itsupport | World Finance

Defending the indefensible

Posted on December 15, 2008February 3, 2012 by itsupport

For a brief moment in October it seemed as if the world’s financial systems were about to implode. What was once unthinkable, and if we are to believe many financial models, unimaginable, was actually happening. Rock solid corporations were crumbling, governments that had long espoused free market capitalism were rushing to bail out banks, in many cases through part or complete nationalisation.

As is always the case, along with the woe, there was plenty of finger wagging. A once in a lifetime financial crisis is bound to be accompanied by some serious recrimination. And so it has proved.

In the frame are a number of people and practises associated with the crisis. But perhaps three are mentioned more than most as the principle offenders: banking bonuses; light touch regulation; and financial innovation. All three have been identified as culprits at the heart of the current debacle. But how culpable are they?

Executive compensation and the bonus system
The accusation: The compensation system for many employees in the financial services industry is rigged in a way that encourages and rewards excessive risk taking.
When those risks pay off, profits are privatised in the form of huge salaries and bonuses for senior executives, traders and other employees. Yet when the risks prove a bridge too far, resulting in staggering losses, and, in some cases, destroying companies and billions of dollars in value, the losses are socialised. Banks are recapitalised. Ordinary shareholders and taxpayers lose out.

Plus golden parachute deals, and other aspects of executive compensation, mean that senior executives can still receive significant payoffs when they step down (or are removed), despite presiding over, and presumably approving, the risky, often highly leveraged activities that underpin the slump in the value of many financial stocks.

In defence: If you don’t pay the market rate, the best talent will go elsewhere, whether it is another firm, or another industry. Moreover, financial service firms operate in a global market. So the level of compensation must match the best available globally.

And only a small number of people have the experience and skills required to operate as senior executives, or in various specialist jobs, at firms like commercial or investment banks. Therefore these people can justify what might appear extravagant compensation deals, including golden handcuffs and parachutes. Also, employees need incentives to perform well; the greater the incentive, the better the performance. The prospect of significant profit related bonuses as a major percentage of a compensation plan, drives performance.

The verdict: It is true that in competitive markets, firms must pay attractive rates to attract talent. This needs addressing. If people are rewarded according to performance, then some will be tempted to focus on hitting short-term targets to trigger maximum rewards rather than concentrating on the long-term consequences of the business they are doing.

One suggestion is to introduce some kind of time and performance linked provision with bonuses, such as placing them in escrow, thus allowing claw back in the case of poor performance. As for the global market for talent argument, that is not persuasive. The compensation differential may need to be fairly significant to get people to uproot their lives and relocate to another country. And it should not be assumed that experience gained in one country or market will translate to another.

Light touch regulation
The accusation: That the financial services industry failed to appreciate lessons learnt following US stock market crashes in 1907 and 1929. After the 1907 crash, betting on whether shares went up or down without actually owning those stocks was outlawed. After the 1929 Wall Street Crash, the Glass-Steagall Act passed in 1933 separated the operations of commercial and investment banking.

By the 1970s, however, despite decades of relative financial systemic stability, senior executives grew restless for better growth and shareholder returns. The Glass-Steagall Act was finally repealed in 1999. The Commodity Futures Modernisation Act of 2000 removed derivatives from federal oversight, and rendered the bucket shop laws obsolete.

It is no coincidence that, as the regulations were relaxed, systemic financial crises mounted up.

In defence: External regulation stifles financial innovation, and the ability of firms to provide the best service for their customers, and the maximum value for shareholders. Compliance with external regulation is often very costly, having an adverse competitive impact on business within a particular jurisdiction, with respect to businesses outside that jurisdiction. While oversight is required, it is best provided by the people who have the most appropriate industry specific experience – in this case the financial services sector itself. This is a free market after all, and supply and demand should be left to fend for themselves.

The verdict: The concept of self regulation has been hugely discredited in the wake of the current crisis. Surely if light touch regulation is effective the global financial system wouldn’t be in this mess. However, with the financial services sector playing a significant role in economic growth, particularly in the US and UK, governments are reluctant to interfere when things appear to be going well. And financial institutions are a powerful lobbying force.

Inadequate regulation has played a fundamental role in the credit crisis. But, despite the obvious regulatory shortcomings, and the expected tightening of the regulatory environment through legislation in the short term, history suggests that after an initial rush to regulate, lobbying by powerful corporations, and the lure of significant returns, will once again lead to deregulation over the longer term.

Financial innovation
The accusation: Warren Buffett is right – derivatives are financial weapons of mass destruction. Brilliant engineers at investment banks used their talents to create exotic financial instruments, which in turn were used, among other things, to move loan default risk away from lenders to other investors, and in ways that make it very difficult to understand the level of risk involved in the underlying investment.

Collateral debt obligations (CDOs), as sub-prime mortgages, bundled together, sliced up, repackaged, credit rated and sold on, were used to create a vehicle for speculation on the repayment of mortgages. Then credit default swaps, a $54trn market, invented ostensibly to be able to hedge the risk of default on the CDOs, were used to bet on the future solvency of companies.

In defence: Financial innovation is essential for economic growth. After all, many aspects of finance that we take for granted, such as credit cards, or mortgages, are the product of financial innovation. Nor is there anything intrinsically wrong with derivatives. They are an important and useful device for reducing risk through hedging strategies.

The verdict: One unfortunate outcome from the existing crisis is that financial innovation has a bad reputation. Yet it must be encouraged, not legislated. Alongside that innovation must be transparency. Derivatives are a $500trn market. Credit default swaps a $50trn market. These products need to be regulated and traded in transparent markets. Financial innovation is a good thing, providing it is used responsibly.

Regulators could ensure that originators of loans, and those parties that sell them on, are required to leave some risk on their own books, rather than offloading to a third party, thus leaving the originators of the loans, and those that securitise them, with no incentive to do due diligence.

Sins of the few

Posted on December 12, 2008February 9, 2012 by itsupport

A central banker to his finger tips, Jean-Pierre Roth said it through clenched teeth: “We are not giving UBS a present”. Here was the head of the Swiss National Bank, the bailiff of bank bail-outs, not to mention the current chairman of the BIS, doing exactly what he said he wasn’t. Namely, giving Switzerland’s most unpopular bank a gift-wrapped package.

The taxpayer will pick up 90 percent of UBS’s toxic debt through the ministry’s $53bn rescue package. Hard-headed observers like Rudolf Strahm, Switzerland’s retired price regulator, point out that even a 300 percent increase in value won’t lift much of the burden off the government/taxpayer.
It is hard to see where UBS is taking the hit, except that it is very much in the hands of the Swiss authorities who will show little mercy.

You cannot blame Mr Roth for putting a brave face on a bail-out that must have pained him deeply, especially as he lambasted US banks way back in August 2007 for their disgraceful lending practices.

Now that the capital-boosting regulations demanded by Basel II have been deemed to be fatally flawed, mainly because they left the job of internal risk assessment to the banks and various incompetent third parties, the whole issue is up for grabs and the hard-liners are in the ascendant.

The Swiss have often punched above their weight in the great regulatory debates and the view of Mr Roth will be important, particularly as head of the BIS but also because of his remarkable prescience throughout this crisis.

Way back in 2007, he predicted “massive losses” across the financial sector. And even before then, as early as December 2006 when most regulators were still hibernating from reality, he warned that we were not facing “lasting prosperity”.

As he told reporters recently: “From a central bank point of view, more [capital] is better than less.”

You can see why, when UBS’s final provision against bad debts comes out at around fifty times higher than its original estimate.

He’s also winning support from the private sector. For one, new Fortis Chief Executive Herman Verwilst muses: “Under Basel II one thought [that] if we measure risks adequately, then we as banks can operate with less capital. That image has changed completely. Perhaps one should hold even more capital.”

There’s an element of retribution in much bank-talk. As Richard Meier, former head of the Swiss stock exchange, warned recently: “Many of the discussions in US, Germany and other countries sound more like taking revenge on these banks rather than helping them.”

However, we now face the danger of the blunt instrument, a response to the crisis that could end up by bludgeoning banks so hard they have difficulty in producing legitimate profits off sensible multiples of leverage.

While sky-high provisioning might indeed have warded off at least the worst of this crisis (for now), there may be simpler, cheaper and in the long-run safer methods of fire-proofing the banks.

George Soros makes the point that profitable banks are generally the safest.

Specifically, he suggests that Hank Paulson’s recapitalisation scheme should be temporarily accompanied by lower minimum capital requirements “so that banks compete for new business. This would also make sense, argues the great fund manager, in the event of the continuing decline in house prices, which of course also affect banks’ capital integrity.

Then with the panic over, normality should strike. “Once the economy returns to normal, minimum capital requirements of banks would be raised again”. This is not the time to punish all the banking sector for the sins of a few.

Indubitably, bank capital-asset ratios have been at historically low levels. According to the BIS, they stand at an average of about seven percent of total assets on a non-risk-weighted basis. And many banks have implicitly recognised this by mega programmes of recapitalisation.

However this has taken the form of panic responses to the frozen interbank markets which, in turn, were triggered by lousy risk assessment programmes.
Here we may have the solution. As more detached observers suggest, why not just improve the method of risk assessment? Ultimately an exercise in best practice, it would be undertaken by gilt-edged third parties rather than left to the banks.

The next thing to address would be the speed of response through, say, the “prompt correction action” procedures that worked so well in the nineties in the US. As Professor Harold Benink points out, a PCA system would have got bank supervisors running at the double into institutions whose capital levels were triggering flashing red lights.

Thus the best banks are not punished by the sins of the few. As Mr Roth knows better than anybody, Switzerland’s regional banks in the communes and cantons acted far more responsibly than UBS.

Europe’s financial vulnerability

Posted on November 19, 2008February 3, 2012 by itsupport

The most notable innovations of the past two decades have been financial. Like technological innovation, financial innovation is concerned with the perpetual search for greater efficiency – in this case, reducing the cost of transferring funds from savers to investors. Cost reductions that represent a net benefit to society should be regarded favorably. But as the current financial crisis demonstrates, where financial innovation is designed to circumvent regulation or taxation, we need to be more circumspect.

Sadly, the financial revolution has been mostly rent-seeking rather than welfare-enhancing in character. It has been based on eliminating, or at least reducing, two key elements of banking costs closely associated with prudential arrangements.

One is the need for banks and other financial institutions to hold liquid reserves. The less liquid a bank’s assets, the greater the need for such reserves. But the yield on such reserves is small, so economizing on them is profitable. Last year’s Northern Rock debacle in the United Kingdom will long remain an example of how not to manage such risk.

Moreover, increasing a bank’s leverage can be very profitable when returns on investments exceed the cost of funding. Reckless balance-sheet expansion in pursuit of profit is kept in check if financial companies adhere to statutory capital requirements, which mandate a capital-asset ratio of about 8%. But many have sought to ignore this restriction, to their cost: the Carlyle Capital Corporation, a subsidiary of the United States-based Carlyle Group, was leveraged up to 32 times – it held one dollar of capital for every 32 dollars of assets – before adverse market developments wiped out the company.

Avoidance of prudential requirements is at the core of today’s financial crisis, exacerbated by the collapse of confidence in a system based on trust. This has exposed the fragility of the banking system, including quasi-banking institutions, as revealed by Bears Sterns, Lehman Brothers, and other US investment banks, and in Europe by Northern Rock, UBS, WestLB, and many more.

Perhaps the most tragic aspect of this story is the exploitation of low-income families involved in the so-called sub-prime mortgage crisis, whereby variable-rate mortgages were offered to customers with a low credit rating. In fact, “variable rate” is a misnomer, since these mortgages’ artificially low initial interest rates were pre-programmed to include a big rate hike after a couple of years. Thereafter, rates would rise with market rates, but never fall when market rates declined. This structure could only have been devised to suck in as many customers as possible with scant regard for long-term consequences.

