; Martin Wolf, 2008). Goodman (2010) comments that the shadow banking system “came to specialize in innovations that created the illusion that risk was being responsibly manged; in crucial cases they actually intensified the dangers”. The “shadow banking system” consists of non-bank financial institutions that borrow short term and lend long term , such as securitised investment vehicles (SIV’s), hedge funds, conduits, money market funds, etc. These financial institutions are subject to risk and uncertainty. One source of risk arises from liquidity, but in contrast to banks, non-bank financial firms do not have access to central bank lending facilities, but rather relied on interbank lending for liquidity and as a source of funding. There were exceptions as in the case of Long Term Capital Management. Once this market collapsed those financial firms dependent on the inter-bank market as a source of funds either found that the cost of funds increased dramatically or were unable to raise funds at any price. Some banks were so dependent on the interbank market that even though they could access Central Bank lending, they were either nationalised (Northern Rock), or part nationalised (Royal Bank of Scotland) or in the case of US banks received considerable amounts of state aid in the form loans and cash in exchange for assets. In particular as noted earlier, liquidity difficulties with subsidiaries in the IFSC led to liquidity and threats of insolvency within the group as a whole in the case of four German banks with subsidiaries in the IFSC . A further source of risk is poor or non-existent regulation. This is because of the location of ‘shadow banking’ type activities in off shore financial centres one of whose main advantages was ‘light touch regulation’ and in recognised tax havens such as the Cayman Islands. This source of risk typically only becomes apparent in a crisis. As a consequence when markets became aware of the risk associated with these firms, liquidity is reduced, increasing risk further.

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The existence of hedge and other funds, often controlled by a firm located in a low tax regime/tax haven (Bender, 2010) is a key feature of the shadow banking system. These funds may be organised as a special purpose vehicle, thus disguising the true ownership and liability in the event of default. These off balance sheet vehicles also featured in the dot.com crisis involving the collapse of Enron and other firms. Their advantage is that capital adequacy ratios are disguised meaning that the group as a whole has adequate capital ratios and hence is less risky. Their location in a tax haven reduces tax, but perhaps more important, is also associated with light touch regulation. 6. The Irish Financial Services Centre (IFSC) in Ireland Financial centres such as the Irish Financial Services Centre (IFSC) formed a major part of the shadow banking sector. Developing and maintaining a financial centre in Dublin is a major part of current Irish Government Policy. The annual Finance Act often amends or introduces new legislation to enhance the attractions of financial firms located in Ireland. For example the most recent Finance Act (2010) makes it easier to move the location for funds to move from locations such as the Cayman Islands to Dublin (Grene, 2009). State agencies including the Industrial Development Authority (IDA) (http://www.idaireland.com/home/) and the Central Bank are required by law to support the IFSC. The Central Bank and Financial Services Act (2003) required the Central Bank is to “promote the development within the State of the financial services industry”1. This requirement is now being removed. The IFSC along with Luxembourg are the two main centres for administering hedge and other funds in Europe. In 2008 the IFSC approximately 8000 funds were located in the IFSC, with €1560 billion of assets (Johnson, 2008). These funds are also often quoted on the Irish Stock Exchange in order to comply with regulatory requirements. The Irish Stock Exchange states:-

“The Irish Stock Exchange is recognised worldwide as a leading centre for listing investment funds. With over 4,400 funds and sub-funds listed, the ISE’s combination of effective and prudent regulation, flexibility of approach and efficient and timely processing of listing applications has proved attractive and cost effective. The ISE continues to provide a dynamic listing framework to meet market demands and trends”2.

The Irish stock exchange (as well as the Luxembourg exchange) are recognised as major world centres for listed international bonds. In 2007, at the start of the financial crisis, the Luxembourg stock exchange accounted for 46% of international bonds, followed by the Irish Stock Exchange with 26%. In contrast the New York Stock Exchange had a share of just over 4.1% (Source: PricewaterhouseCoopers, 2008, p. 2). In 2009 there were 70,287 listed international bonds quoted on five stock markets (Luxembourg Stock Exchange, 2010). The five stock markets include NYSE Euronext, London Stock Exchange and Deutsche Borse. In the year 2009 the Luxembourg Stock Exchange accounted for 43 % of all issues and the Irish Stock Exchange a further 25%. In

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comparison the next largest in terms of listed bonds, accounted for 18%. This represents a slight fall in market share since 2007.

