Following discussions in various international fora, including the Fund's Interim Committee and the G-7 Ministers of Finance,1 the Financial Stability Forum (FSF) established a working group to look into the workings of OFCs and their impact on financial stability. As a result of the working group's report, the FSF has recommended a system of assessment for a number of OFCs which may have implications for the Fund's work on the assessment of financial stability in general, and for the joint IMF-World Bank Financial Sector Assessment Program (FSAP) in particular.

The purpose of this paper is to provide background information on the business of OFCs and on a number of initiatives taking place in various international fora concerning OFCs. A companion paper addresses the main policy issues stemming from a possible involvement of the Fund in the assessment of OFCs.

This paper is organized as follows.² Chapter II describes what is meant by the business of offshore finance, where it takes place, and presents a number of definitions of an OFC. It describes the principal activities involved, notes the lack of data on many aspects, and discusses why OFCs are used. Most of the discussion relates to banking because that is the only sector for which statistics are available. Chapter III describes the various initiatives that are being taken in a variety of international fora affecting OFCs.

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 definition of an OFC is far less straightforward. At its broadest, an OFC can be defined as any financial center where offshore activity takes place. This definition would include all the major financial centers in the world. In such centers, there may be little distinction between on- and offshore business, that is a loan to a non-resident may be funded in the center's own market, where the suppliers of funds can be resident or non-resident. Similarly, a fund manager may well not distinguish between funds of resident customers and those of non-residents. Such centers, e.g., London, New York, and Tokyo could more usefully be described as "International Financial Centers" (IFCs). In some cases, e.g., New York and Tokyo, some of this activity, but by no means all, is carried on in institutions which are favorably treated for tax and other purposes, e.g., the U.S. International Banking Facilities (IBFs) and the Japanese Offshore Market (JOM).

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.

In addition to banking activities, other services provided by offshore centers include fund management, insurance, trust business, tax planning, and IBC activity. Statistics are sparse—but impressions are of rapid growth in many of these areas in recent years, in contrast to some decline in banking (see Section C below). Box 1 provides examples of uses of OFCs.

These broad definitions, together with the fact that statistics are available for only a part of the business and only for some OFCs, have shaped the coverage of OFCs by international financial institutions and commentators, ranging from the 14 OFCs listed in the joint BIS-IMF-OECD-World Bank statistics on external debt to the 69 OFCs listed in Errico and Musalem (1999).³ Table 1 provides a list of countries, territories, and jurisdictions with OFCs according to coverage.

Table 2 provides the Financial Stability Forum's list of 42 jurisdictions that it considers to have significant offshore activities.⁴ The list is organized according to the FSF's groupings, which are defined as follows: The first group (Group I) would be jurisdictions generally viewed as cooperative, with a high quality of supervision, which largely adhere to international standards. The second group (Group II) would be jurisdictions generally seen as having procedures for supervision and co-operation in place, but where actual performance falls below international standards, and there is substantial room for improvement. The third group (Group III) would be jurisdictions generally seen as having a low quality of supervision, and/or being non-co-operative with onshore supervisors, and with little or no attempt being made to adhere to international standards.

There is also a great variety in the reputation of OFCs—ranging from those with regulatory standards and infrastructure similar to those of the major international financial centers, such as Hong Kong and Singapore, to those where supervision is non-existent. In addition, many OFCs have been working to raise standards in order to improve their market standing, while others have not seen the need to make comparable efforts. There are some recent entrants to the OFC market who have deliberately sought to fill the gap at the bottom end left by those that have sought to raise standards. 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.⁵

While incomplete, and with the limitations discussed below, the available statistics nonetheless indicate that offshore banking is a very sizeable activity. Staff calculations based on BIS data suggest that for selected OFCs, on balance sheet OFC cross-border assets reached a level of US$4.6 trillion at end-June 1999 (about 50 percent of total cross-border assets), of which US$0.9 trillion in the Caribbean, US$1 trillion in Asia, and most of the remaining US$2.7 trillion accounted for by the IFCs, namely London, the U.S. IBFs, and the JOM.

The major source of information on banking activities of OFCs is reporting to the BIS which is, however, incomplete. First, reporting is confined to the major OFCs.⁶ The smaller OFCs (for instance, Bermuda, Liberia, Panama, etc.) do not report for BIS purposes, but claims on the non-reporting OFCs are growing, whereas claims on the reporting OFCs are declining. Second, the BIS does not collect from the reporting OFCs data on the nationality of the borrowers from or depositors with banks, or by the nationality of the intermediating bank. Third, for both offshore and onshore centers, there is no reporting of business managed off the balance sheet, which anecdotal information suggests can be several times larger than on-balance sheet activity. In addition, data on the significant quantity of assets held by non-bank financial institutions, such as insurance companies, is not collected at all. Nor is there any information on assets held by mutual funds as well as private trusts and companies (i.e., IBCs) whose beneficial owners are normally not under any obligation to report.⁷

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).⁹ 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 intermediated through 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 (Chart 1).

