Offshore Banking at the
Close of the Twentieth
Century
Emmanuel N. Roussakis
Florida International University
INTRODUCTION
As the twenty-first century approaches, the global financial market continues to evolve. The globalization of banking in the 1980s and 1990s has contributed to the proliferation of offshore banking markets in different parts of the world. Functioning as conduits for the flow of foreign capital, offshore banking markets are now among the fastest-growing venues for international finance. This study first reviews the forces responsible for the development of offshore banking centers (OBCs) and identifies the financial standing of the most important amongst them. Then it gives special attention to Cyprus, one of the most recent centers to emerge in the global financial market. The particular case of Cyprus illustrates the conditions and practices that can make a financial center a successful, competitive OBC.
INTERNATIONAL BANKING IN THE POSTWAR ERA
the need to escape restrictive domestic regulation, and the gradual liberalization of financial markets in different countries. As a result of the momentum generated by these forces, international bank claims rose to US$441.7 billion in 1975. By 1997, those claims totaled US$10.4 trillion -an increase of over 2,000 percent1.
In the 1990s, additional forces sustained the international banking momentum. One such force was technological change. Advances in computers, satellite communications, and other forms of technology have made international transactions more practical and convenient. The new technologies have enabled banks to extend and maintain real-time control of their overseas operations by decreasing the costs of recording, transmitting, and processing financial information. Another important development was a drastic increase in the demand for international capital. The efforts by many countries to create modem, efficient economies contributed to a surge in intemational capital flows. By the end of 1996, cross-border capital flows exceeded US$2 trillion2. These efforts have also been a driving force in
replacing individual investors with institutional investors as major forces in the intemational financial market. The trend for increasing cross-border ca-pital flows is expected to continue into the 21 st century, when it will be fueled by the anticipated economic integration of Europe and the establish-ment of the monetary union, the prospect of the Free Trade Area of the Américas (FTAA} by year 2005, and the restructuring and eventual recovery of the South-East Asian economies.
Offshore banking centers have been among the major beneficiaries of the growth of international financial activity. These centers have emerged in the past three decades to help facilitate the flow of capital throughout the world for productive purposes.
DEVELOPMENT OF OBCs
Up through the 1960s, international banking transactions were conducted in the important centers of international finance, primarily London, New York, and Zurich. Support facilities, technical expertise, and communication networks were already present in these centers. After 1970, however, some areas not known for their existing banking facilities grew to become important centers for international banking, mainly because their
1 Bank for International Settlements, International Banking and Financial Market Development,
May 1998, p. 3.
2 International Monetary fund, Balance of Payments Statistics Yearbook (Washington DC:
govemments established an environment free from the taxation and regulation imposed upon domestic financial markets. These centers also possessed a combination of other important attributes, such as a stable and receptive govemment, a local supply of skilled labor, convenient time zone locations, the presence of sophisticated telecommunications networks, and strict banking secrecy laws. Recognizing the advantages these new areas offered, U.S. and European banks began establishing offices in these locations from the late 1960s on and through the 1970s.
The lead of Bahamas, Cayman Islands and Singapore in the offshore banking business in the 1960s was followed by Panama, Manila, Bahrain, and the Channel Islands in the 1970s. The success of Panama was noteworthy in this group. Panama’s development has been tied to the fortunes of Latin América. With a substantial shipping business intact and a thriving free trade zone, Panama took steps in 1970 to establish itself as an OBC. Its growth as an intemational banking center, however, came in the 1970s as a result of the massive recycling of petrodollars to Latin América. At the same time, it provided a shelter for capital that was fleeing from the region because of political and economic instability. At its height in 1982, Panama had bank assets that totaled US$49.3 billion. After that, the Latin American Debt cri-sis diminished its importance until the 1990s.
The addition of Panama, Manila, Bahrain, and the Channel Islands substantially increased the role of OBCs in intemational financial markets. Between 1970 and 1981, OBCs’ share of the Eurocurrency market3 increased from 8.7 percent to 28.5 percent4. This growth
contributed to the decentralization of the Eurocurrency market, which until 1970, had existed almost exclusively in London and a few Western European centers.
