Tax Havens

In the wake of the economic crisis gripping much of the world today, so called tax havens have come into sharp focus, for their contributory role in the present crisis.

What is a tax haven?  A tax haven may be an independent country, or a dependency, or overseas territory, of a country, or a principality.   The general term applied to this goegraphical entity is “jurisdiction”.   It is a place where there are either no taxes like Municipal Tax, Wealth Tax, Sales Tax, VAT, etc, or the rates of these taxes are so low, as to attract people, especially non-residents from other countries to take advantage of these laws. at the cost of the home country.

For example, say an American national working for an oil company, in the Middle East, repatriates his earnings to the U.S., and is liable to pay certain tax on it.   However, by parking these funds in Switzerland, he does not pay any tax at all.  Hence the gentleman may be tempted to open a numbered account in a Swiss Bank, including one operating in the Middle East, and then transfer his earnings to that Bank.   In the process, the U.S. Government loses taxes on these funds, apart from the fact that these funds mights have, otherwise been invested in the United States, and generally speaking, contributed to the well being of America.

Another feature of a tax haven is that, they do not disclose the financial information relating to accounts maintained with their Banks, and Financial Institutions, to foreign tax and other authorities.   This presents the home country authoritites, problems in tracking illegal transfers of money, tax avoidance, stashing of ill-gotten wealth etc.   The tax havens actively discourage sharing of information relating to financial transactions of their overseas clients, through administrative practices and legislation that is aimed at protecting the privacy of such clients, even though such practices may cause harm and loss to the home countries, that is, the countries, to which the clients of the tax havens belong.

A third feature of tax havens is the lack of transparency in the legal and administrative processes, that makes it difficult for countries with a proper tax framework, to deal with such jurisdictions.   These countries find themselves at a disadvantage, vis a vis, the tax havens, on account of the obvious differences in approach to the issue of taxes on the one hand, and the concept of accountability and transparency on the other.

Tax havens, typically, do not engage in due diligence of their foreign clients, in respect of their identities, source of funds, etc, before establishing a relationship with them.   Further, they do not require overseas companies to have a local presence or even to have local introductions.   Practically, everything is “arranged” for a price.

Often, tax havens advertise themselves as such, through the media.   One can come across advertisements of tax havens, in financial journals in different countries.   It is not uncommon to encounter an advertisement of a tax haven in a particular edition of a journal, carrying  critiques of tax havens!

Future of Tax Havens:  It is difficult to predict the future of tax havens at this time.   Definitely, they are under pressure to “reform”.   The present economic cisis has led to several countries, notably the United States, coming out strongly against these jurisdictions, and acting to discourage their activities.

It remains to be seen what eventually happens to the tax havens given the complexities of the system.

LIBOR

Introduction:  LIBOR stands for London Interbank Offered Rate.   It is the rate at which Banks lend funds to each other in the London Interbank Market. It is published daily by the British Bankers Association (BBA)

Origin:  London is considered to be the largest interbank money market in the world, after New York.   As such, it has led the international financial markets in many respects, in terms of products and services.   Because of the availability of  high level of expertise in Banking and Finance, excellent communication facilities, a free market, apart from political stability, the London Interbank market grew tremendously, bringing in its wake, many new innovations in Banking and finance.

Alongwith New York, London gained prominence as an international financial center, and most of the big players in the banking and finance fields invariably have representation in these two markets.   Some of the most innovative market instruments that owe their origin to New York and London like Interest Rate Swaps, Forward Rate Agreements, Options, etc., became quite popular, and necessitated certain regulation to bring about uniformity in their operations, and to bring about stability to the market.

It is in this context that, the BBA, in association with the Bank of England, came up with certain standards for interest rate swaps transactions, called the BBAIRS, in 1985, which also included the ground rules for fixing of the BBA interest settlement rates, that later on evolved into the LIBOR in 1986.

How LIBOR is fixed:  The actual calculation of the LIBOR is done by Thomson Reuters, the financial information services company, and is published by the BBA everyday between 11.00 am and before noon, London time.   Libor is calculated for ten currencies viz US Dollar, Canadian Dollar, Australian Dollar, New Zealand Dollar, Pound Sterling, Euro, Japanese Yen, Swiss Franc, Swedish Krona, andDanish Krone.

Each currency has a panel of contributor Banks, who convey the interbank deposit rate offered by them, for maturities betweeen overnight and one year.   Thomson Reuters, then fix the LIBOR on the basis of the average of these rates.

