Tuesday, May 31, 2011

International Financial Centers

Given the recent international transmission of the US sub-prime loan crisis, it is a particularly appropriate moment to consider the long-term development of financial markets and the growth of international capital.

As financial services are increasingly becoming an important component of the service sector of urban economies across the world, an increasing sophistication in their provision is emerging through the coverage of services at various levels and their convergence. In this context, financial centers are becoming important to provide various levels of services. These international financial centers are multidimensional in nature with various factors integrating to provide the necessary infrastructure to support international financial business. Wikipedia defines an International Financial Centre as a non-specific term of reference usually meant to designate a city as a major participant in international financial markets for the trading of cross-border assets. An international financial center (sometimes abbreviated to IFC) usually have at least one significant stock market as well as other financial markets, as well as being subject to a significant presence of international banks.”

International Finance Center (IFCs) is, at its simplest, the provision of financial services by banks and other agents to non-residents. These services include the borrowing of money from non-residents and lending to non-residents. This can take the form of lending to corporates and other financial institutions, funded by liabilities to offices of the lending bank elsewhere, or to market participants. It can also take the form of the taking of deposits from individuals, and investing the proceeds in financial markets elsewhere.

Financial centers such New York and London can expect significant economic impact from the global contraction of the financial sector. The fiscal effects on New York City and New York State will be particularly acute, due to their heavy dependence on tax revenue derived directly or indirectly from financial sector performance. The most pronounced impact of the financial crisis has been faced in the states that comprise the New York metropolitan area - especially New York and New Jersey -- and New York City itself (which despite recent past decentralizing trends, remains the centre of the US financial industry, and more significantly, a cornerstone of the city, state, and regional economy).

Financial sector shrinkage will sharply diminish New York State and City tax revenues (which comprise a combination of income, consumption, and property taxes). Youssef Cassis, Professor of Economic and Social History at the University of Geneva wrote a history of IFCs to mark its bicentennial, and they have certainly generated a fine monument to commemorate their anniversary. This is a truly scholarly work of synthesis drawing on an impressively comprehensive bibliography and with a helpful glossary included.

Beginning with the rise of private banks in the eighteenth century and concluding with the financial conglomerates and hedge funds of the early twenty-first century, Cassis has produced a comprehensive overview of the developments of the main centers of capital: London and New York, Amsterdam, Paris, Brussels, Zurich, Frankfurt and Tokyo. His account shows how these centers were buffeted by political crisis and military conflict but proved resilient through innovation and specialization. The structure is strictly chronological, although themes of rivalry and competition, regulation and innovation emerge. Changes in the financial architecture are traced throughout as private banks gave way to joint stock banks, and stock markets matured and became international.

N Janardhan Rao, Senior Economist.

Independent Directors: Governance Matters

With the new reforms in place and the numbers of independent directors increasing there is a need to consider all aspects of the board’s operations that might reduce the effectiveness of independent directors. In this context awareness of the human and behavioral aspects of boardroom dynamics is essential in the campaign for improved corporate governance.

While external directors have been present on corporate boards since the nineteenth century, focusing on them as monitors of board behavior is still relatively new as it all began in the wake of a series of high-profile corporate scandals that led to collapse of many big corporations in US and Europe, beginning with the spectacular collapse of Enron in 2000. Since then, various governments and regulators including SEBI in India (Clause 49) have responded to a perceived crisis by raising the standard of corporate governance.

A common theme in these reforms has been creating some requirement for the independence of directors - although the extent of these requirements has differed. Recent reforms like the Sarbanes Oxley Act (SOA) to the composition of corporate boards are seen as a way of improving the decision-making processes on corporate boards as well as increasing the rigor of the board’s monitoring of management. The key to many of these changes is the independent director.

Brought in from outside, the independent director is conceived of as having no direct or indirect connection with the corporation other than the position they hold on the board. Therefore they are seen as having the ability to bring an independent judgment to bear on the performance of management. However, how well this reform strategy works in practice is still unclear. And, recent past episodes like the Madoff scandal and Satyam-Maytas fiasco and more importantly the global financial crisis which has seen the collapse of a number of banking and financial institutions either collapse or reach the verge of bankruptcy only exposes the chinks in the firms’ corporate governance structure and that there is something seriously wrong with the independent directors’ framework/system. Against this backdrop, it is critical to evaluate the reality of the independent director’s role and how they can best fulfill these expectations. Central to this is raising awareness of the power of group dynamics to compromise the independent director’s ability to monitor and contribute to the performance of a corporation.

