MODULE 7 – Offshore Centers
Introduction
The history, evolution and functions of offshore financial centers (OFCs) will be discussed in this Module. In the process, we will discuss the significance of the cultural and demographic impact on establishing offshore centers in different geographic areas and regions. We will touch upon the regulation of offshore centers by domestic and international authorities. You will be introduced to the process of managing risks when operating OFCs. And finally, you will be introduced to several OFCs around the globe.
Objectives
Upon successful completion of this module, the student should be able to:
• Articulate the operation of OFCs.
• Examine the cultural and societal influences in the establishment of OFCs.
• List the components of the risk management process in establishing and operating OFCs.
• Examine the role of the regulators of OFCs.
• Summarize the operations of some OFCs.
In the world of private banking, it is imperative that we mention the operations of financial centers whose operational design is strictly for the purpose of secrecy and confidentiality. They provide services to entities that wish to eliminate any form of transparency from their financial and economic activities. OFCs are usually located in a foreign land, either surrounded by water or landlocked, and the main objective of these centers is to hide financial information from regulators, and the court system. This financial information could be lawful or unlawful. For further information, please see Footnote #1.
The role of OFCs is to be the custodian of funds legally or illegally deposited into their care. Therefore, the more regulatory agencies know about an OFC’s activity, the quicker any risky transactions can be detected, which can help international monetary cooperation to be free of any illegal financial influences. Also, obtaining information concerning OFCs’ financial dealings can assist regulatory agencies in cooperatively improving the scrutiny, inspection and examination of OFCs’ financial transactions. OFCs are also used by developing nations with debt obligations, capital flight and currency fluctuations in order to reduce or conceal financial inadequacies. The operation of OFCs can negatively impact the international capital market if the secrecy and confidentiality veil financial information from capital market operatives. For further information, please see Footnote #2.
The function of an OFC is to provide financial privacy, limited regulation, a tax haven, unrestricted access to accounts, and protection from any changes in the political system. Historically, the first financial center to be considered “offshore” was located in the Channel Islands, which were a distance from Great Britain’s shores. A large percentage of OFCs are located in relatively small nations surrounded by water, although the most important OFCs are in landlocked countries such as Switzerland. Even though many OFCs’ financial activities are legal and are to facilitate and safeguard the financial assets of individuals who wish to keep their financial information secret, OFCs’ overall reputation is synonymous with money laundering, tax evasion, organized crime and illegal economic transactions. OFCs are protected through the Bank Secrecy Act and therefore are not bound to disclose details of the economic gain of depositors to regulators of their home countries. The regulation of OFCs is dynamic and has a direct relationship to planetary events, whether economic or political, due to major incidents such as terrorism.
By banking in OFCs, depositors can have advantages such as political stability, hence less risk financially, and OFCs’ lower administrative costs often result in a higher rate of return to depositors. Many OFC locations are likely to provide hospitality and leisure for their clients, which can help the local economy through tourism. A large number of OFCs are located in the tropics. The laid-back environment of the tropics, natural beauty, hospitality of the natives, coupled with economic needs, offer the right environment for international financial clientele to enjoy the services of the OFC, plus the time for relaxation and entertainment. They can also provide tax advantages to individuals whose income cannot be verified with regard to its origin, and banking services and investment opportunities with lower risk.
Like every other economic entity, OFCs also have some disadvantages, such as having a reputation for conducting illegal economic and financial activities. They are also known to have a financial interest in providing private banking services for a wealthy clientele whose assets may have been amassed through illegal economic means. And lastly, since they are offshore, accessibility might be a concern for some depositors.
According to the IRS, OFCs may conduct schemes and activities that are illegal, according the laws of the U.S. They may range from unlawful financial transactions, investment activity, and insurance schemes, to illegal international cartels and cooperative financial dealings. For further information, please see Footnotes #3.
Despite a negative stigma, offshore banking concerns’ operational orientation is to provide legal financial services to international clientele who wish to have the secrecy and confidentiality that offshore banking provides for their portfolios. Some examples are financial centers such as the nations of the British Commonwealth like the British Virgin Islands, Cayman Islands, Channel Islands, Gibraltar, Guernsey, Isle of Man, and Jersey, and some non-British Commonwealth nations such as Antigua and Barbuda, Dominica, and Micronations.
International OFCs evolved historically since the wars between Spain, Germany and the Dutch ended and a peace treaty was signed in the Westphalian provinces. For further information, please see Footnote #4.
As mentioned before, international offshore banking evolved, and after the treaty of Westphalia, many nations were created. These nations became focal points for major investors to hide their money (a.k.a. “hot money”) in those countries, and the countries were compelled to protect the money, whether it was legally or illegally amassed. These investors transferred their funds into some of these countries that provided a better rate of return. As this process evolved, the countries that were receiving “hot money” became stronger financially, whereas the countries that were losing the funds saw the value of their currency decline. Capital formation is the foundation of any economic growth. This means, when a country goes through the stages of economic development, an income is generated that needs to be reinvested into further economic development activity rather than leaving the country through capital flight, which can also be considered “hot money.” The latter activity fundamentally deteriorates the process of capital formation, hence economic development of a country. There are checks and balances in place to decrease the impact of the economic volatility caused by reserve migration, such as time limits for investment activity. For further information, please see Footnote #5.