Scope of LIBOR:  The LIBOR is the benchmark rate used by Bankers and others, for reference purposes, and not the final quoted rate.   For instance, say, an exporter approaches his Bank to have his export documents negotiated, his Banker would quote a rate that would comprise of the LIBOR, plus his margin.  Similarly a Bank lending funds to another in the interbank market would qoute a rate equal to LIBOR plus its margin.

LIBOR is commonly used as a benchmark rate for various financial instruments like:

1. Interest rate swaps, which is an agreement between two parties to exchange one stream of future interest payments for another, based on a specified principal amount.
2. Futures contracts, which is a contract to buy or sell a particular financial instrument, at a pre-determined rate in future.
3. Inflation swaps, which is a derivative product to hedge against inflation linked risks.
4. Syndicated loans, which are loans extended by a group of lenders to a single borrower.

Apart from the above, it is also applied to floating rate notes, variable rate mortgages, currencies, etc.

Criticism:  The LIBOR has come in for criticism from various quarters, for its unsuitability to various situations and instruments.   Notably the Wall Street Journal, came out with a study that suggested that Banks that had relied on LIBOR, would have presented an incorrect picture of their financial health.   This could give them undue leverage in raising funds from the market at competitive rates.

However, the BBA countered this criticism, justifying the reliability of LIBOR, even in times of financial crisis, as the one now underway.   Further the findings of the International Monetary Fund and the Bank for International Settlements, in this regard, were also supportive of the reliability of the LIBOR.

For the present, though, the LIBOR does not appear to be at risk of being dumped, and continues to be the reference rate in all the major currency markets of the world.

Rule in Clayton’s Case

Introduction:  It is one of the most important legal decisions relating to Banking laws, that established the principle of the order of  application of credits against debits, in running accounts, like Overdraft, etc.

The Case:  The Clayton’s case refers to the case of Devaynes Vs Noble in the year 1816.   Mr. Clayton had an account with a Banking firm, of which Mr.Devaynes was a partner.   As it so happened,  Mr. Clayton withdrew more than the available balance in his account, thereby creating a overdraft.  

Subsequently, he repaid the same, and then deposited further amounts in his account, as part of his operations in the said account.   In the meantime, Mr.Devaynes died, but the Banking firm, in which he was one of the partners, continued to operate as usual.   Later on, the firm was declared bankrupt.

At that point of time, Mr.Clayton sought to withdraw money from his account, which was declined, in view of the declared bankruptcy of the firm.   The matter then went to court, with Mr. Clayton laying claim to his monies from the estate of the deceased partner of the Banking firm, Mr. Devaynes.   The Court, however ruled against him, laying down, what came to be known as, “the Rule in Clayton’s Case”. 

The Court held that the first credit in a account would go towards adjusting the first debit in the said account, and so on.   In the case of a Banking firm, under partnership constitution, upon the death of one partner, credits made by a customer in his account would become the responsibility of the remaining partners, and could not be repaid out of the estate of the deceased partner.

This principle of first in first out, uphelf by the English Court in 1816, is still in vogue, despite criticism from certain quarters about its fairness and relevance.   However, there are certain exemptions to the rule.

For instance, a case where the Clayton’s rule does not apply, relates to a Trust Account, wherein the Trustee commits breach of trust, by mixing up his personal funds with those of the Trust, and proceeds to utilize such funds for his personal expenses.   In a case like this, it is assumed that the amount deposited by the fraudulent trustee would go towards adjusting the withdrawal made by him for his personal benefit, irrespective of the order of such credits and debits.   The Trustee holds a fiduciary position in a transaction of this nature.

The Rule in Clayton’s Case is a landmark judgement in the application of Banking laws, and is extremely useful in tracing claims whera fraud is commited in an account by a person, in a fiduciary position, and also where an account is used for stashing away ill-gotten wealth.

For example, a thief deposits various sums of monies he stole, into his Bank account, on different dates, and then withdraws certain amounts on different dates.   The thief is caught, and the Police receive five claims for the balance of credit lying in the thief’s account.   In a case like this, the Court would apply the Clayton’s rule, in settling the rights of the five claimants.

Banks scrupulously follow this rule in dealing with cases of insolvency, bankruptcy, death etc., of their borrowers, and other account holders, especially in partnership accounts.

