Origin of Offshore Banking
The origin of offshore banking units can be traced to the growth of financial activity in tax havens. A “tax haven” is a place where non-residents can receive income or own assets without paying high taxes. Some such places are Bahamas, Bermuda, Hong Kong, the Netherlands, Panama and Switzerland.
Some features of these tax havens are:
- Low rate or complete absence of income tax on foreign investment and income.
- High degree of economical and political stability and a political system, which directly or indirectly encourages and fosters business activity at the center.
- Strict and well enforced rules of banking secrecy.
- Absence of exchange control
- Availability of supporting infrastructure such as an efficient communications and transportation network.
- Presence of well developed legal system and professional accounting expertise.
- Investor’s confidence due to past credential.
- No incidence of violence or criminal activities.
These features encourage various types of business operations some of which are bonafide but most of them generate what has been termed as ‘dirty offshore funds’.
Operations of Offshore Banks
Offshore banking centres are an integral part of the foreign currency markets. Therefore, the operations of banking units set up at these centers comprise foreign currency transactions, in the form of accepting and placing of funds in foreign currency outside the country of issue. The functional offshore centers engage in the issue and placement of foreign currency certificates of deposits, loan/credits and bonds.
These centers contribute to the economic development of the host country in the following ways.
- The offshore banking units can raise foreign currency loans and bonds for the host country at reasonable interest rates, due to their connections with well known international banks. These foreign currency funds can be lent to the host countries or invested in onshore projects or even projects in a third country. Indirectly, the host country gains better access to international capital markets.
- The functional offshore centers contributes to the foreign exchange income of the host country through local operating expenditures, such as rent paid on leased property, salary paid to local staff, and license fees/taxes recovered from the offshore units.
- The presence of functional units speeds up the communication and transport network in the host country, which helps to upgrade local skills and technology and constitutes productive assets to the host country.
- The onshore banking industry in the host country is compelled to improve its efficiency and skills in order to retain its competitive edge.
- The local staff employed at the center develops sophisticated international banking skills and this pool of highly trained personnel can be brought in to the host country to attain a faster growth level.
Once an offshore center consistently offers an attractive package of incentives, the above benefits will accrue to the host county, which will be able to induce more and more reputed foreign banks to set up banking units in its territory.
Role of Offshore Banks and Investments
In today’s highly integrated global network international Offshore Financial Centers (OFCs) have come to play a vital role in facilitating investment worldwide. An offshore center exists for comfort and convenience. OFCs are jurisdictions where offshore banks are exempted from a wide range of regulations, which are normally imposed on onshore institutions. Specially, deposits are not subject to statutory reserve requirements. Bank transactions are mostly exempted from tax or treated under a favorable fiscal regime and they are free of interest and exchange control restrictions. In many cases, offshore banks are exempted from regulatory scrutiny with effect to liquidity or capital adequacy.
An important activity in OFCs is offshore banking, which is the cross border intermediation of funds and provisions of services by banks residing in OFCs to non-residents. Offshore banking is an increasingly attractive alternative to heavily regulated financial markets of emerging economies. They exploit the risk – return trade – off by being more profitable than onshore banks and in many instances they have more leverage.
Offshore Banking – Method of Operation
Offshore banks deal mostly with other financial institutions and transact wholesale business in currencies other than that of the country hosting the OFC. Offshore banking is carried out typically through offshore establishments that are offshore branches. Offshore branches are legally indistinguishable from parent banks onshore, which facilitate intra-branch transfers. Offshore activities may also take place through what are called parallel-owned banks. These are banks established in different jurisdictions having the same owner(s), but at the same time they are not subsidiaries.
Offshore banks are mainly engaged in three types of transactions; Foreign currency loans and deposits, the underwriting of bonds, and Over the Counter (OTC) trading in derivatives for risk management and speculative purposes. Foreign currency transactions form the bulk of offshore banking operations. They include transactions between banks and original depositors, between banks and ultimate borrowers, and between banks themselves on the inter bank market. Underwriting of bonds floated in international capital markets is also a significant part of offshore banking activities.
Offshore Financial Centers in Developed Countries and Emerging Economies
In the developed countries, OFCs appear to be losing their attractiveness and appeal for financial institutions, which are operating in liquid, increasingly competitive and well-regulated financial markets. With competition under prudential supervision and capital account convertibility being increasingly adopted, the distinction between onshore and offshore banking is progressively disappearing in industrialized countries.
In Asia, offshore interbank markets developed after 1968 when Singapore launched the Asian Dollar Market (ADM) and introduced the Asian Currency Units (ACUs) and Japan established the Japanese Offshore Market (JOM). The ADM was an alternative to London Eurodollar market for the investment of oil surpluses from Indonesia and Malaysia and ACUs enabled local banks to engage in international transactions under a favorable tax and regulatory environment.