As the world economy continued to grow and international trade expanded, so did the size of the Eurocurrency market and the role of the OBCs. This momentum prompted more countries, especially small ones, to embark upon the creation of offshore banking markets during the 1980s and 1990s. These countries realized that by offering operating advantages that attracted foreign banks, their economies stood to benefit from an increase in local employment, bank expenditure, and licensing and other fees, all of which improved their standard of living. Some of the latecomers in the offshore banking business include Aruba, Malta, Cyprus, Manila,
3 Eurocurrency is any currency deposited in a bank outside the country where that currency is
the unit of account.
4 Bowman Brown and Emmanuel N. Roussakis, “Offshore Banking Centers,” in E.N. Roussakis
and three U.K. centers outside London -the Isle of Man, Jersey and Guernsey.
Late in 1981, in an attempt to attract Eurodollar business into the United States from offshore locations, the Federal Reserve introduced what developed into a second model of offshore banking market. It authorized U.S. banks, including U.S. branches and agencies of foreign banks, to establish international banking facilities (IBFs). Located mainly in the major U.S. financial centers mFs serve essentially as record-keeping entities. They may receive foreign deposits and make foreign loans without the restrictions that apply to the domestic market (for example, reserve requirements and insurance assessment on deposits). Only foreign residents –including banks, other IBFs, and parent banks– may become loan or deposit customers. U.S. residents may not conduct transactions with IBFs. Nonbank deposits must be nonnegotiable time deposits with a maturity of at least two business days and a minimum size of US$l 00,000. Negotiable instruments, such as certificates of deposits (CDs), are prohibited. Also, IBFs cannot offer trust accounts and they are subject to fede-ral income taxes.
Although IBFs attracted a significant portion of offshore business away from jurisdictions in the Caribbean, they did not threaten the existence of these centers because only the latter may conduct business with U.S. residents. On the other hand, many non-U.S. residents prefer to conduct business with IBFs because, from a risk perspective, they would rather hold their balances within the political and legal jurisdiction of the United States. The success of IBFs is evident in the fact that by year-end 1997, they accounted for a little more than one-third of U.S. banks’ extemar positions in all currencies5.
In 1986 Japan established its own version of the IBF, the Japanese Offshore Market (JOM). Participating banks must maintain a set of accounts that are handled apart from domestic accounts, and they must employ the Euroyen as their currency of denomination for interbank transactions. The primary depositors and borrowers in this market are the Japanese banks, themselves, and their foreign branches. The JOM has proven especially attractive to regional and small banks that previously had no direct access to international markets, and it has enjoyed rapid growth. By year-end 1997, over half of the international assets of Japanese banks were held in this market6. Both the U.S. and Japanese arrangements offer an alternative model
of an offshore market, by providing special institutional provisions within established financial centers, such as New York and Tokyo. This model has
5 Bank for International Settlements, International Banking and Financial Market
Develop-ments, Statistical Annex, May 1998, p. 2.
also been used in other financial centers, such as Bangkok (Thailand) and Taipei (Taiwan).
Centers where financial transactions are liberalized for both residents and non-residents constitute a third type of offshore market. In this type of model, domestic and foreign transactions are integrated and hence there is no distinction between onshore and offshore transactions between non- residents. Switzerland and centers like London and Hong Kong are examples.
Table 1 identifies offshore banking markets of all types by geographic área. As seen in this Table the competition for offshore banking is very intense, and the market is crowded throughout.