The Irish Stock Exchange states that seeking a quotation for a fund has benefits in terms of source country investors because there may be restrictions in investing in unlisted securities or securities that are not listed on a “recognised, regulated stock exchange”3. Hence a quotation on the Irish Stock Exchange enables “a fund to market to these institutional investors”. The Irish Stock Exchange also states that the Exchange has “standards of regulation to stockbrokers and listed companies which are acknowledged to be among the highest in Europe”4, and as a result the Irish Stock Exchange is recognised as an appropriate regulator from “the market authorities in many jurisdictions including Japan and the United States”.

In spite of these stated high regulation standards many of the funds that have collapsed in value because of liquidity difficulties, are listed on the Irish Stock Exchange. The collapse of the subprime market in turn led to large losses at subsidiaries of three German landesbanks (Sachsen Bank, IKB, and WestLB) located in the IFSC. The largest and potentially most serious losses occurred at Depfa Bank, an Irish registered bank located in the IFSC which became a subsidiary of Hypo Bank in 2007. Losses at these banks required large amounts of State aid from the German Government. This issue is discussed later in this paper. Hedge funds quoted in Dublin are often managed in London but domiciled in a tax haven/low tax regime. As a result of the financial crisis there was an estimated outflow from hedge funds of $400 billion in 2008 (Financial Times, 21/1/09). This outflow led to a restructuring and closure of hedge funds. Of three funds announcing a closure on one day (Mackintosh, 2009), all were managed in London, quoted in Dublin but domiciled in a tax haven. For example, one of the funds (Lansdowne Partners) had seven funds consisting of 148 sub funds quoted in Dublin and all but one, were domiciled in the Cayman Islands. A second firm (Rab Capital) had seven funds and 23 subfunds quoted in Dublin, 19 were domiciled in the Cayman Islands, three in the Isle of Man, and one in the British Virgin Islands, and the third firm (New Star) had three main funds and eight subfunds quoted in Dublin, and all were domiciled in Bermuda. The IFSC dominates financial flows for the Irish economy. Table (1) shows total foreign investment in Ireland for the period 2003-2008. The table shows that foreign direct investment reached a peak in 2003 and has since fallen. In contrast total foreign investment in the IFSC has continued to rise until 2007 and fell in 2008 reflecting the financial crisis. In 2008 IFSC investment was over 13 times the size of foreign direct investment and approximately 11 times the size of GNP.

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Table (1)

The growth of the IFSC in Dublin: Total foreign Investment in Ireland (€ billion)

(1) This number may understate IFSC type activities, as these are no longer required to locate at the IFSC see Stewart (2008) for a further discussion. Source: CSO (2009) and (2008), International Investment Position, Table 1 and 3. Competition between financial centres is considerable and this in turn has led to reduced regulation. Historically hedge funds were often domiciled in the Cayman Islands, Bermuda of the British Virgin Islands, but more recently European jurisdictions such as Channel Islands, Ireland and Luxembourg have been “streamlining regulation” amongst other factors to attract funds. One effect of this is that in Ireland if the relevant documents are provided to the regulator by 3 p.m. and fund will be authorised the next day (Steward, 2008)6. In 2008, Luxembourg introduced a new law, so that as long as the fund manager “notifies” the regulator within a month of launch, the fund can enjoy pre-authorisation approval. Steward comments that unlike the Irish regulator, the regulator in Luxembourg does not “scrutinise promoters”. An important issue is where responsibility for regulation rests. The role of tax havens and locations with ‘light touch regulation’ however has not been subject to any criticism or suggestions for reform in the current banking crisis. For example an editorial in the Financial Times laid the blame on the difficulties faced by German banks exclusively with the structure of the German banking industry and State owned banks (“Banking Bother”, 3/9/07). The Irish Financial Regulator has been quoted as saying that the Irish regulator had no responsibility for entities whose main business is raising and investing in funds based on subprime lending.7 Part of this issue is a conflict between financial firms who might like to locate activities which incur lowest cost (least regulated) and lowest tax, and the requirements of the location of investors/liabilities of these firms who are concerned with conduct of business type regulation for example, greater protection of investors and regulation that will prevent systemic risk to the financial systems in the parent country. Part of this conflict is demonstrated by the debate on regulating the fund management industry within the EU. The industry would like to locate outsourced activities in any jurisdiction. This position was supported by regulators in Germany, France and the UK (F.T. January 14 2008). In contrast Luxembourg and Ireland opposed this position and wish to maintain the current system where there are restrictions on outsourcing. Thus Luxembourg and Ireland as centres of the fund management industry have a considerable number of employees involved in administration of funds. However an issue that has arisen in relation to the current arrangement is whether these funds even

