Offshore Financial Centres(OFCs) & AML/CFT

An Offshore Financial Centre (OFC) is defined as a "country or jurisdiction that provides financial services to nonresidents on a scale that is incommensurate with the size and the financing of its domestic economy

A more practical definition of an OFC is a center where the bulk of financial sector activity is offshore on both sides of the balance sheet, (that is the counterparties of the majority of financial institutions liabilities and assets are non-residents), where the transactions are initiated elsewhere, and where the majority of the institutions involved are controlled by non-residents. Thus OFCs are usually referred to as:

·         Jurisdictions that have relatively large numbers of financial institutions engaged primarily in business with non-residents;

·         Financial systems with external assets and liabilities out of proportion to domestic financial intermediation designed to finance domestic economies; and

·         More popularly, centers which provide some or all of the following services: low or zero taxation; moderate or light financial regulation; banking secrecy and anonymity.

However, the distinction is by no means clear cut. OFCs range from centers such as Hong Kong and Singapore, with well-developed financial markets and infrastructure, and where a considerable amount of value is added to transactions undertaken for non-residents, to centers with smaller populations, such as some of the Caribbean centers, where value added is limited to the provision of professional infrastructure. In some very small centers, where the financial institutions have little or no physical presence, the value added may be limited to the booking of the transaction. But in all centers specific transactions may be more or less of an "offshore" type. That is in all jurisdictions it is possible to find transactions where only the "booking" has taken place in the OFC, while at the same time business involving much more value added may also take place.

Researchers who study OFCs use a range of measurements to determine whether a country or jurisdiction is an OFC. Such measures include:

 

·         Ratios that compare the size of domestic economies to their net exports of financial services;

·         Ratios that compare the size of domestic economies to the amount of bank- and shadow bank-assets existing therein; and

·        The number of “custodian entities,” or firms that manage the wealth of non-resident clients, located in a country or jurisdiction.

 

In a 2018 working paper, the IMF lists the following countries as top OFCs (also called “pass through economies”): the Netherlands, Luxembourg, Hong Kong, the British Virgin Islands, Bermuda, the Cayman Islands, Ireland, and Singapore. Each of these jurisdictions house an astronomical amount of shadow banking assets. The value of assets managed by shadow banks in the Cayman Islands in 2016, for example, was 2,118 times greater than its GDP. In other words, the Cayman Islands provide a home to more than US$10 trillion in shadow bank assets. In the same year, Luxembourg’s shadow bank assets (US$15 trillion) were 247 times greater than its GDP, and Ireland’s shadow banks held assets worth US$4 trillion, or 1,333 percent greater than its GDP.

Although there can be no hard and fast dividing line and the definition of an OFC depends on the use to which it is to be put, the following taxonomy can be proposed:

·         International Financial Centers (IFCs)—such as London, New York, and Tokyo—are large international full-service centers with advanced settlement and payments systems, supporting large domestic economies, with deep and liquid markets where both the sources and uses of funds are diverse, and where legal and regulatory frameworks are adequate to safeguard the integrity of principal-agent relationships and supervisory functions. IFCs generally borrow short-term from non-residents and lend long-term to non-residents. In terms of assets, London is the largest and most established such center, followed by New York, the difference being that the proportion of international to domestic business is much greater in the former.

·         Regional Financial Centers (RFCs) differ from the first category, in that they have developed financial markets and infrastructure and intermediate funds in and out of their region, but have relatively small domestic economies. Regional centers include Hong Kong, Singapore (where most offshore business is handled through separate Asian Currency Units), and Luxembourg.

·         OFCs can be defined as a third category that are mainly much smaller, and provide more limited specialist services. As noted above, OFCs as defined here, still range from centers which provide specialist and skilled activities, attractive to major financial institutions, and more lightly regulated centers that provide services that are almost entirely tax driven, and have very limited resources to support financial intermediation. While many of the financial institutions registered in such OFCs have little or no physical presence, that is by no means the case for all institutions.

