Offshore Financial Centres: Effects on the Global Economy

Introduction and Background

"Only the little people pay taxes." — Leona Helmsley, 1989

Critics of offshore financial centres would likely suggest that the epigraph above indicates that Ms. Helmsley would have made a good "poster child" for the offshore financial services industry, while proponents would likely counter that the global economy absolutely needs such offshore financial services in order to grow. Despite the controversy and a modest reduction in the total number of offshore financial centres following the passage of the U.S.A. PATRIOT Act, there has been overall continued growth in the offshore financial services sector since 1936 that has resulted in hundreds of offshore financial centres (OFCs) being concentrated in several geographic regions of the world. These OFCs are typically located in small, low-tax jurisdictions that specialize in the provision of corporate and commercial services to non-resident customers (Suss & Williams 2002). The growth in offshore financial centres has been due in large part to several of the same reasons around the world. These centres feature specific tax advantages, enhanced privacy, lower banking costs, and more relaxed regulatory systems than their onshore counterparts (Masciandaro 2004). According to an analysis conducted by KPMG (2010), one of the largest professional services firms in the world and one of the Big Four auditors, although OFCs continue to focus on the same types of financial services, they must remain sufficiently flexible and agile to respond to rapidly changing conditions in the global economy.

Based on the evidence to date, offshore financial centres appear to be increasing in popularity for many of the same reasons (Offshore Financial Centres 2008). For example, offshore financial centres provide a viable alternative for banks competing in regions of the world where emerging market economies are highly regulated. A good indication of this can be seen in the amount of cross-border assets being exchanged through offshore financial centres (Offshore Financial Centres 2008). Besides the U.K. and the low countries of Belgium-Luxembourg (but including the Netherlands), total transnational exchanges with emerging countries increased from 58.5% in 1991 to a record of 67% in 1997 and, as of year-end June 1999, receded to about 56% (Offshore Financial Centres 2008). This significant reduction in emerging economy exchanges may be attributable to a wave of consolidations that occurred in the Japanese banking system during the late twentieth century, together with the Asian monetary crisis that occurred shortly thereafter, resulting in a sharp decline in offshore financial services activity in Hong Kong (Offshore Financial Centres 2000). Since that time, the industry has experienced consistent growth in terms of the number of such centres as well as the amount of money that passes through them, to the point where more than half of the global monetary supply is handled at some point by offshore financial centres.

Statement of the Problem

One of the recurring themes that quickly emerges from a review of the literature concerning offshore financial centres is their dual-edged quality. On the one hand, offshore financial centres have been demonstrated time and again to be an essential component of successful multinational corporate business, facilitating financing and insurance requirements, mitigating risk, and providing the foreign exchange services required between banks and commercial customers (Rose 2006). On the other hand, the same attributes that make offshore financial centres attractive for legitimate businesses are also highly attractive to organized criminal and terrorist organizations. Indeed, in popular context, offshore financial centres have become virtually synonymous with money laundering and tax evasion, and for good reason. These criminal groups have exploited offshore financial centres with the assistance of collusion from some unscrupulous banking officials, making detection difficult or impossible, and regulating this industry has been challenging to say the least.

In response to the illegal activities that have characterized the offshore financial services sector, a wide range of initiatives sponsored by the international community have been implemented in recent years, including an OECD initiative designed to address the effects of harmful tax competition, the G7's Financial Action Task Force (FATF), the Financial Stability Forum (FSF), the United Nations Office on Drugs and Crime (UNODC), the EU, and international non-governmental organizations (NGOs) (Rose 2006). These and other regulatory and law enforcement agencies around the world are actively involved in searching for better ways to monitor and regulate the offshore financial services sector in order to identify criminal activity and reduce the prevalence of these practices in the future (Dwyer 2009). By and large, the overwhelming majority of offshore financial centres have been compliant with these initiatives and have implemented the OECD program targeting harmful tax practices (Dwyer 2009). Notwithstanding the increased costs of compliance (not to mention the lost illicit revenues previously attained), these trends in increased oversight are expected to continue in response to corresponding growth in the offshore financial services sector (Dwyer 2009). Although it might be possible to improve domestic tax receipts through the elimination of offshore financial centres, the impact on the global corporate community would more than offset any gains realized through such a drastic measure (Dwyer 2009).

Purpose and Research Question

The overarching purpose of this study was to deliver a comprehensive and critical review of the relevant literature concerning offshore financial centres and their effect on the global economy. In support of this purpose, the study was guided by the following research question: "Is the demand for financial services going to increase or decrease the importance of offshore financial centres in the global financial market?"