2003 2004 2005 2006 2007 2008 Direct 176.435 152.446 138.626 118.824 138.362 120.954 Portfolio 542.200 720.952 1025.902 1223.683 1329.908 1183.690 Other 389.807 443.796 556.906 678.293 838.713 995.659 Total 950.469 1108.442 1721.428 2020.800 2306.983 2300.303 Represented by IFSC1

813.336 975.357 1300.223 1566.668 1727.005 1645.535

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though they may have an administrative presence are adequately supervised and if in fact they have key decision making functions. The recent Madoff and Stanford cases also illustrate some of the regulatory and other issues involved with financial firms located in tax havens8. 7. The IFSC and Securitised Investment Vehicles A front page article in the Financial Times (Sakoui, 2008) cites a plan to restructure an SIV called Cheyne Capital after 10 monthes of negotiations, but without referring to the fact that Cheyne capital and its funds are quoted on the Irish Stock Exchange. The same article refers to further restructuring at four more SIVS (Golden Key, Mainsail, Whistlejacket and Rhinebridge). Again all funds were quoted on the Irish Stock Exchange. The implications of a quotation is that the funds were regulated by the Irish Financial Regulator, were subject to the rules of the Irish Stock exchange, and if managed by an incorporated entity in Ireland, this entity would be subject to Irish company law, and accounting regulations, yet the location of funds and the market where they were quoted receives very little (if any) attention. There are numerous connections between funds involved in the subprime crisis and the IFSC. There are over 4000 investment funds and many more subfunds, quoted on the Irish Stock Exchange. Many of these funds assets consisted of subprime loans. In order to be quoted on the Dublin Stock Exchange they must be sponsored by a local stock broking firm (Mostly Davy and Goodbody Stockbrokers) documents must be lodged with the regulator, and in the case of an entity incorporated in Ireland, Company Registration Office. In return fees are paid to the Irish Stock Exchange and to the sponsoring broker. Regulators in the resident country of potential investors may require securities to be listed on a ‘recognised’ stock exchange. These investment funds may in turn be owned by a legal entity (the so called conduits), managed by a firm based in the IFSC, as in the case of Rhinebridge and IKB or in the case of the ‘conduit’ Ormond Quay, managed by Sachsen Bank (Ireland) which was in turn a wholly owned subsidiary of Sachsen Bank. Banks and investment funds were not the only entities involved in sub-prime loans at the IFSC. A Treasury management firm operating at the IFSC, Dublin (GMAC-RFC) which is a wholly owned subsidiary of the Residential Financing Corporation of the US and in turn owned by General Motors, was extensively involved in mortgage lending in the US. The web site of this firm states:-

“GMAC-RFC, one of the largest private mortgage conduits in the United States, has led the mortgage industry for over two decades. A pioneer in the field of mortgage securitization, we continue to build on our track record of success. Our relationships last—and the mortgage lenders that we partner with grow and prosper along with us” (Source:- https://www.gmacresidentialfunding.com/lenders/).

In total over 40 funds quoted on the Irish Stock Exchange have been the subject of media reports indicating financial difficulties9.

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8. Bear Stearns and the IFSC The collapse of Bear Stearns and its subsequent takeover by JP Morgan in March 2008, was one of the early indicators of the severity of the current crisis. The first public indication of problems at Bear Stearns emerged when a Bear Stearns hedge fund announced considerable losses (Business Week June 12, 2007), and a second fund announced a smaller loss (Bear Stearns High-Grade Structured Credit Strategies). Lenders attempted to reclaim loans (Bajaj and Cresswell, 2007). On June 22nd Bear Stearns pledged $3.2 billion in loans (Cresswell and Bajaj, 2007), but this was insufficient to prevent further withdrawals. redemptions were suspended and both funds filed for bankruptcy approximately six weeks after the first announcement of losses. Both funds were incorporated in the Cayman Islands where they were liquidated (Bloomberg August 7 2007). While key executives at both funds faced prosecution in the US (Thomas, New York Times, 20/6/08), they were acquitted in November 2009 (Kouwe and Slater, 2009). One puzzling aspect is that the reported reason why Bear Stearns attempted to rescue these funds was because of “reputational risk” rather than a contractual obligation (Baily, et al. p. 52). This failed intervention is likely to have been a key component of the collapse of Bear Stearns. Bear Stearns had several investment vehicles listed on the Irish Stock Exchange. These consisted of two investment funds (Bear Stearns Offshore Fund of Hedge Fund Series and Bear Stearns Offshore Leveraged Fund of Hedge Fund Series), and seven debt securities divided into 69 sub funds with a total issued value of $7.069 billion. Bear Stearns also operated three subsidiaries in the IFSC, Dublin through a holding company (Bear Sterns Ireland Ltd.). Table (2) shows the main features of the holding company: 1. Capital ratios are very low and have fallen since 2004, $1 of equity financed $119

of gross assets In contrast the minimum Tier 1 ratio for commercial deposit taking banks (equity/risk weighted assets) is 4% although all deposit taking banks have ratios substantially in excess of this..