OFCs as defined in this third category, but to some extent in the first two categories as well, usually exempt (wholly or partially) financial institutions from a range of regulations imposed on domestic institutions. For instance, deposits may not be subject to reserve requirements, bank transactions may be tax-exempt or treated under a favorable fiscal regime, and may be free of interest and exchange controls. Offshore banks may be subject to a lesser form of regulatory scrutiny, and information disclosure requirements may not be rigorously applied.

Small countries, with small domestic financial sectors, may choose to develop offshore business and become an OFC for a number of reasons. These include income generating activities and employment in the host economy, and government revenue through licensing fees, etc. Indeed the more successful OFCs, such as the Cayman Islands and the Channel Islands, have come to rely on offshore business as a major source of both government revenues and economic activity.

OFCs can be used for legitimate reasons, taking advantage of: (1) lower explicit taxation and consequentially increased after tax profit; (2) simpler prudential regulatory frameworks that reduce implicit taxation; (3) minimum formalities for incorporation; (4) the existence of adequate legal frameworks that safeguard the integrity of principal-agent relations; (5) the proximity to major economies, or to countries attracting capital inflows; (6) the reputation of specific OFCs, and the specialist services provided; (7) freedom from exchange controls; and (8) a means for safeguarding assets from the impact of litigation etc.

They can also be used for dubious purposes, such as tax evasion and money-laundering, by taking advantage of a higher potential for less transparent operating environments, including a higher level of anonymity, to escape the notice of the law enforcement agencies in the "home" country of the beneficial owner of the funds.

In practice, determining which countries are in fact OFCs is nontrivial and as such a highly debated topic.

• Sink-OFC: a jurisdiction in which a disproportional amount of value disappears from the economic system.
• Conduit-OFC: a jurisdiction through which a disproportional amount of value moves toward sink-OFCs.

The Offshore Finance Activity

Financial centres that specialise in cross-border financial activity have become an entrenched feature of the international financial system. Until the 1970s, international financial intermediation was concentrated in a few major cities that also served as centres of domestic intermediation, notably London and New York (Kindleberger (1974)). Since then, financial centres in smaller economies have emerged as important intermediaries of cross-border financial flows. In 2020, large economies that make up the G20 accounted for a far bigger share of the global economy than of cross-border financial activity, about 80% versus 60%. The reverse was true for smaller economies home to financial centres that cater predominantly to nonresidents, which we call cross-border financial centres (XFCs). XFCs are a channel for international investment, as opposed to an ultimate source or final destination for investment, and consequently have a larger global financial footprint than economic one. Thus when analysing international financial developments it can be useful to distinguish XFCs from other countries. We propose a method for identifying XFCs that is quantitative, transparent and replicable.

 

Business characteristics

 Financial centres can also be classified according to their business characteristics, such as the type or range of services that they provide. Some financial centres specialise in selected services, like banking, insurance, fund management or corporate support services. Others offer a full range of services.

Source: BIS Working Papers No 1035 Cross-border financial centres by Pamela Pogliani and Philip Wooldridge Monetary and Economic Department July 2022

Business characteristics are often used to rank the competitiveness of financial centres. Z/Yen and China Development Institute (2022) publish a Global Financial Centres Index, which ranks financial centres at the city level based on information in five areas: business environment, financial sector development, infrastructure, human capital, and reputation. Over 100 cities are ranked, capturing the gamut of financial centres from provincial to global. Some classifications focus narrowly on the regulatory and tax environment. OFCs in particular are often characterised as jurisdictions with low or zero taxation, moderate or light financial regulation, banking secrecy and anonymity (IMF (2000)). As a result, they are sometimes perceived as engaged in dubious activities and equated with tax havens (Hines (2010)). However, regulatory and tax practices in OFCs are not homogeneous, and some actively adopt and implement internationally agreed economic and financial standards (FSF (2000), IMF (2008)). For the purpose of identifying financial centres, an important shortcoming of focussing narrowly on regulatory and tax characteristics is that these are neither necessary nor sufficient to attract nonresident business (Pogliani, von Peter and Wooldridge (2022)). A stable, transparent legal system is a prerequisite. For example, as part of Dubai’s efforts to promote itself as a financial centre, the government established a special administrative area – the Dubai International Financial Centre – with its own courts as well as commercial and civil laws based on English common law