Banks follow a simple procedure of stopping the operations in such accounts, where the Clayton’s rule is applicable.   And in case of joint accounts, a seperate account is opened in the names of the surviving account holders.

Check Truncation System

Introduction:  Check truncation is the reduction of the number of steps involved in the processing of checks, either through the local check clearance system, or the national one.   Essentially, it involves the electronic transmission of the image of the check, instead of the check in its physical form, from the point of origin to its destination.

How check truncation works:  Consider the case of a Bank customer, Mr. Muhammad Ali, having an account with Bank A, who issues a check for USD 10,000.00, favoring Mr.Grave Thomson, a customer of Bank B, both of the Banks located in the same city.

 In the normal course, Mr.Thomson would deposit this check at his Bank, and his Bank, in turn, would forward the check physically to Bank A, through the local check clearance system.   Bank A, would then, honor the check, subject to it being in order, and the Drawee’s account having sufficient balance to pass the check.   Bank B would get the advice of realization of this check, through the normal clearnace system, and then afford firm credit to Mr.Thomson’s account, enabling him to withdraw the relative amount.

Now, where the check truncation practice is in vogue, in the above example, Mr. Thomson would still deposit the check of USD 10,000.00 at his Bank.   However, his Banker, instead of forwarding the check to the Drawee Bank physically, would only transmit the electronic image of the check.  

The Drawee Bank, in turn, would honor the check in the same fashion, as in the manual system, and the transaction comes to its logical conclusion, with the drawer’s account being debited, and the beneficiary’s account credited, with the proceeds of the said check.

Benefits of Check Truncation:  The following are the major benefits of the check truncation system.

1. It is fast:  An electronic image travels faster than a check in its physical form, between two Banks, and hence the processing of the check is also fast.
2. It is safe:  Electronic transmission of the check is safer, as there is no risk of loss or misplacement of the check.
3. It is secure:  The level of transaction security is enhanced in electronic transmission as the scope of malpractice with physical checks like deliberate mis-sorting, replacement, tampering with checks, etc., is either eliminated or minimized.
4. It is economical:  The cost of transferring checks in physical form is more expensive compared to electronic transmission.
5. It is user-friendly:  All parties connected with the processing of checks beneift from its user-friendly properties.   For instance, reconciliation, the bane of check processing, is a breeze with electronic processing of checks.
6. It is efficient:  Elimination of human handling of checks also eliminates the typical human errors, associated with repetitive and tedious jobs.
7. It is effective:  The entire system of check clearance is streamlined in its electronic version, making it  an effective way of dealing with millions of instruments on a daily basis.
8. No geographical limitations:  Electronic clearance systems can cover a larger geographical area with ease and convinience, whereas, physical transfer of checks can be carried out over a limited area, on account of the time and safety factors.
9. Better customer service:  Electronic clearance enhances customer service through faster and more efficient service.
10. Eliminates manipulative practices:  Electronic check processing eliminates the leverage of ‘float’ by the drawers’ of the checks.   Float is the time between the presentation of a check and its eventual payment.

As can be seen, there are several benefits of the check truncation system, both for the customers, as well as the Bankers.   It is one of the areas of successful technological innovations in Banking, that has enhanced customer service, as well as contributing to the growth of Bank’s business.

G-20 Commitment to Developing World-Part II

This is the second and concluding article on the financial commitments made by the G-20, at their London Meeting on the 20d of April, to counter the effects of the global economic crisis.

The G-20 agreed to support the Multilateral Development Banks in the following ways:

1. To increase lending to low income countries, to the tune of USD 300.00 billion, an increase of USD 200.00 billion, over the existing limits.
2. To increase the capacity of the MDBs, so that it results in enhancing their own capacity to increase lending to to meet the growing demands.
3. The Asian Development Bank (ADB) would get a shot of capital infusion at 200% over and above the existing capital.
4. A similar need for increase in the capital requirements of other MDBs, such as the African Development Bank, and the European Bank for Reconstruction and Development would be reviewed, and a decision taken accordingly.
5. The G-20 would support efforts of the MDBs to leverage private capital through deployment of guarantees, bond insurance, and bridging finance.
6. To provide a sum of USD 250.00 billion in trade finance in the next two years.   This would be achieved through a combination of the International Finance Corporation program of Global Trade Liquidity Pool, and private sector financing.  Further, the G-20 members would voluntarily contribute 3to 4 billion to the IFC pool.
7. Export credit and Investment agencies would be roped in to provide tade financing, project financing, etc.,  working in concert with the MDBs.

