Offshore Banking

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Offshore Banking

DESCRIPTION AND TERMINOLOGY

SPONTANEOUS OFFSHORE BANKING SITES

INTERNATIONAL BANKING FACILITIES

TAX HAVENS

TYPES AND USES OF OFFSHORE FINANCIAL MARKETS

EFFECTS ON THE WORLD ECONOMY

BIBLIOGRAPHY

The term offshore banking has no precise definition and thus means different things to different people. In part, confusion arises because the term is applied to two separate yet related phenomena. The generally accepted view is that offshore financial markets consist primarily of the various segments of the euromarkets, a “wholesale” or interbank market that is used primarily by commercial banks. The most important characteristics of offshore banking markets are their relative freedom from direct regulation and their specialization in wholesale banking transactions. Collectively these markets tend to function as a distribution mechanism for shifting funds from lenders to borrowers or deficit spending units on a global scale. Therefore, the economic rationale for offshore banks is that they perform this distribution function efficiently.

DESCRIPTION AND TERMINOLOGY

The offshore financial market is fully integrated, internally coherent, and global in reach yet is not literally offshore. It is situated in and between different types of financial centers, all of which are in major onshore cities such as London and Tokyo or in tax havens, some of which are called offshore financial centers (OFCs). That has led to some confusion. Intergovernmental bodies such as the International Monetary Fund (IMF) and the Bank for International Settlements (BIS) apply the term offshore banking in a more restrictive sense to describe financial activities that take place in an offshore banking sector of an OFC, or a tax haven in colloquial usage, such as the Bahamas and the Cayman Islands. However, only some countries employ the term offshore sector to describe a portion of their financial sectors. Two of the best known tax havens, Switzerland and Luxembourg, for instance, do not use that term. Intergovernmental bodies thus apply the term only to those countries. Academic scholars use the term more broadly to refer to all financial activities that take place in the unregulated offshore financial market.

The offshore financial market is not entirely unregulated: It is subject to so-called self-regulation based on market principles by the banks and other financial actors that use that market. The best known among a series of self-regulating agreements was the capital adequacy agreement, or the Basle Concordant of 1988, which was followed by Basle II, whose final accord was issued in 2004. In addition, for the sake of convenience, clearing goes through New York, giving the U.S. government some control over the market.

Transactions usually are thought to be offshore from the perspective of the host country even though the banks that conduct those operations are onshore. Among the reasons for this are the following:

Some attempt usually is made to separate offshore from onshore banking activities and the rest of the domestic financial system by means of exchange control, regulation, tax incentives, separate accounting procedures, and the like.
The institutions in the market tend to be classified as nonresident for balance of payments purposes.
Transactions in these markets have a significant nonresident component. In some cases transactions are restricted specifically to nonresidents, but in other cases resident access to the market is permitted to varying degrees.
Transactions in the offshore market are restricted primarily to foreign currencies.

SPONTANEOUS OFFSHORE BANKING SITES

There are three routes by which offshore centers are set up: the so-called spontaneous offshore sites, such as London and Hong Kong; international banking facilities (IBFs) such as New York and Tokyo; and tax havens, which include over seventy states. The offshore center in the city of London originally was called spontaneous because it allegedly was created accidentally as a result of attempts by the British government to reestablish London as the center of global financial activities after World War II.

The exact origins of the offshore financial market are in dispute, but it appears to have emerged in a set of fortuitous events. In late 1956, during the Suez Canal crisis and the ensuing run on the British pound, the British government attempted to defend the currency from devaluation by imposing restraints on sterling credits on countries that engaged in third-party transactions in the sterling area and by raising the bank rate from 5 percent to 7 percent. As a result, a number of second-tier merchant banks, such as the Bank of Latin America, that specialized in third-party international loans were faced with complete cessation of their business. In response, they began actively to solicit dollar deposits to use in trade credits to replace sterling credits. They have argued that the British government’s rulings explicitly prohibited the use of sterling credits in third-party loans but said nothing about other currencies, specifically American dollars. The British government allowed and perhaps encouraged the merchant banks to turn to American dollars; otherwise they would have gone out of business.