Banking activity in OFCs is now predominantly carried out by branches and affiliates of banks incorporated elsewhere, mainly in major countries, but also in larger emerging market economies. Since the failure of BCCI and Meridian Bank it has become difficult for a bank incorporated in a jurisdiction with limited domestic markets to carry on business in other countries. Supervisors now require banks wishing to open branches and affiliates to demonstrate a capacity for their home supervisor to exert consolidated supervision, which it is almost impossible to do for a bank whose business is almost entirely outside the home country's jurisdiction.

The physical presence of establishments of foreign banks in OFCs varies. In some centers they may originate and, in some cases, fund the business carried on their books. But in other cases, they may have a very limited physical presence and the business decisions may all be taken elsewhere.¹¹ Such establishments are sometimes known as "shell" branches. There has been a tendency in the more successful OFCs for the amount of local value added to grow, as these OFCs have acquired the ability to supply specialist capabilities and skills. Offshore activities may also take place through so-called parallel-owned banks, that is, banks that are not subsidiaries of a bank in the onshore center, but have the same owners or controllers. Effective consolidated supervision is more difficult in such cases.

Gujarat International Finance Tech-city (GIFT) SEZ

 

India’s first International Financial Services Centre (IFSC) under Special Economic Zone Act, 2005 (“SEZ Act 2005”) is being developed as a global financial services hub. GIFT IFSC is a Multi Services Special Economic Zone with 105 hectors of land and commenced its business in April 2015.

Government of India operationalized International Financial Services Centre (IFSC) at GIFT Multi Services SEZ in April 2015. The Union Budget 2016 provided competitive tax regime for the IFSC at GIFT SEZ. It is the vision of the Hon’ble Prime Minister that GIFT IFSC emerges as a hub for international financial services activities.

Ministry of Finance, Government of India provided new initiative for undertaking international financial services business in India. The Indian Regulators namely Securities and Exchange Board of India (SEBI), Reserve Bank of India (RBI) and Insurance Regulatory and Development Authority (IRDAI) has also issued guidelines for Capital Markets Intermediaries, Banks and Insurance companies/Insurance Brokers respectively. Thus, allowing financial institutions to set up IFSC Units under various areas of business at GIFT City.

The new Regulatory approvals at GIFT IFSC is poised to attract foreign investments and particularly financial institutions and intermediaries to its precinct. Therefore, in a short span of 3 years of its operations, it is already host to more than 125 financial entities licensed by financial services regulators namely RBI, SEBI and IRDAI.

GIFT IFSC provides very competitive cost of operations with very competitive tax regime, single window clearance, relax company law provisions, international arbitration centre with overall facilitation of doing business. GIFT IFSC is now moving toward unified regulatory mechanism.

With a vision of becoming a leading global financial & technology hub, the evolution of GIFT City is an opportunity to drive reforms towards providing a thriving financial ecosystem critical to support and expand businesses. GIFT City is inclined to provide the conducive business eco-system at par or above with leading global financials hubs.

History

The maintenance of historic and distortionary regulations on the financial sectors of industrial countries during the 1960s and 1970s was a major contributing factor to the growth of offshore banking and the proliferation of OFCs. Specifically, the emergence of the offshore interbank market during the 1960s and 1970s, mainly in Europe—hence the eurodollar, can be traced to the imposition of reserve requirements, interest rate ceilings, restrictions on the range of financial products that supervised institutions could offer, capital controls, and high effective taxation in many OECD countries.