2. Most assets and liabilities are short term. 3. Although profitable no dividends were paid. Most capital consists of contributed

capital reserves. 4. There are large intra-group assets and liabilities most likely representing extensive

intra-group transactions.

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Table (2)

Assets and Liabilities of Bear Stearns Ireland Ltd. $ billion

Year Gross

Assets

Ratio of Equity/ total assets2

Financial Assets held for Trading

Securities purchased under agreements to sell to group companes1

Reserves -capital contributed

Retained Profits

Number Employed

2007 61.218 0.85 48.4 3.01 0.378 0.14 141 2006 36.033 1.25 27.5 5.34 0.271 0.11 114 2005 14.231 2.05 7 .4 3.49 0.201 0.90 85 2004 9.228 2.27 3.5 3.23 0.154 0.55 69 2003 7.315 1.77 3.0 3.22 0.105 0.25 67 2002 6.889 1.53 4.0 2.22 0.105 0.00 61 Notes (1) Other intra-group transactions are described as loans receivable from an affiliate and market and client

receivables;. While intra-group liabilities are described as market and client payables, swap agreements and forward contracts and short term borrowings.

(2) This is similar to Tier 1 capital ratio. The main difference is that assets are not risk weighted. The accounts also state that the group and subsidiaries are regulated by the Irish Financial Services Regulatory Authority. One of the subsidiaries is an authorised bank requiring considerable disclosure and compliance activity. Despite the location of managed funds in Ireland and substantial operations including an authorised bank the Irish regulator does not feature in any media analysis or discussions relating to the insolvency and subsequent take-over of Bear Stearns. In an interview, the Irish regulator appears to consider the remit of the regulator is to ‘Irish banks’ that is banks which have their headquarters located in Ireland. The regulator is reported as stating that he meets the chief executive of the Irish Banks ‘at least once a week’ (Clerkin, Sunday Business Post, May 11, 2008). Bear Stearns is not an isolated example in relation to the use made by US financial institutions of the IFSC . Lehman Brothers had four debt securities with approx. $27 billion issued and five funds administered from the IFSC and quoted on the Irish Stock Exchange in September 2009. The minimum subscription of which varied between $0.25 million and $5 million, although one of the funds had a minimum subscription of $2500. In addition there are 10 Lehman subsidiaries incorporated in Ireland under the companies Acts. The prospectus of one of these states:-

“The company may employ investment techniques and instruments for efficient portfolio management.. .. Under the conditions and within the limits stipulated by the Central Bank under the UCITS regulations” Prospectus of Lehman Bros Alpha Fund PLC 2003, p. 11)

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Another prospectus states the company is a collective investment scheme organised as a company and “authorised by the Financial Services Regulatory Authority” (p. 19) “all the capital of the company is invested via another Lehman subsidiary located in the Cayman Islands. Both prospectuses state that the company is tax resident in Ireland Apart from Bear Stearns and Lehman Brothers, most if not all large banking and insurance companies have securities quoted on the Irish Stock Exchange. For example. AIG had three funds listed in Dublin with an issued value of $1298 million) and one debt security; Merrill Lynch had one investment fund and 2 debt funds; Goldman Sachs had 31 investment funds and 2 debt funds; UBS has numerous quoted debt instruments on the Irish Stock Exchange. 9. German Banks and the IFSC German banks in particular had considerable connections with the IFSC. Deutsche Bank had quoted notes and trust certificates to the value of €160 million, the trustees of which are registered in the Cayman Islands; Deutsche Bank (Luxembourg) also had €433 million in debt instruments quoted on the Irish Stock Exchange, and Deutsche Investment Managers had three funds quoted on the Irish Stock Exchange (February 2009). Commerzbank has three debt securities quoted on the Irish Stock Exchange with a value of €1.30 billion, and £800 million. All three are domiciled in Delaware. Of particular interest are German banks with subsidiaries in the IFSC, that required State aid (Sachsen Bank, IKB, West LB and Hypo). Sachsen bank had securities quoted on the Irish Stock Exchange with a value of $92 billion. Sachsen Bank also had €200 million invested in Synapse Investment Management, managed in Dublin, which became insolvent. Sachsen bank was taken over by LBBW in 2007. LBBW had two funds quoted on the Irish Stock Exchange. The offices of LBBW were searched by German state prosecutors in Stuttgart in December 2009, because of suspected breaches of trust involving investing in subprime loans since 2006 and which are likely to result in large losses (Sackmann, 2009). At the start of the subprime crisis IKB had exposures of €16 billion to the sub-prime market ((Bacchus 2008-2 plc, prospectus) and total exposure to risky investments of €24 billion (BBC News 21/8/08).. An investment vehicle owned and run by IKB, Rhinebridge, with securities quoted on the Irish Stock Exchange of at least €370 million was forced into liquidation in 2007 and in 2008 IKB was taken over by Lonestar – a US private equity firm. West LB had one investment fund and quoted securities with a value of €1.587 billion. Although West LB was reported as having a “hugh exposure” to US subprime investments (Morajee, 2008). Depfa Bank which became a subsidiary of Hypo Bank in 2007, had numerous quoted debt securities with the nominal value of debt instruments of €12.6 billion, and $5.2 billion as well as other currencies. Hypo bank largely as a result of this takeover, required funds of €102 billion in state aid, €50 billion in the form of loans and a further €52 billion in state guarantees. The German State has made a capital contribution of €3 billion to Hypo and may need to contribute a further €7 billion (Wilson, 2009). Hypo Bank became a wholly state owned in October