Some practical steps can assist in this regard:

• The corporation can develop protocols to ensure that important information is automatically passed to the independent directors.

• The board’s agenda can be set at the end of each board meeting thereby allowing members of the board to add any important issues.

• Independent directors can be encouraged to meet both formally and informally outside the board process to share ideas and concerns.

• Independent directors can have access to independent outside advice on matters relevant to their role in the corporation.

• The board can increase awareness of external issues and improve the decision-making process allowing indirect input by shareholders and stakeholders through access to independent directors.

Definitions of independent directors
According to Higgs’ definition: “that a non-executive director is considered independent when the board determines that the director is independent in character and judgment and there are no relationships or circumstances which could affect, or appear to affect, the director's judgment”. Such “relationships” are enumerated.

According to the SEBI’s Clause 49 of the Listing Agreements an ‘independent director’ shall mean non-executive director of the company who apart from receiving director’s remuneration, does not have any material pecuniary relationships or transactions with the company, its promoters, its senior management or its holding company, its subsidiaries and associated companies; is not related to promoters or management at the board level or at one level below the board.

Satyam-Maytas fiasco calls in question the role of the independent directors The Satyam-Maytas fiasco has drawn the attention of Government towards the role of independent directors, especially when the new Companies Bill provides for 33 per cent of such directors in boards of companies. In the longer run, it needs to be seen. The Satyam deal certainly raises the question whether the independent directors of the company failed to carry their duties. India's fourth largest software company Satyam Computer Services recently decided to buy two firms -- Maytas Properties and Maytas Infra -- promoted by Satyam chief R Raju's two sons for USD 1.6 billion (about Rs 8,000 crore), but called off the deal within few hours following investors' wrath. The IT major's decision to buy out the two firms also raised the larger issue of corporate governance. Satyam's Board, including independent directors, had unanimously given a go-ahead to the deal.

The listed companies are already bound by SEBI's Listing Agreement, which calls for certain proportion of independent directors in the board for keeping a check on the management of companies and work as an oversight mechanism. Apart from value addition they are also entrusted with the task of representing the financial interests of others investors. The fiasco has raised some important questions about the role of the independent directors of the firm and hence calls for some serious introspection.

Indian Scenario
For the sake of mere compliance a company may appoint independent directors but whether they are really independent in their thinking, approach and actions is a moot issue. For instance, director resignations are an important indicator of the sensitivity and urgency of issues involved at the board level. We have no studies in India illustrating how director resignations impact stock prices and what other signals they provide for interpreting the existing or evolving corporate governance practices in India. There is hardly any shareholder activism in India.

Shareholder associations exist but whether they able to exert any meaningful influence over the managements of the companies is a moot issue. The limitations of influence of independent directors arise because of internal sources such as the personality of an individual director or external sources such as ownership of a firm, board composition and structure, board process and strategies. The value that independent directors add to the board process only will ensure effective corporate governance.

Board independence is to be achieved and the board needs to emerge as a role model; rather than a predictable stereotype. We in India do not have any formal mechanism of evaluating a board performance and therefore, we have no precedent or comparable information. We also need to note that leadership is not synonymous with designations and age; for leaders need to be developed at a fairly early stage of managerial career life cycle.

There is therefore, scope for introducing leadership courses and a generic curriculum at the higher secondary levels of education so that in the more specialized modules of management education can be inculcated in the mindset of the potential managers. The regulatory and legislative framework can only streamline the existing practices of corporate governance but too much focus on compliance orientation so far has not resulted into awareness for self-regulation and accepting best practices of corporate governance as a way of life for the corporations.

A conscious effort by the top leadership in companies is required, regardless of ownership, to inculcate a culture of transparency and accountability and propagate a well articulated message that in the long run ethical behavior and corporate social actions are not incompatible with good corporate governance and sustainable profitability of the companies.

Recent changes in corporate governance require firms to maintain boards with a majority of outside independent directors. The belief seems to be that outside independent directors will strengthen corporate boards by monitoring the actions of management and ensuring that management decisions are made in the best interests of the stockholders. This belief, however, may be founded on an assumption that has its roots in public perception and not in fact.