The G-20 expressed its confidence in the ability of the International Financial Institutions(IFIs) to tackle the current crisis, and also to meet the needs of the emerging markets and developing countries.

Some of the major steps initiated/to be initiated by the IFIs to counter the threat of the ongoing global economic and financial crisis, and which has the support of the G-20 are:

1. The IMF has launched a new and more flexible financing option called the Fexible Credit Line, meant for countries with strong fundamentals, and policies, and also a track record of implementing  such policies.   It is a renewable credit line, with no ongoing conditins, and a longer repayment period.   Mexico is among the first countries to avail of this facility.
2. The IMF would address the issue of countries’ Balance of Payments financing needs, and the underlying causes of it.   Of special concern would be the withdrawal of external capital flows to the Banking and Corporate sectors.
3. The programs initiated by the the IFIs  viz. Vulnerability Framework, Infrastructure Crisis Facility and Rapid Social Response Fund would get practical support from the G-20 members by way of volunatry contributions.
4. The present lending limits for individual countries, by the World Bank, would be increased, to enable the larger countries access more funds, as per their requirements.   This would contribute to the stability and recovery in the respective countries.
5. Many low income IDA (International Development Assistance) countries that have sustainable debt positions, and also sound economic and financial policies, are facing problems on account of loss of access to capital markets.   Such countries should be given temporary access to non-concessional lending of the IBRD.

The G-20 called upon the IFIs to cooperate and coordinate with each other, in their developmental activities, for better results.   Further, the developing countries, including the poorest of them, must have more say in the functioning of the IFIs.

It remains to be seen how many of the above resolutions of the G-20 would be actually implemented, and how many of such implemented resolutions would beget the intended results.

                                                                                                 Concluded

G-20 Commitment to Developing World-Part I

This is the first in a two part series of articles on the financial commitments made by the G-20, to the emerging markets and developing economies, in their meeting, in London, on the 2nd of April, in the wake of the global economic crisis.

The G-20 leaders met on the 2nd of April to chart out a course of action, to save the world as it were, from the economic and fnancial crisis that is gripping it, and threatens the established world order.

One of the significant steps taken by the G-20 leaders, was the actual commitment to fund various developmental activities in the emerging markets, and developing countries, to counter the effects of the economic crisis in which the poorer nations are more at risk.

However, it should be noted that the question of individual contributions of the G-20 members, to the overall funding, was not spelt out in their meeting.   How much money would be made available to the international financial institutions, and other such developmental institutions, by each member is not clear.

The G-20 resolved:

1. To support and protect the economies of the emerging markets, and developing countries, by ensuring free flow of capital to them.
2. To provide necessary funding in the order of USD 850.00 billion to the International Financial Institutions (IFIs), to carry out the above task.
3. The IFIs would promote counter-cyclical funding to increase demand and spur growth.
4. Banks would be recapitalized to address the issue of risk management and prudential regulation.
5. Infrastructure would receive priority, as it is the base for developmental process.
6. To enhance world trade by providing funds for trade financing.
7. To provide Balance of Payment support to countries that are facing the problem of depletion of foreign exchange resources.
8. Debt rollover would be another measure to be encouraged to provide relief to countries unable to service their debts in time.
9. To ensure adequate funding to countries for various developmental activities, so that they do not divert funds from important social support activities related to health, education, etc.

In order to achieve the above goals, the G-20 has made financial commitments to International Financial Institutions, like the IMF and the World Bank, which in turn, would carry out the mandate of the G-20 in this regard.  

The following is a list of the financial commitments made by the G-20:

1. To make immediate contribution to the tune of USD 250.00 billion to the IMF, by the G-20 member countries.
2. To pump in an additional USD 250.00 billion, through the New Arrangements to Borrow, and to club the entire amount of USD 500.00 billion under this new program.
3. If necessary, the IMF would resort to market borrowing, to raise resources necessary to meet the demands.   This would be in addition to the existing programs of resource mobilization underway.
4. Concessional lending to low income countries through the IMF would be doubled from the present level.
5. Another source of funds would be the sale of IMF gold, which is expected to fetch, together with surplus income, an amount of USD 6.00 billion.   This money would go to support the poorest of the countries.
6. In order to increase global liquidity, an amount of USD 250.00 billion would be allocated through the mechanism of Special Drawing Rights.
7. Of the above amount of USD 250.00 billion, USD 100.00 billion would be allocated to emerging markets and developing countries.
8. The Fourth Amendment to the IMF charter would be expeditiously ratified, that would ensure a equitable distribution of the SDRs among member countries.
9. The next quota review would be completed by January 2011, in order to sustain the IMFs ability to meet the growing needs for financing, especially from emerging markets and developing countries.