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2009. The main reason for the collapse of Hypo Bank was due to short term funding difficulties by its Irish subsidiary Depfa Bank (Bloomberg, 31/10/08; Der Spiegel, 10/6/2008). The head of the German financial regulator Bafin is quoted as saying that the rescue of Hypo had “prevented a run on German banks and the collapse of the European finance system” (Scaly, 2009). This bank made large losses because of overdependence on short term borrowing and the subsequent rise in short term interest rates5. Other issues have arisen in relation to the lack of transparency and risk in financial products sold by Depfa bank. In particular many municipal authorities in the US issued variable rate loans from Depfa without understanding the risk of much higher interest payments (Duhigg and Dougherty, 2008)6. Similar issues have arisen in Italy (Segreti, 2010). The operation of German owned banks at the IFSC in Dublin, also provide a useful example of issues arising from ineffective cross border supervision. The de Larosiere Report notes (p. 40) that failures in home country supervision if inadequate, as in the case of the Icelandic banks, can create significant difficulties for other countries. Fonteyne et al (2010, p.9) identify three cases which a European crisis management framework should focus:- (i) systemic importance in an EU country outside the home country; (ii) systemic importance because of size to the EU; (iii) systemic importance in an EU home country with substantial cross border activities. None of these categories cover the case of the four German owned banks operating at the IFSC (Depfa, IKB, Sachsen Bank and WestDeutsche LB). These banks posed large risks to the source country Germany, and in one case (Depfa Bank) systemic risks to the source country but most of their operations in terms of liabilities, assets and profits were outside Germany in another EU country. Hence a fourth category needs to be added to the above categories (iv) systemic importance to an EU country but with incorporated and controlled largely in another EU country. There were failings in source country regulation (Germany), in the case of these four German owned banks but these failings were compounded by failures in source country regulation (Ireland), and failure of coordination between both regulators. The case of Depfa Bank is an illustration of problems with source country regulation. Prior to takeover by Hypo Bank in 2007, and following a company restructuring, Depfa was an Irish incorporated entity since 2003, with its seat of government in Ireland, but with German subsidiaries and extensive operations in Germany and with shares listed and mostly traded in Frankfurt 16. Hence from the period 2002 to 2007 the main regulator of Depfa was the Irish regulator during a period when financial strategy and policies were developed which eventually led to a crisis for Hypo Bank. It is doubtful that if Depfa had remained an independent entity that the Irish regulator would have provided liquidity, even if the sums were a fraction of those eventually required. In addition Hypo bank had a subsidiary (Hypo Real Estate Bank International) whose headquarters were located at the IFSC since 2003 (IDA, Dublin Report, Autumn 2003). One of the key problems with the regulation of German banks in the IFSC was the difficulties with cross border supervision as described in the de Lasoriere Report, (pp. 73-74). Nevertheless these entities were subject to considerable potential regulatory

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requirements in Ireland, for example they required a licence to operate from the Central Bank and must submit extensive documentation. Table (3) shows State aid to four German Banks located in the IFSC as a result of losses on subprime and other securities.