Table 1
Offshore banking centers
FACTORS THAT DETERMINE THE SUCCESS OF A TRADITIONAL OBC
Among the various types of offshore markets, traditional OBCs –those offering an environment free of taxation and regulation- are the most common. Successful OBCs in this group must satisfy some crucial conditions. Some of these
Europe
Campione d Italia
Channel Islands Cyprus Ireland Isle of Man Liechtenstein
Luxembourg Malta Madeira Netherlands Switzerland United Kingdom
The Americas
Anguilla Antigua
Aruba Bahamas Barbados Bermuda
British Virgin Islands Cayman Islands Netherlands Antilles Panama
St. Kitts and Nevis Turks and Caicos Islands United States: IBFs
Asia
Bahrain Cook Islands
Hong Kong Japan: JOM Mauritius Nauru
conditions can be met through legislation and other deliberate governmental policies. Others depend on factors beyond a nation’s control, such as geographic location, time zone, international political developments, and policies of neighboring countries. Table 2 identifies the necessary conditions for establishing and operating a successful OBC.
Table 2
Important conditions for the development of traditional offshore banking centers
An offshore banking presence may take the form of a branch office or a subsidiary of the parent bank. In the two primary Caribbean banking centers (Bahamas and Cayman Islands) banks may operate through “shell branches.” These permit “booking” offshore transactions that take place on the U.S. mainland. This alternative has been available to U.S. banks since the early 1970s, when the Federal Reserve, to promote competition among U.S. banks in international markets, exempted all offshore booked transactions from domestic regulatory constraints. Whatever the form of banking presence, the primary goal of offshore banks is to seek deposits and grant loans in foreign currencies other than the currency of the host goverment (e.g., placement of short term funds and syndicated credits). Some offshore banks specialize in attracting deposits to fund the credit needs of their home country.
The ability of banks to attract deposits is a key factor in their success. Depositors choose to conduct their business in particular OBCs for a variety of factors, including personal, cultural, and emotional reasons, as well as more purely financial considerations, such as the costs of banking services, the regulatory environment, and tax laws. The availability of banking personnel who speak their language is another important concern for many depositors. Others seek to achieve safety for their investments by spreading their funds among several centers throughout the world. As a result of their diversified
Crucial Significant Desirable
• Political stability
• Confidentiality of records
• Flexible banking laws and
regulations
• No currency conversion
limitations
• Low, or no, domestic taxes
• Possession of adequate
telecommunications
infrastructure
• Availability of qualified
personnel
• Advantageous geographical
location
• Low cost of operation
• Favorable government
policies
• Mentality of the general
population toward the
offshore business
• Reasonable fees and levies
clientele, some banks have established offices in more than one center in order to appeal to a broader spectrum of depositors.
GROWTH RECORD
Table 3 shows the volume of foreign currency assets held by banks in select major offshore banking centers. As seen in this Table, Hong Kong accounted for the most assets held by any single OBC, US$566.2 billion. A British colony until July 1, 1997, Hong Kong has since been returned to China and now holds the status of a Special Administrative Region. Liberal banking regulation and a prime location contributed to the influx of substantial numbers of local and foreign banks, international investment banking houses, and portfolio mana-gers, all of which have turned Hong Kong into a highly active international financial center. It is the general belief that China will adhere to its commitment in a 1984 agreement with Britain that provides for Hong Kong to keep its present status for another 50 years. The sustained financial prominence of Hong Kong is of great importance to China.
The Cayman Islands also played an important role in offshore banking, ranking second on the basis of assets (US$511.2 billion). The Caymans are attractive to outside banks because they possess a number of the attributes identified in Table 2, including a location in the same time zone as the United States, easy accessibility to the U.S. mainland, allowance of shell operations, and absence of taxation. American banks are an important force in the Caymans and the Caribbean offshore markets in general.
Next in size of foreign assets (US$478.5 billion) was Singapore, with a thriving offshore financial services industry. On the other hand, the JOM slowed significantly since 1990, reflecting the effects of the worldwide recession and the slow recovery of the Japanese economy. By contrast, Cyprus, although much smaller than other centers exhibited unprecedented growth. As seen in Table 3, its annual growth rate between 1990 and 1997 was a record 51.9 percent.