The results of several studies suggest that outside independent directors do appear to strengthen corporate boards; however, more needs to be done to reestablish the market's confidence in corporate America's ability to effectively govern itself. The time to ensure independent directors work best in their role on corporate boards is now. With the new reforms in place and the numbers of independent directors increasing there is a need to consider all aspects of the board’s operations that might reduce the effectiveness of independent directors. In this context awareness of the human and behavioral aspects of boardroom dynamics is essential in the campaign for improved corporate governance.
N Janardhan Rao,  Senior Economist.

Farmland Investment

Farmland has emerged as an attractive investment alternative for fund sponsors and institutional investors in the prevailing scenario characterized by low returns on investment. Farmland investment facilitates diversification of portfolio and serves as inflation hedge. The risks involved in farmland investing makes it suitable for investors who are prepared to make long-term investments in farmland.

As the world economy struggles with food shortages and rising prices, farmland is becoming the new gold. Both food-poor and even developed nations are facing concerns of high food prices and food shortages. Top grain producers like India, Vietnam and Indonesia are reducing export quota of key crops like rice and wheat to ensure domestic supplies. These developments are also fueling food prices worldwide and raising concerns about potential shortages.

To feed billions of people, countries are racing to garner rights to surplus farmland in developing countries. There are two major reasons which encourage investments in farmland. One is the rising food crisis and the other is the potential of farmland as an alternative investment or as part of investment portfolio of investors, as they are competing to cash in on one of the few sound investments left in the aftermath of the global financial crisis. As a result, farmland is changing hands more than ever before and is the lone bright spot in the real estate sector.

In most countries, urban and suburban home values are decreasing while those of farmlands soaring. In the US, farmland is the strongest and reflects extraordinary profits as America’s energy policy encourages the production of ethanol from corn. Investors who never sat on a tractor are driving the farmland prices at record levels against assured returns.

On the other hand, farmland has been plowing profits to farmers which, in turn is helping them buy farm equipment and land. Earlier, mainstream investors had overtaken farmers as the largest buyers of farmland and now farmers are leading the front. Over the last two decades, consumer demand for food products has witnessed significant growth and diversification owing to economic reforms, rise in GDP, youthful demographics and rising incomes. Along with the growth in consumption of traditional food items, such as, cereals and pulses, other food categories, such as, vegetable oils, eggs, fruit, vegetables, milk and meats have also registered rapid growth. The private investment climate for agriculture in India has witnessed significant improvement with the elimination of plant-scale restrictions, eased regulations on storage of farm produce, better credit environment, reduced business taxes, simplified food laws.

There are many factors that drive investment in farmland. These include commodity market boom, stock market volatility, tax incentives and favorable interest rates and continued development of residential and commercial developments. More importantly, farmland investment acts as a nature hedge against inflation and is less volatile exposure than equities and commodities futures. It also acts as a recession proof and provides non-correlated source of returns. For property investors, it acts as a viable real asset alternative.

At the same time, increasing concerns of food crisis have led countries, which can afford to spend on overseas farms, to look for arable land to secure food supplies for the future. Sourcing food grains from other countries is increasingly risky in an era of rigid trade restrictions and predictions of escalating food prices. Policymakers in nations facing food shortage are laying the groundwork for a new approach – buying or renting farmland in countries with plenty of arable land.

The world economies led by the US thrust of biofuels are also pushing farmland investment despite concerns of allocating farmland to biofuels rather than food crops. There are concerns that increasing value of farmland may discourage farm investment and encourage speculation. According to some investors, land is the root of all commodities and is an interesting investment option. It is not only investors even wealthy farmers from the United States and Australia are planning to expand their farmland operations, beyond their homeland, particularly in South America. So, the factors behind increasing interests in farmland are not only food security and assured food supply, but also speculative investment.

N Janardhan Rao,  Senior Economist.

Hedge Funds: Myths and Realities

Over the past decade, hedge funds have grown tremendously in terms of assets under management and also garnered a lot of media attention.