In Asia, offshore interbank markets began to develop after 1968 when Singapore launched the Asian Dollar Market (ADM) and introduced the Asian Currency Units (ACUs). The ADM was an alternative to the London eurodollar market, and the ACU regime enabled mainly foreign banks to engage in international transactions under a favorable tax and regulatory environment.⁸

In Europe, Luxembourg began attracting investors from Germany, France and Belgium in the early 1970s due to low income tax rates, the lack of withholding taxes for nonresidents on interest and dividend income, and banking secrecy rules. The Channel Islands and the Isle of Man provided similar opportunities. In the Middle East, Bahrain began to serve as a collection center for the region's oil surpluses during the mid 1970s, after passing banking laws and providing tax incentives to facilitate the incorporation of offshore banks. In the Western Hemisphere, the Bahamas and later the Cayman Islands provided similar facilities. Following this initial success, a number of other small countries tried to attract this business. Many had little success, because they were unable to offer any advantage over the more established centers. This did, however, lead some late arrivals to appeal to the less legitimate side of the business.

By the end of the 1990s, the attractions of offshore banking seemed to be changing for the financial institutions of industrial countries as reserve requirements, interest rate controls and capital controls diminished in importance, while tax advantages remain powerful. Also, some major industrial countries began to make similar incentives available on their home territory. For example, the U.S. established in 1981, in major U.S. cities, the so-called International Banking Facilities (IBFs).  Later, Japan allowed the creation of the Japanese Offshore Market (JOM) with similar characteristics. At the same time, supervisory authorities, and to some extent tax authorities, were adopting the principle of consolidation which reduced the incentives for banks to carry on business outside their principal jurisdiction.¹⁰ As a result, the relative advantage of OFCs for conventional banking has become less attractive to industrial countries, although the tax advantages for asset management appear to have grown in importance. In fact, reported bank intermediation on the balance sheet in IFCs has declined over the period 1992-1999, thus contributing to the overall decline in the share of bank cross-border assets intermediatedthrough OFCs from 56 percent of total bank cross-border assets in 1992 to about 50 percent of total bank cross-border assets at end-June 1999 

In XFCs, international financial business was once synonymous with interbank positions, but that is no longer the case. Until the mid-1990s, the bulk of cross-border financial activity in XFCs comprised business either among affiliates of the same banking group or between unrelated banks. Since then many XFCs have diversified into other activities, and today non-bank business accounts for the largest share of their cross-border activity. For example, for a large sample of XFCs, non-bank borrowers’ share of external liabilities to banks rose from an average of 10% over the 1977-94 period to about 40% in 2005 and 64% in 2021 (see Graph 1, left-hand panel). In 2021 non-bank financial institutions like asset managers and insurance companies accounted for the largest share of these XFCs’ liabilities to banks abroad, at 40% (right-hand panel). Banks accounted for 33%, and non-financial entities (mainly corporates) 22%.

Source: BIS Working Papers No 1035 Cross-border financial centres by Pamela Pogliani and Philip Wooldridge Monetary and Economic Department July 2022

More generally, structural changes in the global financial system have increased the reliance on non-bank financial intermediation to finance growing levels of debt (FSB (2020)). They have also increased the importance of interconnectedness within the non-bank sector as well as between non-banks and banks. The 2007–09 financial crisis and 2020 Covid-19 crisis heightened policymakers’ attention to the risks posed by the growing importance of non-bank financial intermediation. These changes suggest that, for the purpose of analysing international financial developments and risks to global financial stability, the most relevant measure of international financial business is the broadest possible one, which captures all cross-border links among banks, among non-banks, and between banks and non-banks. Total external assets and liabilities from the IIP capture all such links in the form of portfolio investment, direct investment, other financial investment (consisting mainly of bank loans and deposits) and derivatives. While our baseline methodology is based in this broad measure, we complement it with a narrower measure focussed on interbank activity, as discussed above.