Table (3) State Aid to German Banks with operation in Ireland and Quoted Securities on the Irish

Stock Exchange

Name of Bank Amount of State Aid IKB1 €12.0 billion Sachsen Bank2 €2.8 billion West LB3 €6.4 billion in guarantees and 3 billion

equity injection under consideration. Hypo bank (Depfa Bank)4

€102 billion of State aid, €50 billion of which consisted of guarantees. Source: F.T. 18/2/09

. (1) http://www.german-info.com/press July 7 2009 (2) Europa Press release:- State aid: Commission approves restructuring of Sachsen LB, 4 June 2008. (3) Reuters 16/11/09 and Worldnews.com 7/11/09 (4) Problems at Depfa bank was the main reason for difficulties faced by Hypo Bank and its eventual rescue. One commentator has reports that total losses at all of German Landesbanken could total €800 billion or one third of GDP (Munchau, 2010). Depfa Bank Depfa bank, following a reorganisation became an Irish registered company whose headquarters were in the IFSC in 2003, and was taken over by Hypo Bank in 2007. Largely because of Depfa, Hypo had the most serious problems amongst German Banks as a result of the financial crisis and required the largest State aid. From 2003 to 2006 the Irish regulator was the main regulator of Depfa Bank. One of the features of Depfa bank was the high ratio of equity to assets. In 2006 equity amounted to €2.77 billion and assets €223 billion (Table 4). The regulator allowed such a high level of leverage because risk weighted assets according tp Depfa amounted to just €33 billion. The problem was that the assets Depfa Bank held were in fact highly risky. Depfa bank was the worlds largest guarantor to act as buyer of last resort to variable rate bonds (Duhigg and Dougherty, 2008). These bonds had in the initial stages low rates of interest which in later years increased. Thus their risk was a function of the time date of the bond. Duhigg and Dougherty state:- “By 2006 Depfa was the largest buyer of last resort in the world, standing behind $2.9 billion of bonds issued that year alone”. In effect Depfa bank was acting as an insurance company without hedging any of the risks involved. The other main form of risk was in the form of financing. The €229 billion in assets were financed by short term deposits from banks (€63 billion, other deposits ( €31 billion) and debt securities in issue (€103 billion).

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Table (4)

Assets and Liabilities of Depfa Bank 2005-07 € billion

2007 2006 2005 Gross Assets 217.9 222.9 228.6 Risk weighted assets 44.9 33.3 24.08 equity 2.95 2.77 2.30 Financed by Debt Securities in Issue 62.8 102.8 101.6 Deposits from Banks 89.8 63.2 67.0 Other Deposits 30.2 31.1 28.8 Source: Annual Report and Accounts of Depfa Bank With such high leverage the gap between interest income and interest expense was narrow. For 2007 Depfa reported interest and other income of €6.8 billion and interest and other charges of 6.5 billion. As interest rates rose following the collapse of Lehman Brothers, the cost of funding also rose. The margin between interest revenue and costs of funding became negative. Depfa Bank became regarded as being highly risk and sources of funding were withdrawn, precipitating a liquidity crisis and the eventual rescue. Sachsen LB Sachsen Bank was one of the most widely reported examples of a German bank which made losses on subprime funds. SLB Europe received a full banking Licence from the Central Bank of Ireland in February 2000. The main losses occurred through a conduit called Ormond Quay, based in the IFSC, Dublin, but in addition large losses were made on a fund quoted on the Irish Stock Exchange and run by Synapse Investment Management. Sachsen Bank operating in Ireland (Sachsen Bank Europe PLC) employed 45 people, approximately 12% of the total employees of the bank. Table (5) shows that from 2003 Sachsen Bank in Ireland has accounted for most of the group profits. For the year 2006 the Group as a whole reported € 20 million in gross profits but for the same period the IFSC based firm reported a profit of € 22 m. This means that the group outside Ireland reported a loss of € 2 million. Thus the Irish subsidiary accounted for all of the group profits even though employing a minority of group employees.

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Table (5)