The little-known understanding between the Bank of England and the merchant banks produced a subtle but important reinterpretation of the purview of British sovereignty: It placed dollar transactions, along with all other third-party currency transactions, outside exchange rate regulation, reserve regulation, and any other regulation by the British state. However, because those transactions took place within the territorial boundaries of the United Kingdom, they were sheltered from the regulation of other states; they therefore were, de facto, under no state regulation, or “offshore.”

The new understanding was applicable only to third-party transactions, that is, cases in which British banks served as intermediaries between two non-British nationals using dollars or other foreign currencies. To ensure the legality of those transactions, British banks, who soon were joined by branches of American and other foreign banks in London, kept two sets of books: one for onshore financial transactions in which at least one party to the transaction was British and the other for offshore transactions when both parties were non-British.

INTERNATIONAL BANKING FACILITIES

An IBF is a more restricted type of offshore center in which, in contrast to spontaneous offshore centers, companies must apply for a license to trade. The first IBF was the Asian Currency Units (ACUs) set up in Singapore in 1968. The better known IBFs are situated in the United States.

The first New York IBF came about as the result of prolonged and complex battles between the U.S. Treasury, the Swiss government, and a number of Caribbean tax havens. The United States government had tried hard to reregulate the euromarkets in 1979. Failing that and with the active encouragement of the New York banking community, particularly Citibank and Chase, the U.S. Treasury concluded that rather than fight the onset of offshore centers, the United States stood to gain more by encouraging the formation of its own offshore centers. A swift about-face took place, culminating in the establishment on December 3, 1981, of a New York offshore market: the New York International Banking Facilities. A decade later more than 540 IBFs had been established across the United States to take advantage of those cost and tax benefits. New York had the largest number (over 250); California had 100 IBFs, and Florida had 80. However, as a result of their restrictiveness compared with other offshore centers, interest in IBFs waned. The New York IBF spawned the creation of the Tokyo IBF. In 1982 the Hosomi plan was put forward in imitation of the New York IBF to spur domestic liberalization in Japan.

TAX HAVENS

The third category of offshore financial centers is tax havens, of which there were seventy in the first decade of the twenty-first century. Tax havens are centers that offer an array of tax and regulatory incentives for nonresident investors and complete flexibility in the management of foreign assets. There are as many varieties of tax haven laws as there are jurisdictions, but it is common practice to distinguish among four classes of tax havens: countries where there is no income tax and where foreign corporations pay only license fees; jurisdictions with low taxation, such as Liechtenstein and Jersey; countries where taxes are levied only on internal taxable events but not at all or at very low rates on profits from foreign sources; and jurisdictions that offer special tax privileges to certain types of companies and operations. Crucially, most tax havens maintain strict bank secrecy laws and prevent banks located in their territory from revealing the identity of account holders even to the tax haven government. Many tax havens have created provisions for trusts and other financial entities whose ultimate owners are difficult to identify. For these reasons tax havens are used not only for tax evasion and avoidance, but also for money laundering purposes and other criminal financial activities.

Tax havens are employed by the banking community for a number of interrelated reasons: avoiding current tax, preserving wealth, securing secrecy, avoiding regulation, and gaining easy access to the euromarkets. Banks tend to register high-volume, lucrative wholesale financial transactions through offshore subsidiaries as the financial equivalent of transfer pricing to reduce their tax bill. More important, tax havens are employed to help wealthy clients reduce current tax or preserve wealth or to secure secrecy. In addition, banks are able to avoid domestic regulation by diverting certain activities to their offshore subsidiaries. U.S. banks, for instance, employed offshore subsidiaries in the 1970s and 1980s to access other lucrative financial sectors, such as insurance and mortgages thus avoiding U.S. financial regulations.

Tax havens provide a cheap and easy way for resident companies or individuals to masquerade as nonresidents for euromarkets purposes; hence, a strong symbiotic relationship has evolved between tax havens and the euromarkets. In addition, tax havens permit companies to syndicate their profits worldwide in jurisdictions with zero or nearly zero regulation. Tax havens thus are used to accumulate dividends, interest, and other income. They also are used by multinational enterprises as central points for handling paperwork and preparing and processing trade documents. Many companies depend on tax havens for passage of title to goods to minimize red tape.