The $1.5 trillion hedge industry posted its worst ever performance in 2008. Almost a third of hedge funds will shut or merge after. The failure rate is going to go up, the closure rate is going up, and the merger rate is going up. The number of hedge funds more than tripled in the last decade to a record 10,233 at the end of June 2008. That number will likely tumble after funds dropped 18 percent in the year through November 2008, the worst year since HFR started its Fund Weighted Composite Index in 1990. The size of the industry in 2005 were around $ 1 trillion and in 2006 perhaps $1.5 trillion and in 2007 over $2 trillion.

However, the credit crunch has caused assets under management (AUM) to fall to $1.56 trillion as of November 2008 through a combination of trading losses and the withdrawal of assets from funds by investors. A record number of hedge funds were liquidated in the third quarter, as the business faces the worst crisis in its history.

Despite their growth and popularity, hedge funds still remain a mystery to many people who do not understand exactly what they are and how they work. Billionaire investor George Soros says hedge funds will be decimated by the global financial crisis. A new survey of financial advisers and institutional investors by Morningstar and Barron’s magazine finds widespread concern about the lack of liquidity in hedge funds, which more than half of respondents citing it as a reason to hesitate in picking hedge funds. Advisers and institutions also worry about the industry’s lack of transparency and fee structure.

Competition for investor assets in the hedge fund industry is fierce. According to Hennessee Group, nearly 70% of hedge fund assets now come from demanding institutional investors. In difficult market conditions, every basis point counts and fund managers need to be keenly aware of where money is made and lost and where it is being spent. Although it’s often overlooked, operational inefficiency may account for hundreds of thousands of dollars in unnecessary spending on technology, data and personnel. 

 Likewise the risk stemming from operations may expose the firm to thousands, if not millions of dollars in potential losses due to error-prone manual processes, unknown risk exposure to entities and counterparties and failed trades. The events during the global financial crisis have demonstrated the difference between firms that have strong operations and risk management practices, and those that do not. Further, institutional investors are demanding, not only in terms of performance but also in terms of operational soundness. They are more likely to invest their money with firms that can prove that they have a strong operational infrastructure.

Current market conditions and the investor and regulatory backlash is placing more importance on transparency, requiring fund managers to disclose more information about positions, risk management and operations to their investors. 

Historically pillars of safety for hedge fund managers, the reliability and the viability of service providers have recently come into question. Managers can no longer feel completely confident that their service providers offer absolute safety. The bankruptcy of Lehman Brothers revealed a new type of risk for hedge funds, who now have to worry about the viability and the balance sheet of their prime brokers. Those managers stuck with assets frozen in Lehman’s bankruptcy proceeding have learned this lesson the hard way.

Fortunately, the average hedge fund employs two to three prime brokers, either to access liquidity or asset classes or to protect their “intellectual property.” This practice made moving assets and switching prime brokers easier in the run-up to Bear Stearns’ and Lehman Brothers’ collapses.

N Janardhan Rao,  Senior Economist.

Monday, May 30, 2011

Indian Pharmaceutical Sector: A Paradigm Shift

The strengthening of patent law and the increasing cost pressures on branded drug makers in the West are fueling the growth tempo of Indian pharmaceutical sector.

Indian Pharmaceutical sector was once tarnished for making cheap clones of Western medicines and selling them in developing countries. However, this is no longer the case; seasoned in the basics of medicine making, it is now playing a significant role in the global drug industry. The industry achieved phenomenal progress over the years and is currently valued at $21.4 bn. According to the consultancy KPMG, the industry is expected to grow at a compound annual growth rate (CAGR) of about 18% till 2013-14. The Indian pharma market has become the third largest in the world in terms of volume and is ranked 14th in terms of value at over Rs 1 tn. During 2009-10, Indian pharmaceutical was among the few sectors that managed revenue growth despite the global economic recession. Another positive development has been the development of biotechnology sector in India.

Driven by increasing affordability, the industry is undergoing a major transformation and is slated to move into the world’s top-ten pharmaceutical market by 2015. Until recently, global pharmaceutical players have been incredibly proud and never outsourced from countries like India. However, analysts predict that everything in the value chain will move to different parts of the world destinations, which are cost competitive. India is going to be a major beneficiary because of this. The pharma outsourcing is no longer confined to preclinical trials but has also moved to the more sophisticated end of the drug making spectrum, including research and development (R&D) for the global drug giants and even development of proprietary medicines for Indian players. The global pharma giants have shown high interest in India going by sustained economic growth, healthcare reforms and patent-related regulations. 