CYPRUS: A CASE STUDY
T
able 3
Offshor
e assets of banks in select markets
(In billions of dollars, end of year)
Annual growth Market 1990 1991 1992 1993 1994 1995 1996 1997
rate in per
cent United States IBFs $51,60 $56,40 $45,90 $43,30 $35,60 $52,50 $41,50 $46,20 0,73 Japan Offshore Market 280,00 230,00 202,00 178,00 184,90 208,50 178,70 222,60 -2,14 Luxemburgo 291,10 307,30 325,40 311,60 382,60 415,20 420,80 406,90 5,23 Switzerlan 290,50 291,40 291,60 272,50 309,00 337,60 394,50 436,30 6,28 Bahamas 185,00 191,10 168,70 167,00 194,20 185,40 190,50 236,00 4,13 Bahrain 55,90 50,10 66,20 56,40 61,00 60,00 63,40 68,30 3,84 Cayman Islands 411,90 413,20 404,80 394,00 437,50 457,70 460,50 511,20 3,27 Cyprus 1,80 1,70 1,60 1,70 2,40 2,60 3,50 13,70 51,89 Hong Kong 457,30 494,70 496,50 503,60 593,80 636,40 579,40 566,20 3,40 Singapore 347,20 322,90 318,90 341,70 362,90 420,0 444,30 478,50 4,90 Other 1 4,20 5,60 8,40 7,90 8,70 8,70 14,80 20,10 27,63 T otal $2.376,50 $2.364,50 $2.330,00 $2.277,70 $2572,60 $2.784,60 $2.791,90 $3.006,00 3,56
1Includes the Netherlands Antilles and the of
fshore branches of U.S. banks in Panama.
Sour
ce:
Bank for International Settlements
, International Banking and Financial Market Developments,
stastical annex, various issues, 1990-1997; Central Bank of Cyprus
, Consolidated Assets and
Liabilities of Cyprus OBUs, various issues,
1990-1997
Historical Factors
A 1974 Turkish invasion partitioned Cyprus into separate Greek and Turkish communities, and since then the Greek-dominated Republic of Cyprus has emerged as a significant center for offshore activities. Consequently, when the Cold War ended in 1990 and the Soviet Union dissolved into autonomous republics in 1991, Cyprus was positioned to take advantage of the outflow of funds that had hitherto been contained behind the Iron Curtain. Indeed, in the 1990s most of Cyprus’ offshore banking business has come from Russia and other Eastern European countries. A significant amount of banking business has also come from Lebanon, which collapsed as a major Middle Eastem center of finance in the 1980s, due to that country’s civil war. Of Cyprus’ 37 foreign banks, 7 are Russian, and 8 are Lebanese. (See Table 4 for a complete breakdown of offshore banks by country.) Today, Cyprus serves a springboard for Russian businesses with the rest of the world, and many Russian expatriates have been insuring themselves against the uncertain political situation in their native land by managing their money and their businesses from Cyprus7.
Table 4
Offshore banks in operation by country of origin, 1997
Note: Two additional banks, from Russia and Jordan, are licensed but not yet operating as of year-end 1997. Country of Origin Number of Banks
Lebanon Russia France Yugoeslavia Bulgaria Switzerland United Kingdom Jordan Romania Belgium Greece Cayman Islands United States Luxembourg Total
8 7 3 3 3 3 2 2 1 1 1 1 1 1 37
7 Mark M. Nelson, “Russian Firms, Fed Up With Chaos and Crime, Are Flocking to
Source: Central Bank of Cyprus, List of Offshore Banking Units, Administered Banking Units, and Representative Offices, November 25, 1997.
Geographical Factors
A large island in the Mediterranean Sea, Cyprus enjoys close proximity to Eastem Europe, the Middle East, and Africa. Its time zone straddles the closing of the financial centers in the East and the opening of financial centers in the West. This location, seven hours ahead of New York and seven hours behind Tokyo, gives Cyprus a desirable trading window for portfolio transactions by banking units.
Socio-Economic Factors
Since its independence from Great Britain in 1960, Cyprus has undergone a major change from an agricultural state into a thriving economy of international stature. The development of Cyprus into a maritime, financial and commercial center has contributed to a booming economy that enjoys one of the highest GNP per capita in the Mediterranean (over US$13,500)8.