With the property market booming, prospective capital gains promised untold wealth. And most mortgage holders probably expected to refinance their mortgages before their rising interest-rate trebled or quadrupled monthly repayments. Another hoped-for benefit was that capital gains could be converted into home equity loans, boosting homeowners’ living standards.

The rude awakening came when property values began to decline. For those without an equity cushion, refinancing was not a possibility, and rising interest rates have led to default, foreclosure, and homelessness.

Now we hear that sub-prime mortgage holders have only themselves to blame. No one talks of the bank manager, under pressure to sell “financial products” and eager to sign up customers, even if the products were not in a customer’s best interest. The banker did not question a bonus system that favors one year of super profits, followed by bankruptcy, over two years of moderate, but stable, results.

It is astonishing that sub-prime mortgages and their like were repackaged and resold in securitized form. That these collateralized mortgage obligations (CMOs, or bonds backed by a pool of mortgages) found a ready market, both in the US and abroad, reflects failure on several fronts.

The nature of these CMOs should have been apparent to risk managers. Any financially literate fund manager knows that risk and return are positively correlated. Any fund manager who claims to have been deluded by the apparently favorable risk-yield characteristics of CMOs or related credit instruments can be accused of having fallen for Milton Friedman’s “free lunch.” Risk models do not justify abandoning one’s natural sense of incredulity.

In a world where capital is free to flow across international boundaries, the crisis in the US has spread to Europe. This is a new form of contagion, which transcends national boundaries and is amplified by an international crisis of confidence. This is why the global problem today is many times greater than the Savings & Loan crisis of the 1980’s and 1990’s, which cost American taxpayers an estimated $150 billion to clean up.

Today, the global integration of financial markets means that problems can pop up anywhere, at any time. Central banks are currently attempting to plug one leak as the next appears. But if the financial system’s dykes collapse, we may be headed for a decade of severe deflation, rendering expansionary stimulus useless.

When the US Federal Reserve was created in 1913, its most important function was to serve as a lender of last resort to troubled banks, providing emergency liquidity via the discount facility. The current crisis suggests that this is no longer enough. Central banks worldwide are being forced to act as market makers of last resort in securities markets. The signs are already visible.

The European Central Bank has also failed to tackle local bubbles in Europe. The justification was that the ECB is concerned with inflation, not relative price adjustments. This means that monetary policy is geared towards the needs of large countries, like Germany, not to those of, say, Belgium. But, given the scale of the threat to Europe’s economy from a full-blown financial crisis, this apologia for inactivity has outlived its usefulness.

A waiting game

Posted on October 8, 2008February 9, 2012 by itsupport

The OECD sounded cautiously optimistic when it published its latest economic outlook in the middle of September. “Banks appear to have recognised most of the losses and write-downs related to sub-prime based securities,” it said. Yet within days, Lehman Brothers had slumped into bankruptcy protection, Bank of America had stepped in to bail our Merrill Lynch – buying it for about €35bn, half its value a year ago – and AIG was asking the Federal Reserve for a €28bn bridging loan.

That, of course, is the risk of making forecasts in such turbulent times. No doubt the irony of the timing was clear in Nice, France, where the EU’s finance ministers just happened to be holding a get together. At the top of their agenda: how to respond to financial turmoil and economic downturn.

The ministers decided to provide extra lending for small firms but ruled out public spending on the large scale seen in the US, which has spent €70bn on tax rebates in an effort to spur economic growth. The EU’s public lending arm, the European Investment Bank, is going to double the loans it makes available to small and medium-sized companies, which, because of the credit crunch, are finding it harder to secure finance from commercial banks. It will lend around €30bn over the next three years.

“We’re not simply adopting a ‘wait and see’ policy, we are not going to sit on our hands,” said French Economy Minister Christine Lagarde, who was hosting the event. “We need to make sure that our economies perform well.” Indeed they do, as the economic outlook for the Eurozone is bleak.

Inflation remains the policy priority, as ECB President Jean-Claude Trichet pointed at after the meeting. Soaring oil and food prices have pushed inflation up in the past year. The annual rate of Eurozone inflation hit a record four percent in July but has since eased a little after oil prices retreated from a high of more than €103 a barrel. The ECB has refused to reduce interest rates – which would encourage growth, but could also push up inflation. Its last move was to increase rates to 4.25 percent from four percent, on the grounds that inflation had to be tamed.

It’ll be interesting to see whether the ECB sticks to its strict line on rates. In April, the consensus view among policymakers was that Europe was not at risk of recession. With hindsight, that was hopelessly optimistic. Three days before the ministers got together in Nice, the European Commission cut its Eurozone growth forecast for this year to 1.3 percent from the 1.7 percent it predicted in April. It forecast growth of 1.4 percent for the broader EU group – including those, like the UK, that do not have the euro. That’s a big drop on the two percent it predicted in April. One reason for the change of heart is that, since April, gross domestic product in the Eurozone has shrunk – the first time the eurozone has experienced a quarter of GDP contraction since it was created in 1999.

Recession recession recession
That means the Eurozone is on the brink of a recession – it just needs another quarter of GDP shrinkage to fulfill the technical definition. However, the Commission is clinging to its optimism. It still forecasts that the overall Eurozone economy will stagnate rather than contract in the third quarter – although at national level it predicts that Germany will dip into a brief recession, followed by Spain and the UK.

Indeed, recession for some EU states seems now inevitable, even if its politicians refuse to use the word, for fear of making things worse (“Germany is not in a recession but in a downturn,” German Finance Minister Peer Steinbrueck told journalists in Nice).

Elsewhere, there is a willingness to face reality. Before setting off to Nice, the UK delegation had to digest a new economic forecast from the Confederation of British Industry, an influential lobby group. It said the UK would slip into recession in the second half of 2008 – albeit a “shallow” one – and that growth in the economy in 2009 will be the lowest since 1992.

It downgraded its growth forecast for 2008 from 1.7 percent to 1.1 percent and said economic output would shrink by 0.2 percent quarter-on-quarter between July and September, followed by a further 0.1 percent decline in the fourth quarter.

Its good news was that GDP should stabilise early in 2009 ahead of a gradual and growing recovery, with quarter-on-quarter GDP growth reaching a near-trend rate of 0.6 percent by the end of next year. Nevertheless, for 2009 as a whole, the GDP growth forecast has been cut from 1.3 percent to 0.3 percent.

Better news is that it expects inflation to peak at 4.8 percent this quarter, and thanks to an easing in commodity prices and the weaker economy, to fall back rapidly over 2009, reaching close to the Bank of England’s two percent target by the fourth quarter (2.3 percent). There is even a significant risk that, into 2010, inflation will undershoot the bank’s target.

This cheery view of the inflationary outlook should allow the Bank of England to make a series of rate cuts, bring the base rate down to four percent by next spring. “The bank should have leeway to cut interest rates and, as inflation falls, we should be well placed to move beyond this difficult stage in the business cycle,” said CBI director general Richard Lambert. “If all goes well there should be room for a half point cut in November to help restore confidence in the beleaguered economy.”

That’s if all goes well. “Over the past year our forecasts for economic growth have been shaved lower and lower as the UK economy continues to struggle with the twin impact of higher energy and commodity prices and the credit crunch,” Lambert added. “Having experienced a rapid loss of momentum in the economy over the first half of 2008, the UK may have entered a mild recession that will hopefully prove short lived. This is not a return to the 1990s, when job cuts and a slump in demand were far more prolonged. The squeeze on household incomes and company profit margins from higher costs will begin to ease as the price of oil moves downwards and, although the credit crunch will be with us for some time, conditions are set to improve later in 2009.”

Dark outlook
The CBI believes that UK unemployment will break the two million mark in 2009, reaching 2.01 million and a jobless rate of 6.5 percent. Average earnings growth is expected to remain subdued, which will aid the improving inflation outlook. Sharp rises in fuel and food costs, the resulting decline in real incomes and the troubled housing market have undermined consumer confidence and dampened household spending, and the CBI predicts that household consumption will contract by 0.3 percent in 2009.

Forecasts for investment have been downgraded, with fixed investment now expected to shrink by 3.5 percent in 2008 and by four percent next year, compared with flat growth predictions in the last CBI forecast. Much of this decline comes from the weak outlook for investment in buildings, as both residential and commercial property markets continue to struggle.

Is this relative optimism justified? The OECD’s global headline trends seem to be improving, but its forecasters are very cautious about making predictions right now. “Limited experience with some of the main drivers of the current conjuncture as well as uncertainty about some specific influences make for a particularly unclear picture,” it says, which roughly translated means: we haven’t seen anything like this before and we don’t want to come out of it looking like idiots.

Nevertheless, the OECD does venture that in the euro area and its three largest economies, as well as in the UK, economic activity is foreseen to remain broadly flat. More widely, Japan will see only a partial bounce-back and the situation in the US is still tough to call.

Globally, the OECD says financial market turmoil, housing market downturns and high commodity prices continue will continue to bear down on growth. “Continued financial turmoil appears to reflect increasingly signs of weakness in the real economy, itself partly a product of lower credit supply and asset prices,” it said. “The eventual depth and extent of financial disruption is still uncertain, however, with potential further losses on housing and construction finance being one source of concern.”

The downturn in housing markets is still unfolding, with reduced credit supply likely to add to the pressure. US house prices continue to fall, threatening further defaults and foreclosures that may again depress prices and boost credit losses. As regards construction, however, there are some hints of eventual stabilisation with permits and sales of new homes having ceased to fall and inventories of unsold houses coming down. In Europe, downturns in prices and construction activity appear to be spreading beyond Denmark, Ireland, Spain and the UK, with sharply lower transaction volumes a precursor of downturns elsewhere.

On commodities, the OECD notes that the price of oil has fallen from peaks reached around the middle of the year in response to slower demand growth and record production from OPEC. Oil supply conditions remain tight, however, contributing to volatile prices. Prices of other commodities – notably food – appear to have steadied at high levels. Food commodity prices may ease in the period ahead as droughts end in some food-exporting countries and as higher food production comes on stream.

On inflation, the OECD says that sharp increases in energy and food prices have boosted headline rates and sapped real incomes of consumers across the OECD area. Statistical measures of underlying inflation have also drifted up in most large OECD economies, partly reflecting the ongoing feed through of higher commodity prices. Wage increases have been broadly contained, so far. Its prediction: “If commodity prices are sustained at their recent, and in cases such as oil, lower levels some moderation of both headline and underlying inflation is to be expected.”

What should policymakers do in this tough climate? Pretty much what they are doing now, according to the OECD. In the US, underlying inflation is high but appears not to have drifted up further. The continuing credit crunch justifies Washington’s efforts to boost the economy with tax cuts. In the eurozone, underlying inflation has been rising steadily for some time, suggesting that capacity pressures need to be reduced, says the OECD. A recession would achieve that nicely, so there is no need to change policy. If action were needed, the OECD would rather see interest rate cuts than higher spending or tax reductions.

The message seems to be this: politicians and policymakers in the US, the eurozone and elsewhere have done all they can to avoid a deeper economic crisis. Now we just have to cross our fingers and wait.

The dark side of financial globalisation

Posted on September 2, 2008February 9, 2012 by itsupport

Blame should go to the phenomenon of ‘securitisation.’ In the past, banks kept their loans and mortgages on their books, retaining the credit risk. For example, during the housing bust in the United States in the late 1980’s, many banks that were mortgage lenders went belly up, leading to a banking crisis, a credit crunch, and a recession in 1990-91.

This systemic risk – a financial shock leading to severe economic contagion – was supposed to be reduced by securitisation. Financial globalisation meant that banks no longer held assets like mortgages on their books, but packaged them in asset-backed securities that were sold to investors in capital markets worldwide, thereby distributing risk more widely.