The Evolution
The industry strength is no longer confined to generic manufacturing as it has mastered developing and manufacturing generic versions of branded or patented drugs. Reverse-engineering has been one of the greatest boons to domestic players. Moreover, the strength in generic manufacturing has also given them the confidence to challenge patents of some of the top global pharmaceutical giants. With these strengths, the country has fast become the hub of research and development outsourcing.

The Indian pharmaceutical market has emerged a leader in novel drug delivery systems, custom synthesis of new molecules. To add to this, much of the work done by domestic contract research and manufacturing firms is being patented by multinational pharmaceutical corporations.

During the 1990s, there were hardly any exports to regulated markets from India. However, today over 40% of $8 bn exports to North America and Western Europe alone. The industry has a presence in 150 markets, which is more than any other industry in India. According to the data released by the Department of Pharmaceuticals, Ministry of Chemicals and Fertilizers, the total turnover of the industry between September 2008 and September 2009 was $21.04 bn. Of this, the domestic market was worth $12.26 bn. According to the US Food and Drug Administration (FDA) data, it also accounts for 1,735 Drug Master Files (DMF) as against 1,054 from US domestic companies and more than the combined total of European and Japanese companies in 2008. This is a remarkable achievement in a decade.

For instance, in 1998, India filed only three Abbreviated New Drug Applications (ANDAs). In 2009, it filed 181 ANDAs. Satish Reddy, Managing Director and Chief Operating Officer, Dr Reddy’s Laboratories Ltd. applauds Indian market, and adds that, “The understanding of market dynamics and adapting to them quickly is a huge strength that India has. This is illustrated in the number of DMF filings alone that Indian pharma has with the US drugs regulator.” Though the industry has emerged from generics market through innovation as well as hub for contract and manufacturing, it is yet to prove itself in commercializing a New Chemical Entity (NCE). Hitesh Gajaria, Executive Director, KPMG opines “New drug discovery and development has not reached its full potential in India. However, the number of compounds in the Indian pipeline and in the advanced stages of development is also increasing. It is therefore not appropriate to say that India has failed in NCE innovation.” 

                                  Growth Potential 

As domestic pharma players initiated investing in NCE research in 1998, industry experts are of the view that a span of 12 years is too short to judge success or failure. Echoing the same view, G Shah, Secretary General, Indian Pharmaceutical Alliance says, “It takes seasoned players 10 to 12 years to get a molecule from lab to market.  Give them (Indian pharma) at least 20 years and required funding support before sitting in judgment.”

Renowned Business Models
The industry has grown over a period of time and has seen many ups and downs during its evolution process. To meet the challenges of new initiatives, especially in the post patent era, the industry has started probing new business models to meet the ongoing changes in market opportunities and competitive scenario. Experts say in an ever-changing global environment, a homogenous business model is unlikely to work. To navigate competition and opportunities, domestic pharmaceutical players are adopting a combination of alternative business models. These include collaborative R&D and licensing of innovations.

On the collaborative model, Indian market has a huge potential for conducting effective and economical R&D activities and clinical trials, primarily because of the availability of a skilled and competent workforce, availability of diverse ethnic and genetic population, familiarity with Western medical facilities, competency in the English language, world-class medical infrastructure and more importantly, the cost-effectiveness of domestic players.

With the advent of patent provisions, domestic players will not be able to produce and market, generic versions of previously patented drugs. Therefore, they have to focus on innovation, instead of generic drug manufacturing.  Over the last few years, they have been actively involved in the area of R&D either independently or as a contract research partner of a foreign company.

They have adopted harmonious business models, some of them focused on innovation and intellectual property (IP) for licensing (product strategy), others merely embraced a pure services provider model to leverage high-quality, low-cost workforce to bring value to global customers (services strategy). Thus, most of domestic players are in the process of transforming from manufacturing companies to higher-value integrated pharmaceutical companies.