The many ongoing initiatives, aimed at curbing OFC involvement in lax financial regulation, tax evasion, and financial crime. While cross-border and offshore banking have been at the core of the Basel Committee's work since the mid-1970s, OFCs have more recently become a major target of the FATF and OECD because some of them are increasingly viewed as offering opportunities for money-laundering and tax evasion, as well as raising obstacles to anti-corruption investigations.

Financial centres that cater predominantly to non-residents account for an outsize share of cross-border financial activity. These so-called cross-border financial centres are typically located in small economies, in contrast to global financial centres located in large economies. Economies of scale and scope benefit global centres, but physical distance works against the tendency of financial activity to concentrate. So do regulation and taxation, which have set cross-border financial centres apart and propelled their rise. At the same time, these centres pose challenges to regulatory consistency across countries and complicate the analysis of capital flows

Offshore Finance and Offshore Financial Centers

Offshore finance 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. Some of these activities are captured in the statistics published by the Bank for International Settlements (BIS). Probably rather more significant are funds managed by financial institutions at the risk of the customer. Such off-balance sheet, or fiduciary, activity is not generally reported in available statistics. Furthermore, significant funds are believed to be held in OFCs by mutual funds and trusts, so-called International Business Companies (IBCs), or other intermediaries not associated with financial institutions.

The Basel Committee on Banking Supervision has been actively promoting more effective cooperation between "home" and "host" supervisors for many years.  Cross-border banking issues were at the core of the "Basel Concordat" of 1975; the Concordat was revised in 1983 to take account of the growing need for consolidated supervision of international banking groups. That work was given further impetus by the collapse of the Bank of Credit and Commerce International (BCCI) in 1991, which led to the publication in 1992 by the Basel Committee of the Minimum Standards

Minimum Standards for the Supervision of International Banking Groups
and their Cross-Border Establishments

·         All international banks should be supervised by a home country authority that capably performs consolidated supervision;

·         The creation of cross-border banking establishments should receive the prior consent of both the host country and home country authority;

·         Home country authorities should possess the right to gather information from their cross-border banking establishments;

·         If the host country determines that any of these three standards is not being met, it could impose restrictive measures or prohibit the establishment of banking offices.

The prudential and supervisory frameworks set forth in the Minimum Standards, the 1996 Report and the Core Principles are broadly adequate for risk management purposes if effectively and universally implemented. They have effectively eradicated the possibility of a bank based in a small jurisdiction, not capable of exercising consolidated supervision, becoming a significant player in international markets. Although BCCI was a substantial bank and its failure could have had significant systemic effects, in fact it did not do so. However, a high degree of coordination is required between "home" and "host" supervisory authorities. Moreover, remaining supervisory gaps coupled with heterogeneous accounting standards may be an impediment to effective consolidated supervision of offshore banking activities in practice

Many Caribbean islands, including Anguilla, Antigua and Barbuda, Dominica, Grenada, Montserrat, Saint Kitts and Nevis, Saint Lucia, Saint Vincent and the Grenadines, the British Virgin Islands, the Caymans Islands, the Bahamas, Barbados, and Aruba, can be categorised as RFCs. In the early 2000s, the sector was thriving, and positively contributing to the foreign exchange inflows to these countries.

 In the aftermath of the 2008-2009 global financial crises, several regulatory jurisdictions have made attempts to strengthen their financial sector regulation, supervision, and risk management. The objective was to increase the resilience of financial institutions, and prevent another financial sector collapse in the future. Moreover, the regulators sought to restrict potential money laundering and the financing of terrorism, via the implementation of more strict anti-money laundering (AML), countering the financing of terrorism (CFT) and know-your-customer (KYC) regulations. Post the 2008-2009 financial crisis, several Caribbean countries, including the Bahamas, the Cayman Islands, Saint Kitts and Nevis and Saint Vincent and the Grenadines have been subjected to increased financial regulations by the international financial authorities. This has limited the growth of the offshore financial sector.

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