Importance of Study

A 2008 updated report from the IMF emphasized that, "In recent years, there has been increased recognition of the need to improve understanding of the activities of offshore financial centers. Some offshore financial centres have captured a significant part of global financial flows, and their linkages with other financial centers creates the potential for their activities to affect financial stability in many countries" (Offshore Financial Centres: IMF Staff Assessments 2008, p. 1). By definition, offshore financial centres are popular with the international banking community specifically because there are fewer restrictions involved, more lenient regulatory policies, and lower taxes than their mainstream banking counterparts; however, offshore financial centres do not have the same fundamental interests in protecting their depositors as their onshore counterparts because most of their depositors are non-residents located in other countries (Edwards 1999).

Because the home country is not required to reimburse foreign depositors for losses, there is no corresponding financial penalty for lax supervision; there is, however, a benefit to the country with lenient regulatory policies because of increased revenues generated and the employment opportunities these services provide (Edwards 1999). Furthermore, banks seeking to conduct multinational business are attracted to countries where incorporation laws and the regulatory framework offer less regulatory oversight (Edwards 1999). The quid pro quo nature of offshore financial services is clearly indicated by Edwards's observation that, "Multinational banks provide the offshore financial centre with increased tax revenue and employment for its citizens. Because the benefits outweigh the costs, offshore financial centres have a powerful incentive to maintain lenient regulatory policies. As a result, multinational banks incorporated in an offshore financial center successfully avoid supervision by an effective home country regulator" (1999, p. 1267).

Rationale of Study

The research shows that, notwithstanding their exploitation by criminal elements and terrorist organizations, offshore financial centres are not expected to disappear anytime soon. The importance of the legitimate financial transactions that take place in offshore financial centres makes them an important addition to the international community, and restrictions on the industry — or its outright elimination, if that were even possible — would have dire consequences for the global economy. According to McKee, Garner, and McKee, "Through the activities they house, [offshore financial centres] are actually facilitators of various international activities. Indeed it appears as though the leading participants in the global economy, whether corporate or public, are in need of various services provided by or through offshore financial centers" (2000, p. 3). In this environment where each positive is balanced by a corresponding negative, identifying opportunities to eliminate the abuse of offshore financial centres by criminals and terrorists while improving their ability to provide vital legitimate financial services to the international community represents a timely and valuable enterprise.

Definitions and Geographic Distribution of Offshore Financial Centres

Although there is no universal definition of offshore financial centre, a number of such definitions have been offered over the years. According to Mauer, "There is a significant literature on the dimensions and definitions of the offshore finance industry. The first definitional quandary is whether offshore refers to a place or series of places on the one hand, or a phenomenon of financial flows on the other hand" (2008, p. 155). The legal definition provided by Black's Law Dictionary (1999) indicates that offshore transactions are financial dealings that occur outside of a given country. A more useful definition is provided by the International Monetary Fund (IMF), which reports that, "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" (Offshore Financial Centers 2000, p. 2).

An offshore financial centre is an area officially designated by the IMF as being a place where the following types of activity take place: offshore banking, investment, incorporation, company formation, foundation formation, trust formation, insurance, and other vehicles of wealth preservation and asset protection. The criteria required to be placed on the IMF's official list are as follows:

1. Having relatively large numbers of financial institutions engaged primarily in business with non-residents; and,
2. Having financial systems with external assets and liabilities out of proportion to domestic financial intermediation designed to finance domestic economies (Mauer 2008).

Offshore financial centres must provide some or all of the following services: (1) low or zero taxation; (2) moderate or light financial regulation; and (3) banking anonymity (Definition of Offshore Financial Centers 2011).

The IMF also reports that offshore financial institutions can accept deposits from individuals and invest those proceeds in other financial markets (Offshore Financial Centers 2000). Some regions of the world appear to attract more of this type of business than others. According to Stessens (2000), numerous Caribbean jurisdictions are frequently identified as both secret and tax havens; however, this type of identification can also be applied to financial services centres located in Andorra, Malta, the Channel Islands, Liechtenstein, Monaco, Madeira, Gibraltar, Switzerland, and Luxembourg — countries and territories that are also described as offshore financial centres and categorized as "fiscal havens" by the U.S. Internal Revenue Service (Stessens 2000). In the context of financial transactions, Stessens adds, "the term 'offshore' refers to transactions which take place between non-residents. An offshore bank can be defined as a financial institution which is legally domiciled in one jurisdiction, but conducts business solely with non-residents" (2000, p. 93).