Sachsen LB Europe Plc, Gross assets, Profits and Employees €million

(1) Defined as shareholder funds/total liabilities and shareholder funds Source:- Annual Reports of Landesbank Sachsen Girozentralle available at http://www.sachsenlb.de. Annual Reports of Sachsen LB Europe. The 2005 accounts of Sachsen LB Europe footnote (3) a state:- “the quality of the portfolio is of the highest level and continues to reflect the diverse nature of the bank” and “the majority of credit portfolio exposure is to Euroland”. As regards interest rate exposure footnote (3) b(i) and footnote (27) a sensitivity analysis was used assuming an increasing in interest rates of 0.08% basis points. In fact interest rates on interbank borrowings during the crisis increased by several hundred basis points. As in the Bear Stearns case the ratio of equity to total funds is low and has fallen through time. IKB IKB bank made large losses and faced considerable difficulty in raising finance largely as a result of an off balance sheet conduit known as Rheinebridge (Financial Times, March 28, 2008). This conduit was quoted in Dublin. The investment strategy was to borrow short term commercial paper to purchase higher yielding higher assets. Although quoted on the stock market the largest shareholder is the state owned Kfw development bank. This bank has now been sold to a US based private equity Group called Lone Star. West LB WestLB had several subsidiaries operating in the IFSC in Dublin. In April 2008 the Bank reported losses of €1.6 billion after writedowns on subprime loans of over €2 billion. One of these funds (Kestrel) was responsible for further losses of €473 million in 2008 (Carswell, 2009). There are several reasons for the collapse of German banks in the financial crisis. One reason is the failure of regulation. Another contributing reason may have been fraud. The

Year Gross Assets Sachsen LB

Sachsen LB Value of securities on Balance Sheet

Gearing Ratio %

Gross Assets of Sachsen Group

Profits of Sachsen Bank LB

Profits of Sachsen Group

Dividends of Sachsen LB

Employees of Sachsen LB

2001 1563.085 1411.032 8.1 11.751 0.0 37 2002 2317.932 2317.932 6.1 17.014 0.0 26 2003 3816.993

(6.5%) 3816.993 3.8 58549.0 33.016

(58.9) 56.208 25.0 33

(5%) 2004 4899.46

(8%) 3182,235 2.9 60559.0 41.147

(64.3%) 63.941 35.0 38

(5.9%) 2005 4890.453

(7%) 3058.571 2.9 68420.0 50.579

(280%) 18.098 57.5 46

(7.7%) 2006 67760.0 82.953

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SEC has brought fraud charges against Goldman Sachs in relation to the sale of a CDO fund based on US residential mortgages (Abacus 2007-AC1) to IKB. This issue is also likely to arise in relation to other large banks such as Merrill Lynch, Citi, UBS and Deutsche Bank (Jenkins, 2010). It may also involve other German banks as ‘victims’ such as WestLB and Sachsen Bank (Wilson and Jenkins, 2010). 7. Conclusion The subprime crisis and the emergence of the ‘shadow banking sector’ and subsequent collapse described in this paper is an example of a Minsky process. Financial innovation is a pervasive aspect of market based economies. Minsky has argued that a boom based on financial innovation necessarily results in a collapse. Minsky argues part of the solution to instability by financial innovation is through regulation that is through constraints on debt levels both for the personal sector and the corporate especially the financial sector. The emergence of the shadow banking sytem illustrates the problem of regulating complex financial products, operating across a number of different jurisdictions one or more of which may be a tax haven. The recent controversies in relation to Goldman Sachs illustrates the issue of information asymmetries between purchasers of complex instrument and those who create and market them (Schwartz and Dash, 2010). It also illustrates conflicts of interest that allows one party to the contract to exploit information asymmetries. Underlying these issues is the issue of the whether derivates have any social value (Soros, 2010) or economic value (Grantham, 2010). In this context the much criticised unilateral action by Germany to ban certain derivative trading in Germany is likely to be followed by other countries ((Wiesman, et al., 2010; Ewing, 2010). The enforced liquidation of the Carlyle Capital Corporation which in February 2008 was reported as managing $21.7 billion in funds (New York Times 14/3/08) is a good example of the difficulties in regulation following from different country locations of discrete parts of the group. The New York Times comments (March 14, 2008) that “Carlyle Capital’s problems also provide a glimpse into the challenges faced by the usually secretive hedge fund industry because, unlike most such funds, Carlyle Capital is publicly listed.”. While true that Carlyle Capital was publicly listed in Amsterdam it was registered in Guernsey to benefit from a low tax regime (Guardian Newspaper 14/8/08). Seven of its funds were listed on the Dublin Stock Exchange, three of these funds were registered in the Cayman Islands, and a further three were registered in the Cayman Islands and Delaware. These and other examples cited in this paper confirm the need for extensive regulatory and other institutional reform, There is especially an urgent need to take into consideration the use of low tax regimes/tax havens by financial firms. For countries based in the EU this is likely to mean an EU based regulator as in the ECB model.