Brand Portfolio Management
While the Indian generics industry has only a 20% share globally, it is time to focus on supplies of ARVs for treatment of HIV/AIDS in developing countries to grab the biggest share in this segment. Analysts argue that if Indian companies had not intervened in this sector with their significantly cheaper versions, a very large number of HIV/AIDS patients would have gone untreated. The government should play an active role to ensure that the potential of the industry is realized. Global consultancy firm McKinsey suggests raising spending on healthcare to 3% of GDP, increasing investments in rural and tier-2 healthcare infrastructure, adopting measures to contain healthcare costs and increasing the number of doctors in the system as policy measures to aid the industry. Industry experts say brand building is a continuous process and it takes time for a product to become a brand. Kedar Rajadnye, Vice-President, OTC Division, Piramal Healthcare suggests, “To create a brand is a time and capital-consuming exercise. Along with many years of investing, a product has to earn the trust of consumers to become a reputed brand, which is very difficult.” Therefore, building of large brands through brand portfolio management is the need of the hour to grab the global market share.

Growth Potential
Despite the industry’s commendable achievements, India contributes a meager share of the global pharmaceutical market sales. According to a study done by Pharmabiz, the top Indian pharmaceutical companies seem to be less enthusiastic about the R&D activity if one goes by the expenditure incurred by them during last year. The study reveals that the overall R&D spending of top 20 companies increased by just 5% during 2009-10 to Rs 2,989 cr as against Rs 2,845 cr in the previous year. This worked out to 7.5% of their stand-alone net sales during 2009-10 as compared to 7.9% in previous year. R&D expenditure of Indian pharma companies is considerably lower than the global standards.

Strong pricing competition among local players leads to low margins which in turn lead to limited capital to R&D. The post patent regime would not allow the launch of ‘me-too’ or ‘copycat’ products in the market. Analysts say “deterring research focus and priorities is the key challenge.

Since discovery research is a long-term activity, it requires lot of patience and calls for different attitude as the failure rate is also very high.” Indian players are yet to consolidate this approach as it may take years to get good lead. Apart from this R&D, regulatory environment is also another key challenge going by increasing due diligence and compliance with standards which leads to cost overrunning and delay in new product launches. Beyond industry concerns, other problems like frequent power cuts and lack of proper transport are also act as another drawback to the growth of the industry.

Healthy Future Ahead
According to a report by PricewaterhouseCoopers (PwC), India will join the league of top 10 global pharmaceutical markets in terms of sales by 2020 with the total value reaching $50 bn. Industry observers are of the view that many premium drugs coming of patent and the increased confidence of international companies on India due to the product patent regime would mean a boom for the pharmaceutical industry. On the other hand, Indian players should focus more on R&D and better productivity to capitalize on the immense existing opportunities and the future will be extremely promising. Though the expenditure on R&D still remains sluggish, some leading players such as Ranbaxy and Dr Reddy Laboratories are leading the show for new formulations and molecules. Nevertheless, according to McKinsey, sustained progressive and collaborative efforts by the government and the pharma industry hold the key to achieving India’s full potential.

N Janardhan Rao,  Senior Economist.

Swiss Banking Sector: End of Confidentiality?

Amidst rising global pressure to crack down on non-cooperating tax zones, tax havens like Switzerland are starting to rethink their secrecy laws. Is the age of banking secrecy over?

Switzerland is known to the world as famous for chocolate, watches, and more importantly, confidential bank accounts. Banking secrecy is an integral part of the national banking system, where investors can hide their wealth. This is one of the key reasons behind Switzerland’s becoming the biggest offshore banking-services center in the world. However, its bank secrecy laws came under increasing scrutiny when the US government decided to take measures against tax havens all over the world. Over the years, after refusing to reveal information about their customers to foreign governments, top offshore tax havens like Switzerland, Luxembourg and Austria have bowed to international pressure and agreed to comply with the information-sharing standards established by the Organization for Economic Cooperation and Development (OECD). Often Swiss bank accounts are viewed as a tool to hide huge wealth by affluent Americans and Europeans, African dictators and Russian oligarchs.

During the recent boom period, trillions of dollars flowed into Switzerland and other tax havens in search of safety owing to the tax haven nature of their banks. At the end of 2008, around €1.47 tn in assets were deposited in Swiss banks, including about €450 bn of clandestine personal wealth that belonged to private customers. Banks in Switzerland, which employ about 3% of the total working population and contribute more than about 13% of GDP to the economy, have often come under criticism for their secrecy laws.

The Union Bank of Switzerland (UBS), the largest Swiss bank, was in the limelight recently due to a lawsuit involving US tax investigation. American tax authorities had accused many of its employees of helping American citizens to set up and conceal offshore accounts by falsifying, and destroying important information. It is being projected as a major blow and even as the beginning of the end of the fabled secrecy of the Swiss banking system.