Moreover, the work force on Cyprus is well educated and largely fluent in English and other European languages. Cyprus has a modern infrastructure, with one of the most highly developed telecommunications facilities in the world, and it is rapidly becoming a major international transit station for commercial transportation. Its European-level standard of living, low-crime rate, low-pollution environment, availability of high-level professional services, and glut of skilled labor have also contributed to Cyprus’ success as a developing OBC. It offers an orderly and familiar legal system that is based on the same principles as those in the United Kingdom. Its government is widely perceived as being generally free of official corruption, and despite its partition, Cyprus is politically stable, one of the primary requirements for the success of any OBC.
International Agreements
An active member of the international community, Cyprus belongs to the Council of Europe, the Commonwealth, and other organizations. Its currency, the Cyprus pound, is now pegged to the European Currency Unit (ECU), a practice that encourages stability by minimizing currency fluctuations. Furthermore, taxation agreements with 26 other countries have reduced investors’ tax liabilities and enabled offshore banks and other companies to
8 Central Bank of Cyprus, Cyprus: A Center for lntemational Business, 6th ed. (Nicosia:
avoid double taxation of earned income, an advantage not widely shared by most other OBCs.
A 1973 association agreement has abolished most barriers to trade with the European Union (EU) and is in process of establishing a customs union which is expected to be completed by 20039. In 1990, Cyprus filed a formal
application for full membership in the EU, and accession negotiations began in spring 1998. These negotiations are expected to be successful, and Cyprus may join the EU before the turn of the century. Reforms within Cyprus have already been implemented to bring its institutional framework into line with EU requirements. For instance, the Central Bank has begun to relax regulation of the financial sector and ease restrictions on foreign ownership in order to conform to the EU requirements10.
Regulatory Practices
Like other countries where offshore banking has flourished, Cyprus offers a comparatively relaxed regulatory environment and does not impose stiff requirements for establishing an offshore bank. Such banks must maintain their accounting systems in English, base them on the U.S. dollar, and keep their books and records within the country. All statutes regulating business matters and procedures are essentially based on English law. Cyprus thus offers a convenient and reliable safe haven for funds from less stable regions in the world.
Cyprus’ OBC expansion began in 1981, when the Republic of Cyprus issued its guidelines for establishing offshore banking units (OBUs). Under those guidelines, OBUs wishing to establish operations in Cyprus are expected to have a good international reputation and an established track record of growth and profitability. They must submit audited accounts for the three years prior to their application, as well as details of all foreign branches and subsidiaries already established in other countries. These requirements are slightly more stringent than those for most OBCs, which do not typically require audited
9 Andreas Neokleous & Co., “EU/Cyprus Fast Track Accession Negotiations”, International
Financial Law Review, Vol. 17, No. 2, February 1998, pp. 58-59.
10 Some analysts believe that Cyprus’ membership in the European Union could weaken its
position as a major offshore banking center, because the EU forbids tax discrimination between offshore and onshore activity. In particular, preferential tax treatment for expatriate workers, laws pertaining to property ownership, indirect taxation, social insurance contributions, and some employment restrictions will need to be modified if Cyprus is to achieve full compliance with EU guidelines. But while these changes may slow Cyprus’ growth as an OBC, it is unlikely they will undermine it. “The Center May
Not Hold,” Financial Times, March 26, 1997, p. 12.
11 The Committee on Banking Regulation and Supervisory Practices was created by the
accounts from branches established in other countries. Cyprus closely adheres to the recommendations of the Basle Committee11, and it employs effective
supervisory standards and procedures. The Central Bank requires the written consent of the applicant banks’ home licensing and/or bank supervisory authorities, with the understanding that they will exercise consolidated supervision over the global activities of the applicant bank, including those operations to be performed from within Cyprus. Branch banks are not assigned a capital requirement, but locally incorporated OBUs are expected to have a minimum paid up capital of approximately US$5 million12.