So what went wrong?
The problem was not just sub-prime mortgages. The same reckless lending practices – no down-payments, no verification of borrowers’ incomes and assets, interest-rate-only mortgages, negative amortisation, teaser rates – occurred in more than 50 percent of all US mortgages in 2005-2007. Because securitisation meant that banks were not carrying the risk and earned fees for transactions, they no longer cared about the quality of their lending.

Indeed, there is now a chain of financial intermediaries – mortgage brokers, the banks that package these loans into mortgage-backed securities (MBS’s), and investment banks that re-package MBS’s in tranches of collateralised debt obligations, or CDO’s (and sometimes into CDO’s of CDO’s) – earning fees without bearing the credit risk.

Moreover, credit rating agencies had serious conflicts of interest, because they received fees from these instruments’ managers, while regulators sat on their hands, as the US regulatory philosophy was free-market fundamentalism. Finally, the investors who bought MBS’s and CDO’s could not do otherwise than to believe misleading ratings, given the near impossibility of pricing these complex, exotic, and illiquid instruments.

Reckless lending also prevailed in the leveraged buyout market, the leveraged loan market, and the asset-backed commercial paper market. Small wonder, then, that when the sub-prime market blew up, these markets also froze. Because the size of the losses was unknown – sub-prime losses alone are estimated at between $50bn and $200bn, depending on the magnitude of the fall in home prices – and no one knew who was holding what, no one trusted counterparties, leading to a severe liquidity crunch.

Bankruptcy
But illiquidity was not the only problem; there was also a solvency problem. Indeed, in the US today, hundreds of thousands – possibly two million – households are bankrupt and thus will default on their mortgages. Around 60 sub-prime lenders have already gone bankrupt.

Many homebuilders are near bankrupt, as are some hedge funds and other highly leveraged institutions. Even in the US corporate sector, defaults will rise, owing to sharply higher corporate bond spreads. Easier monetary policy may boost liquidity, but it will not resolve the solvency crisis. So it is now clear that reforms are needed to address the negative side effects of financial liberalisation, including greater systemic risk.

First, more information about complex assets and who is holding them is needed. Second, complex instruments should be traded on exchanges rather than on over-the-counter markets, and they should be standardised so that liquid secondary markets for them can arise.

Third, we need better financial supervision and regulation, including of opaque or highly leveraged hedge funds and even sovereign wealth funds. Fourth, the role of rating agencies needs to be rethought, with more regulation and competition introduced. Finally, liquidity risk should be properly assessed in risk management models, and both banks and other financial institutions should better price and manage such risk.

These crucial issues should be put on the agenda of the G7 finance ministers to prevent a serious backlash against financial globalisation and reduce the risk that financial turmoil will lead to severe economic damage.

The specter of global stagflation

Posted on September 2, 2008February 9, 2012 by itsupport

Inflation is already rising in many advanced economies and emerging markets, and there are signs of likely economic contraction in many advanced economies (the United States, the United Kingdom, Spain, Ireland, Italy, Portugal, and Japan). In emerging markets, inflation has – so far – been associated with growth, even economic overheating. But economic contraction in the US and other advanced economies may lead to a growth recoupling – rather than decoupling – in emerging markets, as the US contraction slows growth and rising inflation forces monetary authorities to tighten monetary and credit policies. They may then face “stagflation lite” – rising inflation tied to sharply slowing growth.

Stagflation requires a negative supply-side shock that increases prices while simultaneously reducing output. Stagflationary shocks led to global recession three times in the last 35 years: in 1973-1975, when oil prices spiked following the Yom Kippur War and OPEC embargo; in 1979-1980, following the Iranian Revolution; and in 1990-91, following the Iraqi invasion of Kuwait. Even the 2001 recession – mostly triggered by the bursting high-tech bubble – was accompanied by a doubling of oil prices, following the start of the second Palestinian intifada against Israel.

The ‘r’ word
Today, a stagflationary shock may result from an Israeli attack against Iran’s nuclear facilities. This geopolitical risk mounted in recent weeks as Israel has grown alarmed about Iran’s intentions. Such an attack would trigger sharp increases in oil prices – to well above €130 a barrel. The consequences of such a spike would be a major global recession, such as those of 1973, 1979, and 1990. Indeed, the most recent rise in oil prices is partly due to the increase in this fear premium.

But short of such a negative supply-side shock, is global stagflation possible? Between 2004-2006 global growth was robust while inflation was low, owing to a positive global supply shock – the increase in productivity and productive capacity of China, India and emerging markets.

This positive supply-side shock was followed – starting in 2006 – by a positive global demand shock: fast growth in “Chindia” and other emerging markets started to put pressure on the prices of a variety of commodities. Strong global growth in 2007 marked the beginning of a rise in global inflation, a phenomenon that, with some caveats (the sharp slowdown in the US and some advanced economies), continued into 2008.

An unlikely scenerio?
Barring a true negative supply-side shock, global stagflation is thus unlikely. Recent rises in oil, energy and other commodity prices reflect a variety of factors:

High growth in demand for oil and other commodities among fast-growing and urbanising emerging-market economies is occurring at a time when capacity constraints and political instability in some producing countries is limiting their supply.
The weakening US dollar is pushing the dollar price of oil higher as oil exporters’ purchasing power in non-dollar regions declines.
Investors’ discovery of commodities as an asset class is fueling both speculative and long-term demand.
The diversion of land to bio-fuels production has reduced the land available to produce agricultural commodities.
Easy US monetary policy, followed by monetary easing in countries that formally pegged their exchange rates to the US dollar (as in the Gulf) or that maintain undervalued currencies to achieve export-led growth (China and other informal members of the so-called Bretton Woods 2 dollar zone) has fueled a new asset bubble in commodities and overheating of their economies.

Most of these factors are akin to positive global aggregate demand shocks, which should lead to economic overheating and a rise in global inflation.

Exchange rate policies are key. Large current-account surpluses and/or rising terms of trade imply that the equilibrium real exchange rate (the relative price of foreign to domestic goods) has appreciated in countries like China and Russia. Thus, over time the actual real exchange rate needs to converge – via real appreciation – with the stronger equilibrium rate. If the nominal exchange rate is not permitted to appreciate, real appreciation can occur only through an increase in domestic inflation.

So the most important way to control inflation – while regaining the monetary and credit policy autonomy needed to control inflation – is to allow currencies in these economies to appreciate significantly. Unfortunately, the need for currency appreciation and monetary tightening in overheated emerging markets comes at a time when the housing bust, credit crunch, and high oil prices are leading to a sharp slowdown in advanced economies – and outright recession in some of them.

The world has come full circle. Following a benign period of a positive global supply shock, a positive global demand shock has led to global overheating and rising inflationary pressures. Now the worries are about a stagflationary supply shock – say, a war with Iran – coupled with a deflationary demand shock as housing bubbles go bust. Deflationary pressure could take hold in economies that are contracting, while inflationary pressures increase in economies that are still growing fast.

Thus, central banks in many advanced and emerging economies are facing a nightmare scenario, in which they simultaneously must tighten monetary policy (to fight inflation) and ease it (to reduce the downside risks to growth). As inflation and growth risks combine in varied and complex ways in different economies, it will be very difficult for central bankers to juggle these contradictory imperatives.

Nouriel Roubini is Professor of Economics at the Stern School of Business, New York University, and Chairman of RGE Monitor

The roots of America’s financial crisis

Posted on September 2, 2008February 9, 2012 by itsupport

The US Federal Reserve’s desperate attempts to keep America’s economy from sinking are remarkable for at least two reasons. First, until just a few months ago, the conventional wisdom was that the US would avoid recession. Now recession looks certain. Second, the Fed’s actions do not seem to be effective. Although interest rates have been slashed and the Fed has lavished liquidity on cash-strapped banks, the crisis is deepening.

To a large extent, the US crisis was actually made by the Fed, helped by the wishful thinking of the Bush administration. One main culprit was none other than Alan Greenspan, who left the current Fed Chairman, Ben Bernanke, with a terrible situation. But Bernanke was a Fed governor in the Greenspan years, and he, too, failed to diagnose correctly the growing problems with its policies.

Today’s financial crisis has its immediate roots in 2001, amid the end of the Internet boom and the shock of the September 11 terrorist attacks. It was at that point that the Fed turned on the monetary spigots to try to combat an economic slowdown. The Fed pumped money into the US economy and slashed its main interest rate – the Federal Funds rate – from 3.5% in August 2001 to a mere 1% by mid-2003. The Fed held this rate too low for too long.

Monetary expansion generally makes it easier to borrow, and lowers the costs of doing so, throughout the economy. It also tends to weaken the currency and increase inflation. All of this began to happen in the US.

What was distinctive this time was that the new borrowing was concentrated in housing. It is generally true that lower interest rates spur home buying, but this time, as is now well known, commercial and investment banks created new financial mechanisms to expand housing credit to borrowers with little creditworthiness. The Fed declined to regulate these dubious practices. Virtually anyone could borrow to buy a house, with little or even no down payment, and with interest charges pushed years into the future.

As the home-lending boom took hold, it became self-reinforcing. Greater home buying pushed up housing prices, which made banks feel that it was safe to lend money to non-creditworthy borrowers. After all, if they defaulted on their loans, the banks would repossess the house at a higher value. Or so the theory went. Of course, it works only as long as housing prices rise. Once they peak and begin to decline, lending conditions tighten, and banks find themselves repossessing houses whose value does not cover the value of the debt.

What was stunning was how the Fed, under Greenspan’s leadership, stood by as the credit boom gathered steam, barreling toward a subsequent crash. There were a few naysayers, but not many in the financial sector itself. Banks were too busy collecting fees on new loans, and paying their managers outlandish bonuses.

At a crucial moment in 2005, while he was a governor but not yet Fed Chairman, Bernanke described the housing boom as reflecting a prudent and well-regulated financial system, not a dangerous bubble. He argued that vast amounts of foreign capital flowed through US banks to the housing sector because international investors appreciated “the depth and sophistication of the country’s financial markets (which among other things have allowed households easy access to housing wealth).”

In the course of 2006 and 2007, the financial bubble that is now bringing down once-mighty financial institutions peaked. Banks’ balance sheets were by then filled with vast amounts of risky mortgages, packaged in complicated forms that made the risks hard to evaluate. Banks began to slow their new lending, and defaults on mortgages began to rise. Housing prices peaked as lending slowed, and prices then started to decline. The housing bubble was bursting by last fall, and banks with large mortgage holdings started reporting huge losses, sometimes big enough to destroy the bank itself, as in the case of Bear Stearns.

With the housing collapse lowering spending, the Fed, in an effort to ward off recession and help banks with fragile balance sheets, has been cutting interest rates since the fall of 2007. But this time, credit expansion is not flowing into housing construction, but rather into commodity speculation and foreign currency.

The Fed’s easy money policy is now stoking US inflation rather than a recovery. Oil, food, and gold prices have jumped to historic highs, and the dollar has depreciated to historic lows. A Euro now costs around $1.60, up from $0.90 in January 2002. Yet the Fed, in its desperation to avoid a US recession, keeps pouring more money into the system, intensifying the inflationary pressures.

Having stoked a boom, now the Fed can’t prevent at least a short-term decline in the US economy, and maybe worse. If it pushes too hard on continued monetary expansion, it won’t prevent a bust but instead could create stagflation – inflation and economic contraction. The Fed should take care to prevent any breakdown of liquidity while keeping inflation under control and avoiding an unjustified taxpayer-financed bailout of risky bank loans.