                                                                                             To be concluded

The G-20 Prescription for a Strong Financial System-Part V

This is the fifth and concluding part of the series of articles on the outcome of the G20 Meeting in London, on 2nd April, 2009 to tackle the challenge of the current global economic crisis.

In this concluding article on the above subject, we examine the sixth and seventh reforms adopted by the G-20 to achieve the goal of bringing financial stability around the world.

Accounting Standards:  The G-20 committed itself to improve accounting standards for the financial institutions.   Valuation of financial instruments would henceforth reflect their liquidity, i.e., the ease with which the investor could encash them;   the investors’ holding horizon, that is, the period of investment in various instruments etc., apart from the existing system of fair value accounting.

The G-20 agreed upon the following steps to be taken in order to imporve accounting standards.

1. To simplify accounting procedures for financial instruments.   The unnecessarily complicated accounting procedures adopted for various instruments, for example, financial derivatives, need to be simplified.
2. Provisioning norms for loan-loss items to be strengthened, by taking cognizance of additional information, relevant to the process.
3. To improve accounting standards for provisioning for loans.
4. To improve accounting standards for off balance sheet items like interest rate swaps, options etc.
5. To address the issue of valuation uncertainty while setting accounting standards.
6. To bring about clarity and consistency in the application of valuation standards, at the goobal level, in co-operation with the concerned supervisory authorities.
7. To move towards one set of global accounting standards, that would help achieve the goal of improving accounting standards.
8. To promote the involvement of stakeholders, apart from prudential regulators, and emerging markets in the accounting standards setting process, to the extent possible, to bring about more transparency to the process.   To this end , the International Accounting Standards Board constitution would be reviewed to accomodate the above reforms.

Credit Rating Agencies:  This is the final reform adopted by the G-20 meeting in London to strengthen the financial system, to bring about its stability, and prevent the crisis situation now faced, that threatens to tear apart the global financial system.

The G-20, perhaps,  felt that the Credit Rating Agencies shoud be subject to more regulation, in view of the fact that many of the Banks and that fell by the wayside, in fact, enjoyed good credit rating.   In order to address this issue, the G-20 resolved that:

1. Credit Rating Agencies, being market participants, must be subject to proper oversight.
2. Credit Rating Agencies, whose ratings of Banks andFinancial Institutions are relied upon, by the regulators, would have to register themselves with the authorities, and would be subject to regulatory oversight.
3. This process would be consistent with the Code of Conduct Fundamentals of the International Organization of Securities Commissions(IOSCO).
4. The IOSCO would be the co-ordinating agency for compliance of the above reform.
5. The quality of the rating process would be improved by ensuring that such rating agencies adhere to a code of conduct, in regard to the issue of conflict of interest.   The rating process of the rating agencies should be transparent, and regulatory authorities should ensure the same, by taking necessary steps.
6. Credit Rating Agencies should be more forthcoming and transparent in respect of their rating process of structured products, and disclose their own track record of such ratings.   They should also disclose the underlying information and details, on which they relied in giving the rating.
7. The oversight regime across jurisdictions must be consistent and provide for sharing of information between them.
8. The Basel Committee should address the issue of external ratings in prudential regulations, and take appropriate steps in this regard.

                                                                                                      Concluded

The G-20 Prescription for a Strong Financial System-Part IV

This is the fourth in a series of articles, on the outcome of the G-20 Heads of State meeting, in London, on 2nd April, about ways to strengthen the financial system, in the wake of the global economic crisis.

In this article, we shall examine the fourth and the fifth reforms adopted by the G-20, to achieve the goal of a strong global and national financial system.

Compensation:  Long term goals of the company, and prudent risk taking, are the new criteria for fixing corporate compensation, as propounded by the G-20.   The Basel Committee on Banking Supervision is expected to include the rules regarding corporate compensation as part of the risk management guidance.