Other formal definitions have been offered by Jao, who reports that "by general agreement, an 'offshore financial centre' or, more narrowly, an 'offshore banking center' is a center where the host country accords preferential treatment to banks and other financial institutions in terms of taxation, regulatory restrictions, prudential supervision, and so on, provided that such banks and financial institutions deal only with nonresidents and in foreign currencies and are thus effectively insulated from the host country's domestic financial sector" (2001, p. 45). According to Stessens, "By this definition 'offshore transactions' can take place in any jurisdiction, but as a result of their fiscal and secrecy rules, some jurisdictions attract a very high number of offshore transactions and offshore banks and have thereby become known as offshore financial centres" (2000, p. 93).

There is sufficient evidence available to indicate that money launderers frequently use offshore financial centres to conceal the proceeds of criminal activities or to avoid taxation on legitimate earnings. As Stessens observes, "In both instances they are likely to benefit from the secrecy rules and from the inertia of local law enforcement or fiscal authorities or their refusal to reply to requests for information" (2000, p. 93). Efforts to address these illegal activities have been hampered by the increasing internationalization of the money laundering enterprise, and a broad-based and sustained effort is required by the international community in order to be effective. According to Stessens, "Strictly national interventions are likely to result only in a geographical shift of the phenomenon. Because of the increasing globalisation of the financial world, the proceeds of crime which have been deposited within one jurisdiction where the rules on the prevention of money laundering are less strict can penetrate into the financial system of other countries as well" (2000, p. 93).

This point is also made by Schiffrin and Bisat, who report that "Offshore financial centres have become synonymous with banking secrecy and tax evasion. In today's open and global financial world, characterized by a high mobility of funds and the rapid development of new payment technologies, the tools for laundering the proceeds of serious crimes as well as the means for anonymous protection of illegal assets in certain countries or territories make them even more attractive for money laundering" (2004, p. 231).

Current debates concerning the true nature of offshore financial centres tend to focus on the following questions: (1) whether offshore is a consequence of the system of state sovereignty or a consequence or cause of global financial liberalization; (2) whether offshore is an effect of the law or an effect of markets and inherent structural tendencies in capitalism; (3) whether offshore is part of a long-term story about conflicts among elites in offshore jurisdictions linked to local development efforts, or is delinked from national aspirations in those jurisdictions; or (4) whether offshore is an index of a new postmodern political geography (Mauer 2008, p. 158).

In reality, any jurisdiction can serve as a tax haven for commercial enterprises and individuals located in more highly regulated venues, provided that it features lower tax rates or more favorable secrecy laws. A number of jurisdictions have specifically designated tax havens that offer different rules for non-residents, as well as a high degree of bank deposit and/or corporate ownership secrecy (Rawlings 2005). Proponents of offshore financial centres would most likely emphasize the positive aspects of such jurisdictions — the opportunities for tax, estate, and corporate planning they offer — rather than tax evasion or money laundering activities, which these jurisdictions also attract.

In spite of their use by criminal elements, offshore financial centres are an important element in the conduct of multinational corporate business today, providing trade financing, insurance, pension administration, and more sophisticated financial instruments such as derivatives and hedge fund investment guidance (Mauer 2008). From a fundamental perspective, offshore financial centres offer valuable risk mitigation services as well as real-time guidance concerning the movement of resources and provide for the efficient processing of foreign exchange between corporations and banks (Mauer 2008). Moreover, offshore financial centres provide the opportunity for individuals and corporations to manage income streams from different jurisdictions without being forced to deal with double-taxation issues (Mauer 2008). As a result, offshore financial centres represent an important form of asset protection for those entities that require such services, and the mitigation of risk through the techniques used by offshore financial centres is widely recognized as sound business practice (Rawlings 2005). Nevertheless, the potential always exists for offshore financial centres to engage in illegal practices intended to camouflage the true source of profits and cloud the distinction between revenues generated through legitimate trade and monies received as payment of some other type (Mauer 2008).

McKee et al. identify three types of geographical locations among offshore financial centre jurisdictions: (a) inland enclave states, (b) coastal enclave states, and (c) island states (McKee et al. 2000). These enclave states have tended to congregate in a global pattern of what McKee et al. term "satellite clusters" that are compatible with four main business time zones corresponding to major global and regional capital markets:

1. The Western Hemisphere was served through the New York epicenter by the Caribbean and the Central American Basin.
2. European enclaves, coastal enclaves, and independent islands were included in the London epicenter.
3. The Asian-Pacific region and Oceania were served within the Tokyo time zone by Hong Kong, Singapore, Vanuatu, and Nauru.
4. The final cluster was composed of Persian Gulf jurisdictions providing service to Middle Eastern oil countries (McKee et al. 2000, p. 5).