Throughout the world, there may be some similar effects, to the extent that foreign banks also hold bad US mortgages on their balance sheets, or in the worst case, if a general financial crisis takes hold. There is still a good chance, however, that the US downturn will be limited mainly to America, where the housing boom and bust is concentrated. The damage to the rest of the world economy, I believe, can remain limited.

Captain’s knock

Posted on August 19, 2008February 3, 2012 by itsupport

Editor’s note
This is an archived article. For the cover story concerning Sir Allen Stanford please click here.

Sir Allen’s new and innovative cricketing enterprise is merely the latest innings in a business empire that spans financial services to upmarket real estate development, hospitality and professional sports. We talked to the Sir Allen about his ability to keep investments on track, whether there’s a formula for making financing work, and his interest in cricket.

Wise investment decisions
Tireless research, meticulous planning and hard work have been the core principles of Stanford Financial Group’s success since the first Stanford enterprise was begun by Sir Allen’s grandfather in 1932. Like other investment firms Stanford Financial offers its clients diversified portfolios fine tuned to meet their financial objectives; near, mid and long-term. Where the firm differs, however, is in the way it measures performance.

“Certainly global diversification across asset classes, economic sectors and currencies is critical to the Stanford Investment Model (SIM) strategy, but we do not measure our performance against current market indices,” says Sir Allen. “Instead of benchmarking as most firms do, we set our own Return on Investment goals. Our SIM strategies are a fluid, therefore constantly evolving process guided by the parameters set by our investment committees. Our investment strategies have always been one of long-term consistency. The current market conditions we find ourselves in today are no exception.”

“We do not invest in anything that we do not fully understand, and often we don’t follow current trends when making investment decisions,” emphasises Sir Allen. “For example, the reason we had no exposure to the securitised debt meltdown was that after doing our own internal research and risk analysis we simply could not get our arms around the underlying assets and their associated risk, therefore any perceived profits became irrelevant.”

Sir Allen also points to the quality of the people working for Stanford Financial as instrumental in the firm’s performance. “A financial advisor who delivers true world class wealth management service to his clients must also be supported internally and externally by world class talent,” says Sir Allen. “At Stanford, that external support is provided by advisors and money managers with whom we have had, in some cases, relationships going back three decades. Internally over the years we have continuously invested considerable sums of money to grow our policy research, financial analyst, equity research and fixed income teams, in spite of current trends to outsource these disciplines.”

The internal Stanford team includes over 100 people constantly searching for opportunities across the globe in order to meet the firm’s ROI goals with palatable risk. As Sir Allen notes, the fact that the housing market in the United States is in distress, yet in Brazil new home construction is booming, shows how important it is to take a global approach to investment strategy, and to thoroughly understand the economies in each country that support the industries being invested in.

“The bottom line is this, there is no short cut to quality investing, or magic formula for making money, it is a process of discipline and hard work.” says Sir Allen.

Identifying opportunities
You do not become a billionaire entrepreneur without having a good understanding of the global economy, and Sir Allen’s opinions on the regional economic prospects and possible investment opportunities for the future are well worth noting.

On the US economy, Sir Allen has concerns. “With a sluggish economic base, dependency on imported oil, tight credit, inability to substantially grow exports with a weak dollar and now commodity prices that are certain to bring on inflationary pressures, and a €0.6bn a day cost to fight the Iraq and Afghanistan wars; any economist will tell you that this scenario points towards stagflation,” he warns. “I hope that I am wrong and the US economy can weather these current storms, but the challenges are in a number of sectors that have been hit hard, and it will take some time for them to recover.”

In the emerging markets, however, Sir Allen sees a number of opportunities, although not necessarily where you might imagine. China, on its way to becoming an economic superpower, is perhaps overexposed, he says. “I am lukewarm for investing in China right now, if for no other reason than everyone else is already in China, the cost of living and wages are guaranteed to rise, and they have some serious environmental issues, which they will soon have to deal with.”

“India has created pockets of great wealth and great investment opportunities, but it is a volatile place for investing that will eat the ill-informed alive.” Says Sir Allen

He sees the Middle East and Africa as the last true emerging market with this observation. “This part of the world is definitely one where relationships determine your success and there is almost no correlation to the rest of the global economy from these oil exporting, enormously wealthy countries.”

Sir Allen is bullish on Russia, currently undergoing a transition from communist society to capitalism, (but with the added caveat that you need to do your homework), just as he is on Latin America, and Brazil in particular.

“Capital inflows have increased significantly in most Latin American countries over the past few years indicating a confidence and enthusiasm for a part of the world with enormous untapped natural resources and a burning desire to move up the economic and social ladder. Most governments are committed to investing in their countries’ infrastructure and the political risk of investing, at least in most countries, is acceptable,” says Sir Allen.

“Just look what a success story Brazil has become, for example. Back in the 1970’s no one took Brazil seriously, except in soccer. Today Brazil is South America’s largest economy, it is a true global player, and produces all of its energy needs internally. If the government can keep inflation in check and give as much attention to the environment and ecology of the country as it has to its economy, then Brazil has an incredibly bright future.”

There is a bright future ahead for the Stanford Financial Group too, according to Sir Allen. “In these turbulent and uncertain times, I see great opportunities for Stanford. I certainly wish that the current chaos and confusion in the markets could have been avoided, but there are great buying opportunities and huge opportunities to grow our business now,” he says. “We had no sub-prime exposure, were extremely conservative in our use of leverage, and our business model has proven highly efficient in the current market conditions.”

A new game
Despite his considerable business success, restless entrepreneur Sir Allen, shows no signs of letting up the pace, with a number of new enterprises on the go, or at the planning stage.

One well publicised venture is Sir Allen’s foray into the world of cricket, shaking up the sport with the relentless vigour of a man not used to failure. While Sir Allen’s commitment to the 20/20 form of the game, and the €12m prize for the winner of the England versus Stanford’s All Stars game on November 1, 2008, may have diehard traditionalists choking on their Pimms, there is no denying Sir Allen loves the game and wants to secure a successful future for it – regardless of format. He is also keen to revive the flagging fortunes of the West Indies national side.

“I looked very carefully at how we could take a sport that was dying in the Caribbean, bring it back to life and give it a future. In the process, we needed to change the entire cricket fan demographic from being male dominated to one that was family oriented and particularly exciting for young kids. The 20/20 format, no doubt about it, is the future of the sport,” says Sir Allen.

“As a point of reference the TV rights for the recently completed Indian Premier League were sold for €0.6bn. Our business model goal for the Stanford 20/20 is for our costs to be covered within three years through TV, sponsorship and other direct revenue streams. With the Stanford 20/20 Tournament, we firmly believe we have created something that will capture a huge global audience and promote the Stanford brand to new and exciting markets.”

On another front Sir Allen is planning something even more ambitious. “I am presently working on a series of projects within a project that is unequalled in the world. I have been working on this for over nine years with some of the world’s top architectural, engineering and design firms,” he says.

“Hopefully we are in the last phases of negotiations with government officials and I am optimistic it will all come to a positive conclusion very soon. This mega project will transform one island nation into a model for sustainable, ecologically correct development, while providing a foundation for future economic and social improvement for an entire population for generations to come.”

The sustainability focus is very apt. For there is one considerable cloud on the horizon, says Sir Allen.

“Poor global leadership, nuclear or biological war, man’s inhumanity to man, greed, religious intolerance, exponential growth of human enterprise… they are all overshadowed by global climate change,” he says. “I am not talking about saving planet earth. I’m talking about saving civilisation. For the next generation to have a future, we as nearly seven billion people living on a planet with finite resources, must immediately begin the process of restructuring the global economy before we reach the tipping point of massive market failure and the collapse of social, economic and government structure.”

And given his track record, there is little doubt that Sir Allen will play a significant role in tackling the challenge of global climate change, applying the same meticulous preparation, dynamic energy, and appetite for sheer hard work, that has made him such a successful businessman, to help knock this global threat for six.

For further information www.stanfordeagle.com

Transfer pricing and over-regulation

Posted on August 18, 2008February 9, 2012 by itsupport

What is transfer pricing?
It embodies the fundamental pricing calculation when services, tangible property and intangible property are bought and sold across international borders between related parties. The arm’s-length principle is formally defined in Article 9 of the OECD’s model tax convention as following:

“Where conditions are made or imposed between the two enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly.”

As the IRS’s section 482 puts it more plainly, transfer pricing regulations are necessary to prevent related taxpayers in differing taxing jurisdictions from easily and artificially shifting items of income and expense between these different tax jurisdictions (with differing rates of tax). The intent of the law is to ensure that an arm’s-length price is charged in all related-party multi-jurisdictional transactions.

Under the umbrella of “best method”, the most important factors to be taken into account for each inter-company transaction is “the degree of comparability between the controlled transaction (or taxpayer) and any uncontrolled comparable, and the quality of the data and assumptions used in the analysis”.

For tax authorities, the pricing calculation is vital because it fixes the profits of the business that are subject to tax in particular jurisdictions. Increasingly these authorities are prepared to re-calculate inter-company pricing if they consider the agreed price would be different from that agreed between two unrelated – or arm’s-length – parties. In short, they are on the look-out for transactions they regard as manipulated in order to obtain a tax advantage. When that happens tax charges can be expected to increase, especially when extra interest and even penalties are applied.

There are important inconsistencies and disagreements between different tax authorities over the interpretation of the arms-length standard. But the OECD’s methodologies have become the gold standard in transfer pricing calculations. Thus the use of arm’s-length provides a measure of certainty and, if properly observed, is likely to keep any adjustments to a minimum. Essentially, it is based on a transfer price being reached that would have been arrived at by unrelated parties for the same transaction.

Regulations Versus Principle
The dominance of the internationally accepted arm’s-length standard in all issues of transfer pricing has tended to blunt the effect of the multiplicity of regulatory changes introduced over the last twenty years. This is because the principle of arm’s-length requires that the prices employed in related-party transactions must make commercial sense. Thus, unlike most other areas of tax law, the measure is not based on explicit rules but a principle grounded firmly in issues of economic substance. As a result it hardly matters what new set of regulations is issued by a taxing authority or even by the OECD because the analytical process required to justify the prices reached in a particular related-party transaction remains the same. Namely, the arm’s-length standard. Therefore arm’s-length, essentially an economic issue, remains pre-eminent as the cornerstone of transfer pricing methodologies.

For example, many countries specify a hierarchy of transfer pricing methodologies to be used (e.g., direct price comparisons are first in the hierarchy and gross margin comparisons are second and third). Before the mid-1990s, the US too specified such a hierarchy in its 1969 regulations. Then the US abolished the hierarchy. Did the change in the US alter real practice? No. “Under the old 1969 rules I never saw a situation in which both parties agreed that method B was better than method A, but nonetheless method A was used because it was higher up in the regulatory hierarchy” Greg Ballentine, of The Ballentine Barbera Group, a CRA International company, explains. “If one party preferred method A and the other method B, they had to debate the issue on the basis of the accuracy of the method employed.”

The introduction in the US in the early 1990s of the best method-rule, replacing the hierarchy, has hardly changed things at all. “We are still seeing the same debate we had until the changes were made,” Mr Ballentine adds. “But it now occurs in the context of the best-method rule.”

It would be overstating the case to claim that all the modifications of the past 20 years have had no effect. Some have manifestly served to clarify issues around the edges. However there is a strong argument that in summary those changes have tended to confuse the issue. In particular they give the impression that, as long as one reads the local taxing authority’s regulations and follow them step by step, the prices reached must therefore be acceptable regardless of the degree to which those prices may clash with commercial reality. In fact this is deceiving because the nub of the arm’s-length standard is that it essentially requires commercial commonsense, whatever the local rules may say.

