What’s wrong with the financial services industry here?

From the inception of the International Financial Services Centre in the late 1980s, public policy sought to develop the financial sector in Ireland: firms were encouraged to locate here to provide financial services to the rest of Europe. This policy was pursued with vigour and significant success, but little thought seems to have been given to any possible risks.

In July 2008, as the financial crisis was about to break, the Department of Finance listed as one of its strategic priorities the development of financial services. Within months of this statement of strategy, the risks involved in uncontrolled expansion of financial services were all too apparent. The financial sector is essential to the operation of a modern economy. That is why it had to be rescued by the Government in September 2008 at such massive expense.

The operation of the payments system is the glue that holds the economy together and the banking system plays a crucial role in transferring money from savers to investors. Without insurance, life would be exceptionally risky for normal citizens and companies, and provision for old age would be very difficult.

However, as discussed in series of Central Bank papers, our financial sector is big relative to the size of the economy, accounting for about 10 per cent of value added (see graph, above). In a more normal economy it might account for about 4 per cent of value added.

The fact that the sector is so large reflects the success of policy in attracting financial services activity to the State. Even with the financial collapse, the sector represents an important part of the economy. However, the real benefit from the value added is not as straightforward, especially for the “auxiliary” financial service sector (which excludes banks and insurance companies) where wages only account for 20 per cent of value added.

The substantial part of the financial sector that supports domestic activity is clearly of crucial importance, so important that it could not be allowed to collapse. However, this sector also came with huge risks. While theoretically the risk was carried by the shareholder, in practice the State ended up carrying a large part of the cost of bailing out the banks. Similarly in insurance, the collapse of Quinn has imposed major costs on everyone here.

International market

Thus the benefits of the domestic financial sector in terms of value added and the services it provides comes at significant risk to the State. It is the responsibility of the European Central Bank and the Central Bank to ensure that, in the future, the sector is managed so that the State is not again endangered. In the case of that part of the financial sector that services an international market, the value added to the economy is rather different from that of the domestic banks. Also the risks for the State are rather different.

In the case of foreign banks providing services abroad from Dublin, where they are responsible to foreign regulators, the financial risk lies with other governments. This was the case when Depfa bank got into difficulties in Dublin. However, even if there is not a financial risk for the State, there is a substantial reputational risk from failure or misbehaviour.

As well as banks and insurance companies, there is a range of other financial services provided from Dublin which include investment funds, financial vehicle corporations (FVC) and special purpose vehicles (SPV).

The fund management industry, employing 9,000 people with a wage bill of more than €1 billion, is a very valuable asset to the economy. However, the recent Central Bank article says that most of the last two exotics – FVCs and SPVs – have no employees and few links to the Irish economy. These “vehicles” operate from Dublin for a range of reasons, among them the favourable tax regime.

In the case of some of these auxiliary financial services operations, they have greatly irritated our neighbours. Last year a German Bundestag committee expressed some ill-informed angst about the operation of some of these businesses.

Even though these concerns were not really justified, this foreign anxiety puts substantial additional pressure on the State in terms of our corporation tax regime, even though the vast bulk of companies here benefit from it in a manner that is not very contentious.

Reputational risk

If these auxiliary financial services activities brought significant benefit to the economy, it could well be worth the attendant reputational risk. However, as shown in the recent Central Bank article, in some cases they bring very little benefit in terms of employment or tax revenue.

In the case of what are termed “redomiciled plcs”, which receive their investment income here but don’t have any value added here, they impose a net cost to the State, through additional EU budgetary contributions, of more than €50 million.

For the future, policy on attracting financial sector entities needs to be more discriminating. We may have difficulty stopping firms locating here that do little for the economy, but we should not facilitate them.

Changes in tax treatment that discouraged some of these operations might even be desirable.

If the UK were to leave the European Union, we could see some of the City of London taking to the lifeboats to move to Dublin. While significant additional real activity moving from the UK would be welcome, some of what goes on in the City would not be good for the State.

See the Central Bank reports at http://iti.ms/1ihzdwj and http://iti.ms/1KS4S4p