For all these reasons, tax havens have been an enormous success. On average 50 to 65 percent of all international banks’ net external liabilities were routed through tax havens between 1980 and 2004; approximately 27 percent of all foreign investments by multinational corporations are routed through tax havens. Havens such as the British Virgin Islands (6.7 percent) and the Cayman Islands (2 percent) are among the most important “foreign” direct investors in China; they were second and seventh, respectively, in 2004.

TYPES AND USES OF OFFSHORE FINANCIAL MARKETS

Regardless of the historical and juridical origins of the different financial centers, they tend to be closely linked, with a division of labor among them. The literature distinguishes four types of offshore financial centers: Primary centers such as London and New York serve worldwide clients and act as international financial intermediaries for their market regions; booking centers such as Nassau and the Cayman Islands are used by international banks primarily as the location for “shell branches” to book both eurocurrency deposits and international loans; funding centers such as Singapore and Panama play the role of inward financial intermediaries, channeling offshore funds from outside their markets toward local or regional uses; and collection centers such as Bahrain engage primarily in outward financial intermediation. This hierarchy indicates the degree of specialization and interdependence among offshore centers.

The offshore financial market in the first decade of the twenty-first century included several markets: eurocurrency deposits, eurocurrency bank loans, euro notes, eurobonds, euro equities, and foreign exchange markets. The eurocurrency market grew very fast. According to the BIS, the gross size of the eurocurrency market increased from $US 12.4 billion in 1963 to $US 149.9 billion in 1972, $US 1,517.4 billion in 1982, $US 6,197.7 billion in 1992, and $US 24,026 billion in 2006. According to a BIS survey, average daily turnover in traditional foreign exchange markets is approximately $1,880 billion. Approximately 80 percent of all international financial transactions take place in this offshore financial market (BIS, Locational Banking statistics, 2006).

EFFECTS ON THE WORLD ECONOMY

The offshore financial market is therefore a secondary space for financial operations that has accelerated the transnationalization of the world economy. The development of offshore banking operations should be considered in the broader context of the general process of internationalization of economic activities involving trade. Because offshore financial markets have widened the access of companies to loan markets, it has been argued, they have brought down borrowing costs relative to the underlying level of interest rates. As a result of reduced costs, competition from offshore financial markets has forced the liberalization of onshore markets. As a result, only the imposition by some central banks of non-interest-bearing reserve requirements on domestic bank deposits remains as a major domestic regulation that favors eurocurrency transactions. Because costs have fallen, companies can borrow in whatever market is most advantageous to them and swap the proceeds for the currency they need.

The apparent lack of regulation and control raises concerns about whether these markets have a capacity to create credit or money beyond the domestic banking systems and the extent to which they have diffused domestic monetary controls. To what extent have they contributed to currency instability? Although offshore finance is distinguished by a relative lack of state regulation and monitoring, there are degrees of regulation and monitoring. Besides the variations among financial centers that were noted above, several agreements reached by various standing committees that meet at the BIS under the aegis of the Governors of the Group of Ten have proved to be successful. The Basle Committee on Banking Supervision is the best known of those committees, and the Euro-currency Standing Committee is the oldest, having been set up in the early 1960s to monitor and assess the implications of the newly established eurocurrency markets.

The most important long-term impact of offshore finance may have occurred elsewhere. The term offshore evokes images of the high seas, of a world beyond borders. However, offshore financial transactions are very much onshore, conceived, organized, and handled in the traditional financial centers of London, New York, and Tokyo. Offshore banking therefore is not outside the state system but is a juridical realm marking the differential degrees of intensity by which states apply regulation and taxation. Offshore banking therefore denotes the bifurcation of the juridical space of sovereignty into mutually dependent relative spaces.

SEE ALSO Banking; Banking Industry; Capital Controls; Capital Flight; Corruption; Drug Traffic; Finance; Financial Markets; Globalization, Social and Economic Aspects of; Money Laundering; Tax Evasion and Tax Avoidance; Taxes