An international issue
The most important issues in transfer pricing over the last twenty years relate to the heightened scrutiny by taxing authorities around the world. Transfer pricing long seemed like a purely US issue but it is now very much a multinational one. The authorities in many countries are rapidly training up auditors to cast a cold eye on transfer prices, even in those jurisdictions with relatively low tax rates and/or tax holidays where they would not be expected to take much interest. It increasingly seems there is no escape as taxing authorities catch up with the international dynamics of the commercial world.

The implications for taxpayers are obvious – they must take every care to fulfil compliance obligations under the relevant jurisdiction’s tax laws. According to UK-based accountancy firms, documentation should cover sales prices, purchase prices, management fees, interest paid on any loans, and even the price paid for general use of facilities such as office space and computer systems. After amending its own regulations in 2004 [see below], Her Majesty’s Revenue and Customs allowed a documentation holiday of two years but the requirements are now fully in force. In the absence of complete records, jurisdictions may feel free to construct the facts as they see fit, which is not generally in taxpayers’ interests.

However in the existing system the taxpayer risks falling between two stools. On the one hand there is a need for local documentation or some well-supported form of defence under the particular jurisdiction’s specific rules. On the other there is the need for a worldwide consistency. The latter becomes especially important as local taxing authorities increasingly seek pricing information in jurisdictions other than their own. For instance, BBG/CRAI regularly finds that, despite a client’s documentation declaring sufficiently high local, taxable profits to satisfy the relevant authority, the IRS also wants to sight the documentation under its own set of transfer pricing rules.

State of flux
The entire transfer pricing issue is highly dynamic, with constant modifications occurring in many arenas. For example, in late 2007 US Treasury urgently recommended measures to combat what it termed transfer pricing abuses. Arguing that the original regulations had remained in force essentially unchanged for almost 40 years, it added: “These regulations have proven to be inadequate to handle the increased volume and complexity of multinational operations and transactions that have occurred since that time.”

US Treasury singled out in particular the absence of updated regulations for the transfer of services which “has led to discontinuities between transfer pricing for services and transfer pricing for tangible and intangible property”. Just one area ripe for attention, US Treasury said, was global dealing rooms.

And in 2004 the UK government amended its rules so they encompassed for the first time transactions between connected UK companies. This was because Her Majesty’s Revenue and Customs feared it could be successfully challenged in the European Court of Justice on the grounds it discriminated against companies from other EU countries because the rules did not apply to transactions between UK companies. Other countries have also been busily updating their regulations in their determination to maximise tax revenue.

Even the OECD, which has made the international pace on transfer pricing, is in the middle of a review of its approach. As of this moment it is weighing up responses to its proposals to modify its application of transactional profit methods, specifically on the issues of profit split and net margin. It is considered highly likely that modifications will result. Indeed the OECD sees the harmonisation of transfer pricing rules as a significant element in fostering world trade.

Economists in demand
As further proof of the economic nature of the arm’s-length principle, BBG has seen a marked swing recently towards the use of economic expertise as clients and governments alike struggle to settle transfer pricing issues. Until relatively recently, BBG/CRA’s economic expertise was in demand by US-based clients because that is what US Treasury-devised laws require whereas, outside the US, clients believed they needed accountants. “I am convinced that a major reason for this is that the IRS relied on economists while foreign tax authorities did not”, adds Mr Ballentine.

However like much else in transfer pricing, this is changing. The Canadian Revenue Authority, which has for years employed economists on transfer pricing audits, has called them in as expert witnesses in transfer pricing trials there. The Australian Tax Authority, another entity that employs economists, has enquired whether BBG’s economists would serve as expert witnesses on several cases heading towards trial. And in New Zealand, clients have tapped BBG/CRA’s expertise and that of other US economists in cases taken by the New Zealand authorities. Similarly in Britain where HMRC has sounded out BBG/CRA’s US-based economists about supplying expert testimony in possible trials there.
Taken together, these examples support the case that arm’s-length is less a tax regulation-based issue than one grounded on economic substance.

For further information tel 202.662-7831; email gballentine@crai.com; www.crai.com

The top ten great financial crises

Posted on June 19, 2008February 14, 2012 by itsupport

The Dutch tulip crisis (1630s)
Perhaps it is possible to understand why investors abandoned all economic logic, and ignored historical evidence, during the dot com bubble. After all, the internet is an astonishing phenomenon, as is the personal computer. But tulip bulbs? What sane person would ruin their family’s fortunes over tulip bulbs? A large proportion of the Dutch well-to-do in the early 17th century, as it turns out.

It was the 1630s when tulipmania took hold, and as with most bubbles, the great and the good, in this case the local mayors, were investing heavily when the market began to wilt. Not wishing their investments to rot, the mayors initiated some neat financial engineering. They agreed to convert their contracts with the-planters from a contract to buy bulbs at a fixed price, to an option to do so if a higher price was reached. If not they paid a fraction of the contract price to the planters.

And so, in the winter of 1637, it was in everyone’s interests for the market to go up. By February 1637 the contract price was 20 times greater than the previous year. One person supposedly paid over 6,500 guilders for a single bulb, the equivalent of an Amsterdam townhouse. But, in the spring of 1637, as all bubbles do eventually, the tulip bulb market burst.

The South Sea Bubble
In February 1720, shares in the South Sea Company, based in England, were trading at £130; by June the price was an astonishing £1050. Adam Anderson, a clerk with the company, described events of the time as an “unaccountable frenzy”. By November 1720, however, the share price was back to £170. The frenzy had subdued. The South Sea bubble, as it is famously known, had burst.

While the South Sea Company may conjure up images of oceanic trading, it was actually established in 1711 as a rival to the Bank of England. Backed by the Lord Treasurer, Robert Harley, it was promised a monopoly of all trade to the Spanish colonies in South America (then the South Seas) in return for taking over and consolidating the national debt incurred as a result of the War of Spanish Succession.

Ultimately, the trading proved to be a diversion, the main money making enterprise being converting government debt into South Sea Company shares and then talking up the trade prospects to inflate the share price.

In a masterstroke of financial innovation four share subscription offers were made to the public using a credit payment system where investors made an upfront payment, paying the balance in instalments over a fixed period. Each issue involved a different down payment and instalment period.

Despite it being effectively the same product – the original shares and four different subscription contracts, the receipts of which quickly became tradeable – the prices of the four assets deviated from each other, and arbitraging failed to bring about price convergence.

The aberrant investor behaviour, described by one lawyer for a Dutch investor as “nothing so much as if all the lunatics had escaped out of the madhouse at once”, has been put down to factors such as complexity and excitement. It certainly must have been both to confuse one of the world’s greatest thinkers. “I can calculate the motions of the heavenly bodies but not the madness of people,” observed Sir Isaac Newton, who lost money amid the feverish speculation.

The Wall Street Crash
Ask the average person in the street to name a financial crisis or stock market crash and the chances are they will name the Wall Street Crash of 1929. Not a single steep one day fall, but rather a long protracted affair, the Crash involved not one but three “black” days – Thursday, Monday and Tuesday (October 24, 28 and 29)– in quick succession.

In August 1921, the Dow Jones Industrial Average was at 63.9. There followed a period of economic boom, through the Roaring Twenties, fuelled by the optimism of a new technological age – radio, cinema, the car, telephone, and aviation. Stock prices reached new records, driving the Dow to a peak of 381.17 in September 1929.

In October 1929, however, the market turned, it fell and continued to fall, (38 points on Black Monday). Mass selling overloaded the telephone and telegraph system. After a brief recovery, the Dow headed southwards once more, and by July 1932 had reached 41.22, it would take over 20 years to recover. At the same time the mass withdrawal of savings precipitated a banking crisis, with the number of banks declining from 25,568 in 1929, to 14,771 in 1933.

Apart from its severity the Wall Street Crash is notable for the great names that it reduced from riches to rags. William Crapo Durant, the founder of General Motors, King Camp Gillette of shaving razor fame, Charles Schwab, one of America’s greatest industrialists; these and many more great businessman (and ordinary investors) were ruined by the Crash of 29.

The Weimar Republic – a banking and currency crisis
A large bank gets into severe difficulties. It reacts by cutting back lending to other banks and to businesses, which in turn has a knock-on effect inducing turmoil in the financial markets. Sound familiar? But on this occasion it is not North America in 2007, but Germany in 1931.

In July 1931, the Weimar republic suffered a major economic blow. The Reichsbank, Germany’s central bank, found itself in difficulty because of a combination of factors, including the collapse of international trade and Germany’s debt burden, and reacted by reining back credit facilities. The result was a panic in the banking sector that led to the nationalisation of two of Germany’s biggest banks, the rescheduling of short-term foreign debt, and the introduction of capital controls.

More significant, however, were the long term effects. Germany ceased World War One reparation payments in 1932 and defaulted on is foreign debt in 1933, both events were important precursors to the rise of the NSDAP party in Germany and the eventual outbreak of the next world war.

Oil crisis 1973
Although not strictly a financial crisis, the oil crisis of 1973 merits inclusion in this list, if only because of the far reaching effects it had on western economies. The catalyst for the oil crisis was the Yom Kippur War, between Syria and Egypt on one side, and Israel on the other, which began on October 6, 1973. The conflict triggered a cascading sequence of events that caused chaos, inflation and recession in the West.

The Organisation of Arab Petroleum Exporting Countries (the Arab members of OPEC plus Egypt and Syria) announced an oil embargo, affecting the US and other nations that supported Israel. In the US, oil imports from the Arab nations plummeted from some 1.2 million barrels daily to around 20,000 barrels. Oil prices rose rapidly and the US suffered its first fuel shortage since the Second World War.

Across Europe the effects of the embargo were patchy. The Netherlands, which supplied arms to the Israelis, was badly hit, whilst France was relatively untroubled. After the embargo was announced on October 17, 1973, the NYSE lost nearly $100bn in just a few weeks. The embargo was lifted in March 1974, although the effects rumbled on, manifest most noticeably in an increased drive for energy security among western nations, as well a radical reshaping of the automobile industry and the rise of the hatchback.

Black Monday
Black Monday, or, if you are Australian, Black Tuesday, is the popular name for Monday, October 19, 1987, the most spectacular of global stock market crashes to date. Not the steepest one day market fall though, that honour lies with the Dow Jones’ 24.39 percent collapse on December 12, 1914.

The significance of Black Monday, when the Dow Jones fell by 22.6 percent, is severalfold. It was a substantial fall, the second largest in the Dow’s history in percentage terms. It was a global event, starting in Hong Kong and rippling across international time zones. By the end of the month markets had declined by 45 percent in Hong Kong, 41 percent in Australia, and 26 percent in the UK.

Perhaps the most interesting thing about Black Monday, however, is that it was not predicted, and has yet to be explained satisfactorily. Not that there is any shortage of suggested causes. Some attribute the crash to automated programme trading, derivative trades, and portfolio insurance, others to recession fears, others still to overvaluation of stocks.

Certainly the supposed “rational investor” of economic theory, capable of absorbing changes in events and making sensible well-informed, if self centred decisions, appeared to have vanished, replaced by irrational, excitable, exuberant investors, who blindly followed the crowd.

But, just as soon as the panic started, it was over. Historic blip behind it, the Dow Jones carried on climbing as normal service was resumed.

Black Wednesday
Another black day in the world of finance, at least from the UK’s perspective, Wednesday the 16th September 1992, was the day that the UK government was forced to withdraw from the European Exchange Rate Mechanism (ERM). The decision came on a day during which the UK treasury spent some $27bn of foreign currency reserves in an attempt to shore up the value of sterling (although the total cost weighing other factors is said to be £3.3bn). At the same time, currency speculators and investors, most notably George Soros, made a small fortune betting against the UK government’s ability to beat the markets.