Like all other financial intermediaries, OFCs are regulated by the local authority where the centers are located, and since their operation reflects the interaction of the center with many other countries and financial intermediaries, they are governed by certain international rules and regulations. For further information, please see Footnote #6.
As previously mentioned, OFCs provide advantages for their international clientele, such as confidentiality, tax savings, transfer of assets to heirs, asset protection, accumulation of wealth, and safety of the assets. There are also disadvantages with the operation and having association with OFCs. It is a common understanding that these centers have connections with crooks, criminals and rogue nations for money laundering, tax evasion, and many other illegal financial activities. One must consider the risks involved with the type of association that they may have with these centers, since the centers are continuously being scrutinized by local and international regulatory authorities.
It is appropriate that the student get familiarity with OFCs located in many places of the globe, their history and evolution. The following are a few examples of major financial centers that are highly recommended for further research and discussion, especially the evolution of private banking in Switzerland that resulted from its geography, culture, agriculture, political system, and economic necessity.
Switzerland
Switzerland is notorious for secrecy and confidentiality. The history and evolution of offshore banking in Switzerland resulted from being mountainous and hidden away from the major urban centers of Europe. Culturally, the Swiss have maintained a certain level of political and economic neutrality throughout their history. Their offshore financial activities were not by choice, since arable land for agriculture was limited. They are famous for having conducted unethical offshore banking activity, such as allowing the Nazis to hide confiscated assets of the Jewish people for almost 50 years until it was exposed by Jewish activists and a lawsuit was brought by the U.S. courts for the release of Jewish assets.
The Swiss government and banking authority eventually agreed to cooperate with international regulatory authorities concerning their secrecy laws which resulted from having an association with narcotic elements, money launderers, and other international crooks and criminals. The catalyst for this cooperation was exposure of the association the Swiss banking authorities had with the Nazis. For further information, please see Footnotes #7 and #8.
Students are encouraged to research and study many other OFCs that are located in the western hemisphere, Europe and Asia, since the operation of each financial center is different, based upon the host country’s culture, demographics, political regime, tourism infrastructure, and local regulatory laws.
Luxembourg
Please see Footnote #9.
Bahamas
Please see Footnote #10.
Singapore
Please see Footnotes #11.
Hong Kong
Please see Footnote #12.
Conclusion
In this module, you have learned about the operations of OFCs, the role of the regulators, and how historical and cultural differences influenced the inception of OFCs in different regions. Furthermore, financial risks that OFC clientele may be subject to as a result of economic association were elaborated upon. And finally, you were introduced to a few important OFCs around the globe.
FOOTNOTES
(1) Offshore financial centre. (2012). Retrieved from http://en.wikipedia.org/wiki/Offshore_financial_center
(2) Offshore Financial Centers - IMF Background Paper. (2000). Retrieved from http://www.imf.org/external/np/mae/oshore/2000/eng/back.htm#I
(3) IRS - Abusive Offshore Tax Avoidance Schemes - Talking Points. (2012). Retrieved from
http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Abusive-Offshore-Tax-Avoidance-Schemes-Talking-Points
(4) Encyclopedia.com - Peace of Westphalia. (2012). Retrieved from
http://www.encyclopedia.com/doc/1E1-WestphalPc.html
(5) Business Dictionary.com - Hot Money. (2012). Retrieved from http://www.businessdictionary.com/definition/hot-money.html
(6) Supervisory Regulations, Guidelines, Implications, and Approaches. (2004). Retrieved from
http://www.fdic.gov/regulations/examinations/offshore/supervisory.html
(7) Switzerland: The Evolution Of Swiss Banking Secrecy And Current Trends In Enforcement. (2001). Retrieved from http://www.mondaq.com/article.asp?articleid=12118
(8) History Bites Back at Swiss Private Banking. Retrieved from
http://www.swissinfo.ch/eng/roots-of-wealth_history-bites-back-at-swiss-private-banking/35033852
(9) Luxembourg in a Nutshell. (2012). Retrieved from http://www.datamonitorfinancial.com/luxembourg-remains-the-largest-offshore-center-in-the-world/
(10) History and Success - Financial Services Evolution. Retrieved from
http://www.thebahamasinvestor.com/2009/history-and-success%E2%80%93financial-services-evolution/
(11) Offshore Investments in Singapore. (2012). Retrieved from http://www.offshore-banking-singapore.com/bank-in-singapore.html
(12) History and Advantages of Banking in Hong Kong. (2012). Retrieved from http://www.taxhavens.biz/other_tax_havens/tax_haven_hong_kong/
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