The principles on which corporate compensation plans would be based are:

1. The Board of Directors of the company should play an active role in fixing remuneration.
2. Compensation schemes should reflect risk taken.
3. Compensation should relate to the period of such risk taking.
4. Companies to be transparent about compensation schemes.   Stakeholders of the company must have opportunity to evaluate and monitor compensation schemems.
5. Compensation schemes of companies would come under the purview of the surpervisory authorities.
6. If necessary, supervisors may even require increased capital whenever compensation is found to be higher than normally acceptable as per the norms.

Tax Havens and Non Co-operative Jurisdictions:  Tax havens and non co-perative jurisdictions have come in for special attention of the G-20, on account of the grave danger posed by them to the financial stability.   The G-20 has called upon all jurisdictions to strictly follow the international standards in prudential, tax, and Anti Money Laundering and Combating of financing of Terrorism.   In order to achieve this, the concerned institutions are required to conduct and strengthen peer reviews as per norms.

The United Nations Model Tax Convention should be adopted by all the countries in regard to information exchange to facilitate compliance of the applicable tax regime.   Countries that do not meet international standards in relation to tax transparency, would be targetted for appropriate action.   Some of the proposed such actions are:

1. Transactions involving non co-operative jurisdictions would be subject to enhanced disclosure norms.
2. Taxes in respect of payments not to be reimbursed to non co-operative jurisdictions.
3. Residents of non co-operative jurisdictions to be denied tax deductions in respect of expense payments, to which others would be entitled.
4. Tax treaty policies between non co-operative jurisdictions and others to be reviewed for suitable corrective action.
5. International Institutions and Regional Development Banks to be advised to review their investment policies such that they do not favor non co-operative jurisdictions.
6. Bilateral aid programs would attract povisions of tax transparency, and compliance on part of the donee nations to be rewarded.

Apart from the above steps, the G-20 would consider further steps in this direction, aimed at reforming the non co-operative jurisdictions.   Developing countries would be encouraged and helped to avail benefits of new co-operative tax environment by end of this year(2009).

The G-20 committed itself to adhere to the international prudential regulatory and supervisory standards.   The International Monetary Fund and the Financial Services Board are charged with the responsibility of assessing the progess of the implementation of these measures in various jurisdictions.   

The Financial Services Board has been instructed to develop systems and procedures, to promote adherence to prudential standards and co-operation with various jurisdictions.

Compliance of the AML/CFT standards by various jurisdictions would be done by the Financial Action Task Force, who would also revise and reinvigorate the review process for assessing compliance of these norms.

                                                                                               To be concluded

The G-20 Prescription for a Strong Financial System-Part III

This is the third in a series of articles on the outcome of the meeting of the G-20 Heads of State on the 2nd of April, held in London, to come up with an appropriate response to the global economic crisis.

In the previous article, we had examined the third reform adopted by the G-20, namely, Prudential Regulation.   In this article we shall study the scope of this regulation.

Scope of Prudential Regulation:  The G-20 agreed for the need for regulation and oversight of systemically important financial institutions, markets, and instruments, with a view to bring stability to the financial system.

In view of the fact that the failure of some of the big Banks in the West led to the near collapse of the financial system, and also the role of complex financial instruments, like derivatives in the Bank failures, has, persuaded the G-20 to take a critical view of them and put them to scrutiny.

Some of the specific steps initiated/to be initiated by the G-20 in this regard are:

1)  To control the build up of systemic risks.   This is sought to be achieved by amending the regulatory system and empowering the concerned authorities to identify and assess the macro-prudential risks covering the entire gamut of the financial system, comprising of regulated Banks, Shadow Banks ( the set of financial institutions operating outside the purview of sovereign regulatory authorities), Private pools of capital like infrastructure funds, venture capital funds etc.

The G-20 has mandated the Financial Services Board to develop macro-prudential tools for the above purpose, in association with the Bank for International Settlements, and other international standard setters for the financial system.

2)  The biggies of the financial world, engaged in big time financing,  and also having a penchant for complex insturments of financing, would come in for special attention, as their failure can have a devastating effect across the system, as witnessed in the recent past.

3)  To pass enabling legislation to empower national regulators, to collect relevant information on all the systemcially important financial institutions, markets, and instruments in order to map out their potential for failure, and contribution to systemic risk.   Linkages will be established at the international level, to bring about consistency across national borders.

4)  The International Monetary Fund and the Financial Services Board are expected to come up with guidelines, which would help national regulators to identify, through a process of assessment, the systemically important institutions, markets, and insturments.   This, in turn, would help prevent regulatory arbitrage, the practice of taking advantage of jurisdictions having lesser regulation and oversight of the financial system, in general.