The UK’s plight demonstrated the perils of fixed exchange rates. With UK sterling entering the ERM in 1990 tied to the deutschmark at DM 2.95, it soon became clear that keeping sterling within its exchange rate limits was at odds with the needs of the domestic economy. Germany was reining back inflation as result of a post unification boom, while the UK needed to promote growth on the back of the recession. When Germany’s interest rates went up, the UK found it painful to follow. A strong pound was damaging exports and prolonging recession.

Currency speculators figured it was a only a matter of time before the UK allowed sterling to devalue, beyond its narrow ERM bands, and that there was not the political will on behalf of the other EU countries to defend the pound. Consequently, they began to short sterling, confident they would be able to buy it back more cheaply in the near future.

Initially, the UK government resisted devaluation, mounting a concerted campaign to shore up sterling both through trading and by hiking interest rates. Matters came to a head on Black Wednesday, as the Chancellor of the Exchequer announced a series of interest rate rises in quick succession, from 10 percent to 15 percent (although the last was never implemented), it was clear to everyone that the game was up, however, and the UK withdrew from the ERM.

The Asian financial crisis
Whether you prefer to call it the Asian financial crisis, East Asian financial crisis, or IMF crisis, the fact remains that the financial crisis that gripped Asia from the summer of 1997 onwards was one of the most significant and long running financial events of the latter half of the 20th century.

Like many other crises, the Asian financial crisis follows an all too familiar pattern. First the boom. During the mid-1990s, foreign investment flooded into Asia and the emerging economies, resulting in high interest rates, high asset prices, and rapid growth rates. Countries like Thailand, Malaysia, Indonesia, the Philippines, Singapore, and South Korea were growing at average rates of over eight percent. Much of the investment was highly leveraged.

Then the bust. The US, emerging from its recession during the early 1990s, began to focus on keeping inflation down, and raised interest rates. Investors switched attention to the US; the US dollar increased in value. At the same time, many of the Asian nations had pegged their currencies to the US dollar and in an effort to remain an attractive investment destination were forced to raise interest rates and expend reserves defending their currencies to avoid devaluation.

You just know that there is going to be trouble when a Prime Minister makes a public announcement that they will not devalue their currency. And so it proved when, in June 1997, Prime Minister Chavalit Yongchaiyudh of Thailand refused to countenance devaluation of the baht, leaving the way clear for currency speculators. Inevitably the baht was eventually floated, and the currency slumped.

And so, temporarily, the “Asian economic miracle” shuddered to a halt, as panic spread throughout the region, badly affecting Indonesia, South Korea, Hong Kong, Malaysia, Laos and the Philippines, with the IMF pumping in $40 billion in an effort to stabilise currencies in South Korea, Thailand, and Indonesia.

On a wider scale the Asian crisis knocked confidence in lending to developed countries, which has a negative impact on oil prices, contributing in part to the Russian financial crisis.

The Russian financial crisis
The bank’s motto may have been, “We are for real, we are here to stay,” however Inkombank had not reckoned with the ferocity of Russia’s 1998 currency crisis, which reached a peak on August 13 1998.

Like many banking crises, the Russian banking crisis was caused by a combination of factors. In 1997 and 1998, the effects of a declining economy were exacerbated by the Asian financial crisis and the decline in demand and price of oil and other commodities that Russia produced.

In the background, amidst the impending crisis, the government were issuing short term bonds, known as GKOs, to help finance the budget deficit. However their issuance resembled something of a pyramid or Ponzi scheme, with the interest on matured obligations met using the proceeds of newly issued obligations.

Internal debt obligations became difficult to fulfil. By August 1, 1998 there was over $10 billion in unpaid wages owed to Russian workers. Various workers were on strike –including the coal miners. And as with the UK and the ERM crisis, Russia’s problems were compounded by its policy of linking the rouble, to another country’s currency, in this case the US dollar. Throughout 1997 and 1998 the Russian government expended billions of its US dollar reserves, supporting the rouble.

Finally, on August 13, 1998, the Russian financial system went into meltdown. Stock, bond, and currency markets collapsed, as investors scrambled to get their money back. The stock market was temporarily closed because of the steep falls. In the fallout, several banks closed, including the not so permanent Inkombank. Russia’s recovery, however, was surprisingly swift, driven in part by a rapid rise in the price of oil and other commodities.

The Great Credit Crunch (2007-08/09?)
In contrast to the short sharp shock of most stock market crashes, the present credit crunch crisis is more like death by a thousand cuts.

The origins of the crunch are well rehearsed. Speculative unsound mortgage lending, the repackaging and reselling of sub-prime mortgage debt as supposedly attractive financial products, the gradual realisation that those products were not quite as attractive as their credit ratings might suggest, the consequent unwinding of positions, recalling of funds, and reluctance of banks to lend money to each other.

If it feels as if the current crisis is interminable, that’s probably because it has been rumbling along since the beginning of 2007 when it became clear that a number of sub-prime lenders in the US were in trouble. Ever since, it has been an endless procession of write downs, financial losses, CEO resignations and now rights issues.

Along the way Wall Street investment bank Bear Stearns has been acquired by JP Morgan Chase, and the UK bank Northern Rock taken into public ownership. The response of the central banks wavered initially between wanting to avoid a banking catastrophe, and not wishing to encourage moral hazard and reward poor lending practices. In the end, the former won out, with concerted action pumping hundreds of billions of dollars into the system in an effort to lubricate interbank lending and bring down the LIBOR rate.

Has it worked? Who knows. Everyone has an opinion, but it is early days still. The only certain thing is that it will happen again, and that one quick read through the following shows that we should all, banks, investors, regulators and governments, know better. Forget neoclassical economics and efficient market theory; fear and greed, that is where it’s at.

Financial crises that shook the world…

Posted on June 9, 2008October 11, 2012 by itsupport

SEPA – simpler, faster, safer

Posted on May 27, 2008February 14, 2012 by itsupport

At the end of last month, January 28, the European banking industry implemented a process that will make it simpler, faster and cheaper to transfer money across national borders. This is the first visible outcome of an ambitious project to harmonise and modernise the retail payments market in the European Union. More practical steps will follow, bringing benefits to bank customers across Europe, and opening up new opportunities for the banks themselves.

Single Euro Payments Area (SEPA) is the name of the project that harmonises rules for euro payments. It will enable bank customers to make more efficient payments in euro, irrespective of their location. The European Central Bank (ECB) and the national central banks of the Euro system have a keen interest in the efficient functioning of the financial system. We are fully committed to help making SEPA a success.

Opportunities for Europe
The SEPA project is an important step towards more financial integration in Europe. It removes the fragmentation in the retail payments markets by introducing a single set of payment instruments or services for euro payments. SEPA is also introducing equal access conditions to payment services or products, thereby ensuring that market players are treated equally across Europe.

With its harmonisation and restructuring efforts, SEPA is a crucial driver for opening up the different national retail payments markets, encouraging European-wide competition and fostering innovation. Banks and other payment service providers are able to offer their services in different European countries, which will intensify competition to the benefit of European citizens. SEPA is also increasing the possibilities for economies of scale and scope, for example in the processing platforms, and is thus stimulating investment opportunities. Indeed, SEPA allows for more rationalisation, consolidation and expansion, all of which we already see happening now.

SEPA will also bring opportunities for corporates and customers as it will simplify their euro payments and allow for cost savings. From one single account it will be possible to reach all other accounts in Europe. Merchants and corporates will also benefit from more efficient processes and common standards for their payments. And payment cards will be used more widely, which will ultimately reduce the costs of cash handling. The introduction of chip and pin for every card will further improve customer safety and convenience.

SEPA will initiate a modernisation process in Europe, which will bring new and innovative products. The SEPA instruments, which have been designed for credit transfers and direct debits, are the basis on which further developments will be made. Several future-oriented initiatives, such as e-invoicing, online payments (web-retail) and mobile payments, permit efficiency gains for customers. For banks, SEPA is an opportunity to reach wider audiences and new sources of revenue.

Challenges of SEPA
SEPA has already led to many changes in the banking industry and will continue to bring new challenges in the years to come. The banking industry is facing in particular three main challenges, which are of a technical, commercial and legal nature respectively. The industry must address these challenges together by removing the barriers that exist between the current national payments markets.

A first challenge is of a technical nature. So far, the banking industry has been very successful in developing common technical standards that enable the smooth connection of systems and the transfer of messages between different banks in Europe. Technical standards are the basis for payment systems, ensuring the transfer of funds. In the years to come the industry should further deepen and widen its standardisation efforts, which could lead to new challenges. National fragmentation through different standards, e.g. in the customer-to-bank space, should soon belong to the past and common standards should be in place. The Euro system fully supports the work of the industry in this field and encourages the adoption of international best practices and standards, such as those developed by the International Standards Organisation (ISO).

A second challenge is of a commercial nature. With SEPA, the banking industry has developed new rules and business practices for euro payments. These are referred to as the ‘rulebooks’ that ensure common treatment for transferring funds in Europe. In particular, the banking industry has agreed on the common rulebooks for credit transfers and direct debits, and two frameworks, one for card payments and the other for clearing and settlement mechanisms. The Euro system fully supports the banks’ work in this field. The challenge for the industry is to develop common rules that will allow different entities to provide more innovative services throughout Europe. The younger generation of bank customers in particular increasingly prefer online and mobile transactions, and a solid common framework for Europe must be developed.

A third challenge is of a legal nature. For a long time the national regulatory differences in Europe hindered the provision of efficient and automated services across borders. The Payment Services Directive will remove these legal barriers. The Directive will create a clear and homogenous framework for making payments in euro, and should be transposed by November 2009 at the latest. The Euro system strongly supports the work on the Directive as it will provide the legal certainty that is necessary for operations across Member States. A coherent and early adoption of the Directive is imperative for the banking industry, as it will facilitate the implementation of SEPA. The European Commission and the ECB are therefore closely monitoring the implementation of the Directive into national legislation.

A bright future
The ECB’s outlook for SEPA is a truly integrated market where all euro payments are treated as domestic payments and the level of safety and efficiency meets customers’ needs. To realise the SEPA vision, strong commitment from all the stakeholders is required.

The banking industry has showed its commitment to the project and has laid the foundation for a new payments landscape in Europe. In January 2008, with the launch of the new SEPA credit transfers, the future begins in Europe. The SEPA direct debit will be launched in a second wave, during 2008-2009.

The success of the single euro payments market, however, does not only depend on the alignment of national practices or on banks developing new services; it also requires economic actors in all countries to change their habits. The banking industry, therefore, must continue its work and engage customers in the further development of SEPA. The modern, informed and demanding European customer wants an attractive offer and future-oriented products and services.

The ECB and the national central banks of the euro area are supporting the developments of SEPA, and will pay particular attention to ensure that the new landscape has all the characteristics of an integrated market which benefits customers. The ECB is acting as a helping hand or ‘catalyst’ for private sector initiatives and is monitoring the progress of SEPA. As a catalyst, the ECB is making special efforts to foster collective action that facilitates financial integration and provides better services for customers. In this respect, the ECB is paying particular attention to providing clarity on all features of direct debits, addressing the need for at least one additional European debit card scheme and ensuring the reach ability of banks.

SEPA has initiated the necessary developments that will bring Europe closer to enjoying an integrated and sophisticated retail payments market. It is now up to banking industry to not lose momentum and to maintain its efforts to develop further ‘state of the art’ products and services.

Transfer pricing and transactions in Finland

Posted on May 23, 2008February 9, 2012 by itsupport

With the election of a new government and renewed focus on employment and productivity, Finland is hoping to continue the economic growth that has characterised the country over the past few years. The new transfer pricing legislation will place Finland directly in line with its European neighbours, whilst the passing of the Companies Act in 2006 enabled greater flexibility in financing and cross border transactions. Despite the credit crunch, the number of transactions in Finland was at a record high in 2007, with the number of deals exceeding the previous record set in 2000. With forecasts of slowing economic growth and employment concerns due to ageing populations, the new government is streamlining bureaucracy and focussing on innovation to spur Finland’s economic growth.