OBUs in Cyprus are not required to adhere to most regulations that apply to onshore banks, such as minimum reserve requirements, ceilings on maximum interest rates, restrictions on foreign assets, or investments in shares and immovable property. But the Central Bank retains a supervisory function in order to ensure that OBUs abide by the conditions attached to their banking licenses and to assess the quality of their assets and ascertain whether the OBUs are following prudent banking policies. OBUs must operate as fully fledged, fully staffed units, and not as paper centers, booking centers, or brass plate entities. They many not conduct business with residents of Cyprus, and transactions must use currencies other than the Cyprus pound13.
Banks that meet the Central Bank’s requirements may also establish themselves as Administered Banking Units (ABUs) or as Representative Offices (ROs). ABUs must conduct business in their own name but may allow another bank already licensed in Cyprus to carry out day-to-day functions. ROs may conduct liaison activities between a head office, or other branches abroad, and non-resident customers. All OBUs, ABUs, and ROs must submit an annual report and pay modest annual fees: US$5,OOO for ROs, US$10,OOO for ABUs, and US$15,OOO for OBUs14.
Expatriate employees of offshore enterprises also enjoy a variety of benefits. They are not subject to all of the exchange control restrictions on capital transfers that apply to residents, and they may hold assets and liabilities in any foreign currency. Offshore businesses that are entirely owned and run by non-residents are exempt from exchange controls, provided that none of their income is earned in Cyprus. There are no requirements for OBUs to employ local staff at the higher echelons, though working permits are issued for
lower-supervision among its members. This committee is also known as the Basle Committee because it meets
in Basle, Switzerland, at the Bank for Intemational Settlements. See E.N. Roussakis, Commercial
Bank-ing in an Era of Deregulation, 3rd ed. (Westport, CT: Praeger Publishers, 1997), p. 120.
12 Central Bank of Cyprus, A Guide to Prospective Applicant Banks on the Establishment of
Offshore Banking Units/ Administered Banking Units/ Representative Offices, Cyprus, August 1996, p. A1. 1.
13Ibid, p A1.2.
level employees only when a qualified Cypriot citizen is unavailable.
Tax Benefits
Its tax laws are one of the island’s greatest attractions as an OBC. Offshore companies and offshore branches managed and controlled from Cyprus are taxed at only 4.25%; offshore branches managed and controlled from abroad are exempt from corporate or income tax; the beneficial owners of offshore companies, branches, and partnerships are not liable for additional taxes beyond the amount owed by their respective legal entities; expatriates are taxed at half the rates applicable to locals; no capital gains tax is imposed on the sale or transfer of shares in an offshore company; and no estate tax is imposed on inherited shares15.
Moreover, the large number of tax treaties (26) Cyprus has concluded with other countries enable offshore businesses to avoid double taxation of earned income. These treaties, combined with the low tax rate assessed to offshore enterprises, offer significant possibilities for international tax planning through the island. Transactions effected by offshore banks are outside the scope of Value Added Tax. Therefore, offshore banks do not need to register for VAT purposes. The Customs and Excise Law allows offshore companies and their expatriate employees to acquire office equipment and other items duty free. Likewise, operations in the Industrial Free Zone escape customs and excise taxes16.
CONCLUSION
Increased demand for international capital and the growth of cross-border ca-pital flows have contributed to the proliferation of offshore banking centers. Many small countries, like Cayman Islands, Cyprus, and Singapore, have benefited from the operation of offshore banking in their territories. Even established international financial centers, such as New York and Tokyo, find offshore banking beneficial in strengthening their international competitive positions. The same argument may be advanced for Switzerland and centers like London and Hong Kong whose markets are free of regulation and where offshore transactions are not segregated from domestic.
There is every reason to believe that the practice of offshore banking will grow throughout the world and play an increasingly significant role in the global financial market of the twenty-first century. As a result, we can expect
15 Cyprus: A Center for International Business, op. cit., pp. 10-11.