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This paper argues that financial innovation undertaken in conjunction with institutional change may be long lasting and to have considerable favourable economic effects. Financial innovation that is not associated with institutional change will not be long lasting and will eventually result in financial collapse. Footnotes (1). See Wall Street Journal 5/12/91 in relation to Lincoln Savings and Loan

Association which collapsed with liabilities of $2.5 billion large due to falls in the value of junk bonds. In another case Columbia S & L purchased bonds from Drexel Burnham Lambert for $4 billion which subsequently fell in value to $2.5 billion. Source: Wall St. Journal 1/10/91.

(2) Central Bank and Financial Services Authority of Ireland Act 2003, section 5 (b).

This clause has been omitted from proposed legislation reforming financial regulation in Ireland. See Central Bank Reform Bill, 2010.

(3) See Irish Stock Exchange ‘Why List’, available at http://www.ise.ie, (4). See Irish Stock Exchange ‘Why List’, available at http://www.ise.ie. (5). See Irish Stock Exchange ‘Why List’, available at http://www.ise.ie (6) In relation to debt instruments the Irish Stock Exchange states that “The Exchange

have committed to very aggressive and specific turn-around times on all documents submitted i.e. a three day turn-around on the first draft of the document and two days on subsequent drafts.” In addition the exchange states “the procedures for listing have been simplified particularly for debt issuance programmes. ‘Housekeeping’ requirements and other administrative procedures have been minimised. “ available at :- http://www.ise.ie/. In 2007 “Qualifying Investor Funds” may be authorised by the regulator on a filing only basis, so that there is no prior review of documentation. Qualifying investor Funds are most frequently used by hedge funds, fund of hedge funds, equity funds, and others Source:- Dillon Eustace, “Important Changes to Authorisation Process for Irish Domiciled QIFs”, available at http://www.dilloneustace.ie.

(7) According to one newspaper report, the Financial Regulator distanced itself from

the issues concerning firms located at the IFSC, and is quoted as saying “it is not required to police the activities of vehicles such as Ormond Quay” (Clerkin, Sunday Business Post, September 2 2007). The Irish regulator has been reported of being informed about difficulties in relation to Sachsen LB (a bank incorporated and registered in Ireland) three years before its collapse (Ihle, 2009). Ihle also states:- “The Irish regulator has repeatedly disclaimed any oversight of unregulated investment vehicles operating out of Ireland” . In 2007 the regulator stated in relation to difficulties with subprime funds located at the IFSC:-

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“.. .. it is important to point out that some of the particular investment vehicles that have recently encountered difficulties and the small number of those that happen to be based in Ireland are special purpose companies, invested in by professional investors, including financial services firms, who are generally regarded as having adequate professional expertise available to them when undertaking such investments. Internationally the approach therefore has been that these vehicles do not require close regulatory oversight. Our regulatory system here is no different in this regard to that in other jurisdictions, including the rest of the EU. Indeed our regulatory regime is recognised as conforming to international best-practice standards”. (See speech to the Irish Bankers Federation National Conference (11/9/2007).

(8) The Madoff case involved Luxembourg and the Stanford case, Antigua. French investors channelled up to €500 million to Madoff via UCIT funds quoted in Luxembourg and Dublin (F.T. 26/1/09. Regulation in Luxembourg has been subject to extensive criticism (F.T. 30/1/09). However despite two Irish funds also investing with Madoff (Irish Independent, 15/1/09) and suing HSBC Trust Services (Ireland) and PWC (Irish Independent 30/1/09) there has been no public criticism of Irish regulation in this case. The Stanford fraud case also involved low tax jurisdictions in this case Bermuda.

(9) Fifteen of these funds are listed as either having been liquidated or being on a

‘watch’ list on the Hedge Fund Implode-o-meter web site. See:- http://hf-implode.com.

(10). Hypo Bank reported a loss for the quarter ending 30 September 2008 of €3.1

billion, of which €2.5 billlion related to Depfa Bank Source Irish Times 13 November 2008. In August Hypo stated that it expects to make losses until 2012 (Financial Times, 7, August, 2009). In October 2009 the final 10% of shares not owned by the State were purchased by Germany's financial markets stabilisation fund SoFFin (Financial Times September 29, 2009). Hypo recently announced the establishment of a ‘bad bank’ to which €210 billion of asset would be transferred (Financial Times 22/1/2010). Most of these assets relate to its Irish subsidiary Depfa Bank.

(11) What has not received much comment is that both a former President of the

Bundesbank (Tietmayer) and a former Governor of the Irish Central Bank (Maurice O’Connell) were on the Board of Depfa Bank for part of this period 2005-06. The auditors were PriceWaterhouseCoopers, who are also auditors of another German bank located at the IFSC, Sachsen Bank, who also experienced large losses through their Irish operations.

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