Continued foreign direct investment activity
The transaction market was active in 2007 with industrial buyers reentering the market and private equity continuing to sell to private equity. The number of transactions was at a record high, with 768 deals exceeding the previous record set in 2000, and a 17 percent increase in deals over 2006. Finnish companies purchased 105 companies abroad, whilst non-Finnish buyers purchased 101 companies from Finnish sellers. Finnish entities sold businesses covering turnover of €5bln both in Finland and abroad. In total, Finnish companies purchased turnover worth €2.8bn, a decrease from €3.2bn in 2006.

In 2007 majority stake transactions, 110 000 employees were transferred under new shareholder control. As the Finns made the largest transactions abroad, about 38 percent of the group, some 41 000 persons, work outside of Finland. Standout deals include Nokia purchasing Navteq for €5.7bn: the purchase price exceeding 14 times the target’s 2006 turnover; Atria, Finnish food product corporation acquiring Swedish Sardus and Finnish Pouttu and Cargotec did 13 acquisitions in 2007.

The State of Finland sold a 30 percent stake of Kemira Growhow, fertilising business, to the Norwegian Yara. M-real, pulp and paper company, divested Map Merchant in the Netherlands, Zanders plant in Germany,

Petöfi plant in Hungary, Tako in Finland and Meulemans in Belgium.

There were two new listings in the OMX Nordic Exchange: SRV Group in June 2007 and Suomen Terveystalo in April 2007. A rather new phenomenon in 2007 was an IPO through a merger: Tiimari merged with listed Leo Longlife, John Nurminen with listed Kasola, and Trainers’ House with listed Satama Interactive. OMX also organised a new market place, First North, for small growth companies.

Impact of the credit crunch
The credit crunch meant that there was a period in the autumn of 2007 in which transactions were delayed and negotiations between parties took longer. It is likely that some transactions did not take place but overall, the effect was not dramatic. Market value of companies listed in the local Stock Exchange decreased some €24bn within a month according to Talouselämä in February 2008. When comparing the October 2007 peak with the current situation, the market values have decreased some €45bn of which Nokia counts only for €10bn. According to the same source, exits by non-Finnish institutional investors and large private investors have played a big role in this development.

Merger of the Financial Supervision and Insurance Supervisory Authority
The merger of the Financial Supervision and Insurance Authority will essentially cover the same duties as the two existing supervisory authorities. The objective would be to enable companies and organisations in financial markets to operate in a balanced business environment, maintain public confidence in financial markets, foster compliance with good practice and disseminate general knowledge about the financial markets. The centralisation will make it possible to supervise more effectively and take into consideration special characteristics of different industries in the financial sector.

Activities within the financial market, including: Icelandic Glittnir acquiring FIM, investment bank, Danish Danske Bank acquiring Sampo Bank, and offers on the OMX Stock Exchange, will have an effect on the roles and responsibilities of the new authority.

Implications of new government
The new government’s approach to taxation has been a movement toward trying to attract business angels to the country, with the Ministry of Employment and Economy and the Ministry of Finance currently drafting a proposal to offer direct tax incentives. This would take the form of exemption on capital gains after a holding period of three years. The incentive would not be targeted to institutional private equity, and although the details have yet to be released, the purpose is to prepare the package by the end of the year.

Despite this, there is also a draft proposal, prepared by the Ministry of Finance, on a new asset classification, which would limit the scope of participation exemption on capital gains. The government recently terminated plans to design a new tax depreciation regime for investments to maintain productive investment activity in Finland. There is also a Real Estate Investment Trust (REIT) discussion pending, as there is currently no tax element included in the REIT legislation.

The Ministry of Employment and the Economy was established on 1st January and its mandate prescribe duties assigned to the current Ministry of Trade and Industry (excluding matters related to immigration and integration), and functions of the Interior Department for Development of Regions and Public Administration (excluding the Regional and Local Administration Unit). The Ministry’s focus will be on innovation, the employment of labour, reforms to meet the challenges of climate change through energy policies and a focus on developing regional co-operation.

2007 transfer pricing legislation
According to Finnish tax law, associated companies are required to comply with the arm’s length principle in their intra-group transactions. The principle may be applied to adjust the profits of a Finnish company in relation to both domestic and cross-border transactions. An adjustment is possible if the taxpayer has agreed to the transaction on conditions differing from those that would have been agreed to between independent parties. Any profits that would have accrued to the company but for the non-arm’s length terms have not, may be included in the company’s profits.

All companies are obligated to comply with the arm’s length principle in their intra-group tradings, even though the transactions would be exempted from documentation requirements. Documentation must be provided separately for each tax year. Satisfactory documentation is to be prepared in accordance with the model set forth in the EU Code of Conduct (COM (2005) 543 Final), taking into account the OECD Transfer Pricing Guidelines.

Under the new regulations, a taxpayer is obliged to provide the documentation within 60 days from the date of request by the tax authorities. The revenue may not request documentation before six months from the end of the company’s accounting period under scrutiny. The tax authorities are also entitled to require additional information regarding the documentation, which is to be provided within 90 days from the date of the request. It should be noted that companies are not obliged to file transfer pricing documentation in connection with the corporate income tax return.

An exemption from documentation requirements applies to small and medium-sized enterprises. However, as the independency criteria set by the EU Commission 2003/361 EC Recommendation apply; Finnish companies that are small and medium-sized on stand-alone basis are required to fulfill the documentation requirements if they are controlled by large non-Finnish corporations. A company is not regarded as an SME if, in accordance with the Commissions Recommendation, the company employs more than 250 persons and has an annual turnover exceeding €50m and/or an annual balance sheet total exceeding €43m.

Transfer pricing has been a subject of increasing interest of the Finnish tax administration during the past decade. In the lack of specific documentation requirements and resources, the Finnish revenue has, in terms of numbers, mostly targeted simple issues, e.g. management fees. During the last ten years or so, especially after the establishment of the Tax Office for Major Corporations in late 90’s, the revenue has placed a certain amount of effort in more complex transfer pricing issues on Finnish based large multinational companies.

Legal issues arising from cross border transactions
Cross-border transactions are subject to documentation requirements and the expectation is that the Finnish revenue will actively monitor the Finnish tax base and there will be more inquiries and disputes in this area of practice. Recent discussions in Finnish tax journals and published case law indicate the revenue’s growing interest in business model conversions as well as issues on intellectual property. Finland actively follows the international tax discussion and it may well be that some of the international developments will be adopted in some form in Finland.

With regard to other legal issues arising from cross border transactions, the amendment of The Companies Act in 2006 allowed greater flexibility in financing and these measures are available for transactions where there is a Finnish acquisition vehicle. There are still some pending tax debates on tax treatment, especially in the area of repatriation.

The documentation should include items listed below:

A description of the taxpayer’s business activities

A description of the connection between the associated companies, including the associated companies names, and a clarification of what the association is based on, as well as a description of the group structureInformation on transactions undertaken with associated companies and information on agreements concerning the transactions between the associated companies

A functional analysis of the transactions undertaken with associated companies, providing information on functions performed, property used and risks assumed

A comparability analysis, including information on comparable transactions or companies, validating the arm’s length level of the applied transfer pricing

A description of the selected pricing method and its application and an explanation of the choice of the selected method

There is less documentation required if the total amount of the intra-group transactions entered into by the taxpayer does not exceed 500,000 euros. According to the section on penalties, a maximum penalty of 25,000 euros may be imposed if the taxpayer has not prepared sufficient documentation in accordance with the regulations. Standard tax penalties may be levied if income is adjusted

For further information:
Tel: +358 20 755 5314
Email: outi.ukkola@deloitte.fi
Website: www.deloitte.fi

India’s tax situation

Posted on May 23, 2008February 9, 2012 by itsupport

There is a growing concern in the international business community about the lack of certainty and transparency in the application of income taxes to their business operations in India.

The general impression is that the administration of tax laws in India is often arbitrary and deviates from well-accepted international norms and interpretations. Executives also are concerned about the time- consuming nature of litigation and dispute resolution in the country.

In order to improve the situation, Ernst and Young regularly participates in discussions with the policy-makers in the Indian Ministry of Finance to communicate the concerns of the international business community, says Gaurav Taneja, national tax director and partner of Ernst & Young in India.

The objective of the discussions is to make the authorities aware of several factors, he said, namely that:

* A gap exists between Indian and international income tax practices

* There is an economic cost from the current practices in the form of lost investment and employment opportunities;

* Simpler and clearer tax policies and interpretations and simplification of the dispute resolution process would facilitate an investor-friendly environment, yield more revenues, and reduce administration and compliance costs.

“The ultimate objective is to assist in the development of credible positions which are seen to be in the overall interest of the Indian government and the non-domestic corporate tax- payers,” said Mr. Taneja, whose firm states that it has the largest integrated tax advisory team in India of more than 1,000 dedicated professionals.

Changes to the tax policies were announced on February 29 in the nation’s Budget and incorporated into the Finance Bill, 2008.

However, says Mr Taneja, “the future of India’s tax policies cannot be foreseen based on the provisions of the Finance Bill alone. Over the years, the corporate tax rate has stabilised with the basic corporate tax rate being 30 percent. Perhaps for the first time, the direct tax collections have surpassed those from indirect tax such as excise, the hallmark of any tax-developed regime. Thus, Indian tax policies do need to take into account the changing environment.”

Indian Finance Bill 2008
The Economic Times in India believed that the Indian Finance Minister’s Budget was “crafted with an eye on the upcoming general elections, rather than giving impetus to the growth story.” The news journal noted that there were some “positives” for certain sectors such as auto and education, but was “rather disappointing” for information technology and banking.

Ernst & Young’s Mr. Taneja, meanwhile, pointed out some of the new taxation issues that are proposed in the Finance Bill 2008 as announced during the Budget.

For example, there has been no change on the corporate tax rate, but one of the most significant proposed changes has been in the manner of computing the book profits for the “minimum alternative tax” levy (MAT).

Presently under the MAT provisions, if the tax payable on total income computed under the normal provisions of the Income Tax Act 1961 (Act) is less than 10 percent of the book profits of the company, then MAT is levied at 11.33 percent on such book profits. (Book profits are the net profits shown in a profit and loss account prepared as per the Companies Act, 1956 as increased or reduced by certain adjustments provided for in the Act.)

However, says Mr. Taneja, the Finance Bill proposes to add back any deferred taxes and provisions to arrive at the adjust book profits. “Moreover, this amendment is proposed to be retrospective from April 1, 2001,” Mr. Taneja added. “By doing so, the Bill has sought to overturn a few judicial decisions and may lead to reopening of tax cases in several instances.”

However, the Finance Bill gives some respite from dividend distribution tax (DDT), says Mr. Taneja. Shareholders have been exempt from paying tax on dividends paid by Indian resident companies, but the companies have had to pay a “dividend distribution tax” of 16.99 percent. “This has lead to a cascading impact in the case of multi-tier group entities,” says Mr. Taneja. “The effective tax burden is high since DDT is a sunk cost and is not allowed as a deduction while computing taxable business profits.”

The Finance Bill provides some respite by proposing that the amounts of dividend paid by an Indian resident company (provided it is not a subsidiary of any other company) will be reduced by the amount of dividend received by it from its Indian subsidiary in the same financial year. This provision, however, does not benefit a subsidiary in India of a foreign company or more than a two-tiered company structure.