Secrecy History
Banking secrecy in Switzerland can be traced back to early 17th century. It was extensively used as a tool to hide the wealth of many of the Europe’s rich dynasties and the Vatican, even though Switzerland had embraced Protestantism.

Nazis also used Swiss banks to hoard looted gold. Later in the 1930s, when France and Germany tried to reverse that ruling with the aim of checking capital flight, Switzerland reacted by making disclosure of banking information a crime. Strict penalties were imposed for violating bank confidentiality.

The Council of Geneva passed a regulation forbidding banks from sharing client information. The system was reasserted in 1984 when almost 75% of Swiss voters gave consent to preserve banking secrecy.

The combination of secret banking system coupled with stable governments provided Switzerland with a competitive advantage in private banking, allowing it to siphon off huge amounts of capital from overseas. At present, according to Reuters, almost one-third of the world’s total offshore assets of $7 tn, equal to $2.2 tn set aside abroad globally, is in Swiss banks, making the Alpine nation the world’s biggest offshore wealth reserve center. Swiss financiers have been facing criticism for destabilizing economies during the last 100 years. Approximately 19 Swiss banks, including Credit Suisse, were used by corrupt former Nigerian general Sani Abacha, who amassed £3 bn from his country between 1993 and 1998. An independent panel of experts found Swiss banks guilty of accepting deposits from the corrupt ruler, even though they were aware that the deposits involved theft. But the Swiss Bankers’ Association (SBA) defended the Swiss system, saying that its report divulged more banks’ identities than British regulators did in the Abacha case.

A legal affair?
There is a clear difference between ‘tax evasion’ and ‘tax fraud’ under the Swiss law. In Switzerland, tax fraud is a crime, whereas tax evasion is a civil offense. As per the principle of non-discrimination, foreigners are treated on a par with Swiss nationals. The Swiss government does not provide any judicial assistance to foreign tax authorities in case of tax evasion. Hence, if someone has evaded tax in his country he can safely park such funds in Swiss banks.

Moreover, recent capital inflows have largely come from regions such as Russia, Asia and the Middle East, where domestic taxation is nominal, denoting dodging is not those depositors’ primary motive. Above all, the Swiss banks believe they offer a credible option for overseas savers in uncertain times. The bankers claim that their traditional investment strategies and focus on longterm wealth generation have cushioned the blow to a great extent. Evidently, most of the banks have capital ratios that are the envy of rivals. Even the UBS had a capital ratio of 11.5% at the end of 2008, whereas several smaller banks boast rates of around 15%.

End of secrecy?
Reports indicate that Indian nationals have deposited a total of $1,456 bn in the vaults in Swiss banks, about 13 times larger than the nation’s foreign debt and if distributed 45 crore poor people can get Rs 1 lakh each. As a result, tax authorities across the world, including in India, are keenly monitoring the outcome of US investigation, in order to identify any of their own citizens who may be caught in the US net. However, there is little hope that Switzerland will lose its status as the world’s leading center for offshore wealth. Some observers believe that US-Swiss tax case is unlikely to reveal any secret accounts held by Indians. UBS too is trying its best to limit the number of accounts it will be forced to reveal. Swiss banks have, of late, agreed to tax offshore savings of EU citizens held in Switzerland and transfer the proceeds to the member states. Further, after sensing that the traditional offshore model will encounter rising resistance abroad, Swiss banks have begun investing extravagantly in ‘onshore’ branch networks in neighboring countries such as Germany, Italy, France and the UK.

Towards Transparency
Swiss banks are justifying it by assuring that such ‘onshore’ services will be fully transparent and subject to the laws of the host country, and their reputation will generate a valuable client base. UBS was the most active in this respect. It is involved in creating small branch networks in big cities in other European nations like Germany, Italy and the UK. Other Swiss banks such as Vontobel, Julius Baer and Sarasin too have invested heavily in Germany, Austria, Asia and the Middle East. All have invested by believing that the desire for service and performance offered by Swiss banks will stay. While the reports of the demise of Swiss private banking may be premature, one thing is very clear: after UBS’ travails and the banking system’s historic shift in policy, private banking in Switzerland is set for irreversible changes.

N Janardhan Rao,  Senior Economist.