The emphasis in the above assessment would be, on the actual activities of the target group, rather than their legal form.

5)  To bring hedge funds/their managers under the purview of dspecial assessment terms to ensure the following:

1. Hedge funds would be registered.
2. They would be subject to disclosure norms, relating to all such areas that can contribute to an increase in systrmic risks across the board.
3. Every hedge fund to have a minimum prescribed size.
4. Adequate risk management mechanism would be put in place.
5. Where the hedge fund, and the fund manager, are based in two different jurisdictions, it would be ensured that information exchange and co-operation between the concerned authorities in the two jurisdictions is established and functioning.
6. The above process is expected to be completed by the end of this year (2009).

6)  Not only hedge funds would be required to have appropriate risk management tools for the purpose, but the institutions that have hedge funds as their counter-parties, would also be required to have an effective system of risk management.   In this regard, the leverage of the hedge fund, that is, the counter party, mst be monitored and limits must be set for single counter party exposures.

7)  The credit derivatives market, whose failure is one of the reasons for the current crisis, would be subject to better regulation and supervision, with the aim of making the market more resilient through standardization.   Central clearing conterparts(a central clearing house for derivatives)  would be established for the purpose.

8)  The G-20 also resolved to review and adapt the extent and application of the regulatory framework, in sync with the developments taking place in the finaqncial system, and to promote good practices and consistent approaches at the global level.

                                                                                          To be concluded

The G-20 Prescription for a strong Financial System-Part II

This is the second in a series of articles on the decisions taken by the G-20 in their meeting on the 2nd of April, in London, to strengthen the financial system.

In this article, we take a look at the second and third of the major reforms to be undertaken by the G-20 to achieve the goal of strengthening the financial system, both within the member countries, as well at the international level.

International Co-operation:  One of the significant reforms to be undertaken by the G-20 is to enhance international co-operation in the economic and financial fields, between countries, with a view to avoid the spillover of the after-effects of financial and economic distress, from one country to another.

The G-20 resolved to keep a close watch on various developments around the world, through international agencies, and to act swiftly and decisively, as and when danger signals are noticed.

In this regard, the G-20 agreed to:

1. To complete the process of setting up supervisory colleges for all the important cross-border firms by the June of 2009.
2. Where several countries have a stake in a major international financial institution, the authorities concerned, in all such countries, would be obliged to meet at least once in a year, and exchange information, and generally keep track of the health of the institution.
3. To help develop a framework for cross-border Bank resolution arrangements, to prevent domestic and international financial instability.   This is sought to be achieved through agencies like the International Monetary Fund, the World Bank, the Financial Services Board etc.
4. Exit strategies would be given due importance, to promote a healthy private sector.   Exit strategies would enable firms to exit the business before the total impairment of their capital.
5. The IMF and the FSB are expected to put in place an early warning system for economic problems, that would measure the impact of such problems on the economic and financial stability of the world at large.

Prudential Recognition:  In an effort to strengthen the financial system, the G-20 resolved to have a strong framework for prudential regulation, as discussed below.

1. The minimum level of capital required for International Financial Institutions to remain unchanged till the end of the current economic crisis.
2. In case any institution has capital over and above the required level, then it should be allowed to reduce the same, and utilize the funds for lending purposes.
3. Prudential regulatory standards to be strengthened in sync with economic recovery.  
4. The minimum capital requirement to be increased once the recovery phase gets underway.
5. A universal definition for the term ‘capital’ should be produced by the end of this year (2009).
6. The Basel Committe on Banking Supervision has been given the responsibility of recommending the minimum capital requirement in the year 2010.
7. The G-20 set a target date of the end of 2009 for implementation of its recommendations and decisions taken in the April 2nd meeting.   It has given this responsibility to the FSB, the BCBS, and the CGFS to complete this process, and to ensure that Banks build up a buffer above the minimum required capital, in times of boom, or economic revival, so that such buffer can be used in times of stress and need.
8. In order to prevent leverage opportunities in the Banking system, a combination of risk-based, and non-risk based capital requirement mechanism to be developed.
9. To provide incentives for risk management of securitization, including the possibility of allowing due diligence quantitative requirements by 2010.
10. All the G-20 members to adopt the Basel II capital requirements progressively.
11. To put in place, a mechanism, at the global level, to imporve the liquidity of financial institutions, including cross-border institutions.

                                                                                                      To be concluded

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