Also in the Finance Bill are certain proposed amendments regarding administrative and procedural provisions which may give the tax authorities further leeway on the issue of notices at the summary (initial) assessment level and the initiation of penal proceedings without giving any reasons. “One proposal which has come in for much criticism is that where a taxpayer has appeared in any proceeding or cooperated in any inquiry relating to an assessment, it shall be “deemed” that the notice from the tax department was duly serviced on him and was not invalid,” said Mr. Taneja. “In other words, he cannot cooperate without prejudice to the right to object subsequently as regards the invalid status of the tax notice.

I.T. industry taxation
Meanwhile, the Budget proposals were not favourable to the I.T. industry, according to Mr. Taneja. Under the present taxation scheme, the I.T. sector operating through undertakings set up under various government schemes such as the Software Technology Park, Electronic Hardware Technology Park Schemes –enjoy a complete direct tax exemption or tax holiday on earned export profits. Such undertakings are also eligible for certain indirect tax benefits such as exemption from payment of customs duty on imports. However, while the indirect tax benefits are slated to continue for companies operating out of such undertakings -. the tax holiday has a sunset clause of March 31, 2009 when it would be due to expire. Perhaps owing to India’s World Trade Organization commitment, this tax holiday period has not been extended in the 2008 Budget, even though the depreciating dollar against the rupee has hit hard the IT exporters.

“The Budget proposals have also been largely unfavourable to the IT Industry on the indirect tax front as well,” said Mr. Taneja. The excise duty on packaged computer software has increased from 8 percent to 12 percent. There is also a proposal to withdraw the service tax protection available to the IT industry by bringing ‘information technology software services’ within the service tax net (taxable at 12.36 percent). “This proposal may actually be beneficial to exporters who will now be able to claim a refund of service tax/excise duty paid on input services/inputs,” he added.

There could have been a more focused set of incentives provided to the IT industry targeted at the continued growth of the IT sector, Mr Taneja adds. “In our view, the Budget could have provided an extension of the tax holiday benefits for at least one year for the smaller players if not for everyone in the industry,” he said.

News reports claim that India may face stiff competition from other countries such as Vietnam for the “Business Process Outsourcing (BPO)” sector which sets up outsourcing companies in nations which offer tax holidays, free space, and reimbursement for salaries and training costs.

However, it is too early to say how the impending sunset clause on India’s tax holiday will affect the growth in India’s BPO sector, says Mr. Taneja.

“Over the years, India has transformed from being a pure outsourcing destination to an innovation or knowledge hub,” he said. “Unlike BPO which is regarded as procedure driven, Knowledge Process Outsourcing (KPO) is more knowledge-driven. Nasscom, an IT industry association, estimates that this sector is poised for a 45 percent per annum growth till 2010 and may touch $17bn by that date. According to Nasscom, engineering, design, biotech and pharmaceuticals are some key areas in the KPO sector. Thus, while it may be possible that other countries may attract investments into BPO operations, by reinventing the wheel India appears to be still capable of attracting investments.” It is also interesting that some large Indian resident companies are migrating their low-value operations to cheaper jurisdictions, Mr Taneja added.

Offshore jurisdictions
Meanwhile, prior to the Budget, there was talk of India’s finance minister introducing anti abuse provisions in the Finance Bill, primarily to take care of treaty abuse, especially as regards the tax treaty with Mauritius,

In the recent past, the practice of routing investments into India through jurisdictions like Mauritius and Cyprus, which contain favourable capital gains tax clause in the treaties, has been a much debated topic,” said Mr Taneja. “In these cases, the sale of shares of Indian companies do not attract capital gains tax in India. Further Mauritius and Cyprus also do not levy any tax on such capital gains.”

However, the Finance Bill, 2008, has not introduced any unilateral amendment which could impact foreign investments. “Fortunately, there has been no knee jerk reaction,” said Mr Taneja. “While interpretation of tax treaties may continue to result in litigation at the lower judicial levels, by and large, India is committed to honouring its treaty commitments.”

Media reports have highlighted efforts at renegotiation of these tax treaties – those with Mauritius and Cyprus, but the outcome of such negotiation is still unclear, as renegotiation is a bilateral act based on consensus, Mr. Taneja said. “The Indian Government may completely want to do away with the favourable capital gains tax clause in these tax treaties similar to the recently amended UAE tax treaty. Alternatively, they may want to introduce specific Limitation of Benefits clause to avoid misuse of tax treaties similar to the one introduced in the Singapore tax treaty,” he said.

Permanent establishments
On another matter, Mr. Taneja has concerns about the treatment of “permanent establishments (PE)” under Indian law. “Despite various judicial precedents, there is a lack of clarity and consistency at the tax assessment stage, especially by lower level tax officers, as regards creation of a PE in India upon deputation of expatriate employees, limited presence in India such as through a representative office, or performance of activities in India by agents,” said Mr. Taneja. “The attribution of appropriate profits to PE of the foreign enterprise in India has also suffered arbitrariness.”

Although, domestic tax laws (Rule 10) provide some guidance for the revenue authorities, these may not be objectively applicable in all situations where the PE would have performed limited role in the over-all business transaction, he said. Owing to the aggressive stand of the tax authorities, especially at the lower levels, it has now become very imperative for MNEs operating in India to review their existing business models to determine the extent of PE risk that they face and the risk associated with the subsequent income attribution to such PE by the tax office, he said.

For further information:
Tel: +91-124-464 4000
Email: gaurav.taneja@in.ey.com
Website: www.ey.com/india

The pole position – a blessing or a curse for FDI?

Posted on May 23, 2008February 14, 2012 by itsupport

Slovenia’s business makeover has not been a bumpy ride experienced by other economies in transition at the beginning of the 1990s. Slovenian companies were a target for foreign interest as early as in the late 1970s thanks to Slovenia’s manufacturers of household appliances, cars and commercial vehicles, furniture and garments. Conveniently nestled between Austria and Italy, Slovenia has traditionally served as a gateway for exports to the discerning markets of West Europe even in former Yugoslavia.

Much has been done to boost the country’s attractiveness as a place to do business between Slovenia’s independence and today. The call for political action was backed within the framework of effort to become a full EU Member State and awareness that the Slovenian internal market was not fully integrated, which in turn meant a lack of competition in some sectors and increased operating costs for foreign investors.

Following the political consensus, liberalisation of the internal market has been built continuously since 2000 as the Slovenian economy become fully integrated with the EU economies, joined the EU in 2004, qualified for Eurozone and adopted the euro on January 1, 2007, and entered the EU Schengen in December 2007.

Adding value
Despite the country’s good economic performance, the government is committed to continuing efforts to improve micro-economic conditions to enhance GDP growth. This includes measures to increase competition by liberalising previously sheltered industries such as electricity, energy, telecommunications, and to dismantle administrative hurdles. In response to the critics quoting Slovenia’s excessive red tape and the shortage of land for industrial use, the Slovenian authorities got down to the business of changing the country’s business landscape attractive to foreign investors. Since 2000, registering a company in Slovenia has been greatly facilitated in many ways including electronic access to practically all public administration services, and the number of locations for property development and redevelopment to technological parks and economic zones has jumped.

When foreign investors consider locations to relocate or expand operations, the attractive tax regime of the eastern Alpine country bordering the Adriatic Sea is a reason to shortlist it. The present government deserves much of the credit for Slovenia’s tax reforms: a gradual corporate tax rate reduction aimed at promoting a pro-growth economy, phasing out of pay-roll tax, a relief on personal income tax. Tax allowances are in place for investment in research, technology and development, while greenfield foreign investment projects in manufacturing and sectors with high value added are eligible for financial incentives when they create new jobs. With tax revenue accounting for some 40 percent of GDP in 2005, Slovenia’s tax rates are lower than in many other European countries and converge with the EU27 average.

While traditionally taxes have been one of the key reasons for locating and investing away from home, transparent and stable political, legislative and administrative environment, the ease of getting about: good transport to airports, good rail links, availability of schools and good quality accommodation, as well as quality of life in general, should tip the scale in favour of Slovenia. The government’s ambition is to make Slovenia the leading European choice of international companies for locating international/European headquarters, an R&D centre, or a centre for administration and/or accounting functions. The government reforms have helped Slovenia’s economy increase its competitive edge and appeal to foreign investors without overheating the economy. Thanks to a wide-spread use of the first common financial reporting standard – IFRS – investors can compare statements produced in one country with those produced in another and exploit the advantages of mobile technology and broadband penetration where Slovenians themselves are early adopters both for business and private purposes. Today investors can benefit also from lower transaction costs arising from the single currency and the implementation of the Single Euro Payments Area (SEPA) where the current differentiation between national and cross-border payments no longer exists. This means that customers within the SEPA are able to make payments throughout the whole euro area as efficiently and safely, and above all at the same price, as in the national context today.

More ingredients for a recipe to attract FDI
Many Slovenians speak English, German and Italian and the Slovenian economy has all the attributes of an open and dynamic system without high leverage. Its budget revenues and expenditures are balanced, services generated 64.4 percent of GDP (2007 estimate) leaving industry behind (33.5 percent), gross fixed investment accounted for over 27 percent of GDP (2007 estimate), value added grew most in construction (well over 18 percent) followed by manufacturing (slightly more than 8 percent). Financial intermediation, trade and transport enjoyed high growth rates, and the only figure to spoil the picture of prosperity was the fact that in 2007 consumer prices increased by 5.6 percent.

In other words, the level of external debt is sustainable leaving room for more private equity and M&A activity. The Resolution on National Development Projects for the Period 2007-2023 lists several national projects worth some €24bn of which some €15m in private equity through public-private partnership.

In conclusion, although foreign direct investment (FDI) is generally perceived a source of economic development and modernisation, income growth and employment, it should truly be a ‘win-win’ situation for both the investor and the recipient country. Over the past seven years, Slovenia has established a transparent and effective enabling policy environment for investment and has built the human and institutional capacities to attract foreign investors. If its FDI stock appears modest in comparison with other CEE countries, it has something to do with the proverbial prudency of its people and their system of values where diligence and loyalty go hand-in-hand with creativity and innovation that are often key to the success of a business. A good pole position seems to make people more prudent and more environment-concerned. In the long run, it should be good for the investor and the host country.

Why invest in Slovenia?

A strategic location as a bridge between Western Europe and the Balkan States boasting strong levels of efficiency and productivity.

A well developed transport infrastructure both on dry land and through the sea port at Koper to serve some of Europe’s major transit routes.

A proficient and skilled labour force boasting a high degree of IT and technological prowess, from electronics to financial services.

All attributes to become a location of choice of international companies for international or European headquarters, an R&D centre, or a centre for administration/accounting functions

Slovenian Ministry of the Economy identifies development priorities
The priorities of the Slovenian EU Presidency in the field of energy, telecommunications and industrial policy – sustainability, competitiveness and security of energy supply with focus on the internal gas and electricity markets, renewable energy sources, energy technology and external energy policy. Energy and waste management offer a host of opportunities for foreign investors (PPP).

The Resolution on National Development Projects for the Period 2007-2023 lists several national projects worth some €24bn of which some €15m in private equity through public-private partnership.

The areas of wholesale and retail trading such as in electronics and garments, as well as consultancy services remain investors’ favourites, but further opportunities exist in sectors such as IT, pharmaceuticals, banking, insurance and telecommunications. Niche sectors and boutique companies may not be high-profile but thanks to specialisation stand to fare better than large household names that often lack flexibility in meeting customers’ needs. From electronic components to sailing boats, from racing skis to roulettes, from ultra-light aircraft to motor exhaust systems – these are some of the products ‘Made in Slovenia’ that do not fear competitors.

Efforts to improve macro-economic conditions to boost GDP growth and attract FDI have delivered the following preliminary figures for 2007:

GDP growth                    6.1 percent
GDP (at current prices)      €33,542m
GDP per capita                     €16,616
Exports growth                 13 percent
Imports growth              14.1 percent
Employment growth         2.7 percent