However, important tax advantages continue, perhaps less for banks themselves than for corporate and individual customers. For the latter, the ability to reduce inheritance and other capital taxes seems to have been a prime incentive and has led to a large expansion in offshore fund management activity, in particular by the use of investment vehicles such as trusts and private companies, for which, however, there is no statistical evidence for the reasons discussed above. Industrial and commercial companies have also been able to reduce their tax liability through the use of foreign sales corporations to maximize the proportion of their profits that arise in lower tax jurisdictions.

Offshore banking, however, seems to continue to be an appealing alternative for banks operating in the sometimes more highly regulated financial markets of emerging market economies. The share of the cross-border assets of OFCs, excluding the U.K. and Belgium-Luxembourg, in total cross-border claims on emerging economies increased from 58.5 percent in 1991 to a peak of 67 percent in 1997 and stood at some 56 percent as of end-June 1999. A possible explanation for this sharp contraction, which occurred for the most part in 1998, lies in the significant consolidation that took place in the Japanese banking system as well as the impact of the Asian crisis (e.g., Hong Kong where offshore activity dropped substantially). The share of OFCs' cross-border liabilities in total cross-border liabilities to emerging economies steadily increased from 36 percent in 1991 to 54 percent at end-June 1999. These figures are particularly noteworthy because, at end-June 1999, for the world as a whole, only 25 percent of banks' assets, and about 33 percent of banks' liabilities, were vis-à-vis emerging market economies.

Among emerging market economies, Asia's OFCs have markedly and progressively increased their net cross-border liabilities, suggesting that they have intermediated a sizeable portion of capital flows into the region. Asian OFCs' net cross-border liabilities as percent of assets, increased from about 15 percent in 1991 to about 53 percent in 1998 (Chart 2), falling back to 38 percent at end-June 1999. It is noteworthy that banks in other OFCs and banks engaged in ordinary cross-border banking maintained broadly squared net cross-border positions over the same period (i.e., a trend around zero in Chart 2).

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.

Offshore banks engage in a wide variety of transactions: foreign currency loans (including syndicated loans) and the taking of deposits, the issue of securities, over-the counter (OTC) trading in derivatives for risk-management and speculative purposes, and the management of customers' financial assets. ¹²

• Foreign currency lending and its associated funding. This is normally an asset driven business, sometimes originated in the OFC, but often originated elsewhere and booked and funded in the OFC, normally for tax reasons. Sometimes the funding is arranged by the office originating the loan, but sometimes it may be arranged by the entity in the OFC itself. This funding activity gives rise to a substantial volume of inter-bank activity, sometimes, but not always, between branches and affiliates of the same bank. At end-June 1999, about 70 percent of OFC banks' cross-border assets and about 60 percent of cross-border liabilities were vis-à-vis other banks. The risks involved in this activity are normally managed by the banks' main offices.

• A significant proportion of eurobonds floated in international capital markets is also issued in OFCs, although the marketing and selling of such instruments would normally be done in major financial markets. Recently, the use of special purpose vehicles registered in OFCs has led to a growing volume of structured finance deals, which again mainly for tax reasons are domiciled in OFCs. Over the period 1992-98, the outstanding amount of international money market instruments (bonds and notes) issued in OFCs grew at an average annual rate of 23 percent, somewhat faster than such issuance in the world as a whole. At end-June 1999, they stood at some US$1 trillion, or 21 percent of total international money market instruments.

• The use of OTC derivative instruments blossomed over the last decade, but was mainly concentrated in a few primary IFCs. Because derivatives entail substantive counterparty, settlement, liquidity and legal risks they require the infrastructure of developed financial centers, where their use is more prevalent. Among IFCs, the use of over-the-counter trading in derivatives is thought to have increased in the U.S. IBFs, the JOM, and to a certain extent in OFCs with major financial markets. But in other cases derivative transactions arranged elsewhere may be booked in an OFC if tax or other reasons make that more profitable.

• Deposit taking from individual customers is an activity specialized in by a number of OFCs. Normally, the banks involved in this business are major international banks with a high reputation (deposit insurance is normally not available). The attraction is normally related to tax, both income and capital taxes. The proceeds of this type of business are normally invested in high quality marketable assets in major financial centers. While some of this business is on-balance sheet, the part that is probably growing fastest is in funds managed by financial institutions and marketed in major centers. In addition, as noted above, OFCs are used for the management of personal funds in a variety of trusts and other forms, some managed by financial institutions but some managed by law firms and other specialists.

Table 3 provides a synoptic description of the many ongoing initiatives—some of which are more fully discussed below, 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.

The Basel Committee on Banking Supervision has been actively promoting more effective cooperation between "home" and "host" supervisors for many years.13 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—see Box 2. Subsequently, in 1996, a Working Group on Cross-Border Banking was established, composed of members of the Basel Committee and the Offshore Group of Banking Supervisors. This group prepared a report (the "1996 Report") including 29 recommendations to address a number of practical problems that had arisen in the implementation of the 1992 Minimum Standards.¹⁴ None of this work is specific to OFCs, although the problems involved in establishing the relative responsibilities and effective cooperation between home and host supervisors arises particularly with supervisors in OFCs. Finally, in 1997, the Basel Committee issued its Core Principles for Effective Banking Supervision, providing, inter alia, a comprehensive framework for effective consolidated supervision which is also appropriate for offshore banking activities.

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.¹⁵ 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.¹⁶

Indeed, effective consolidated supervision is one of the more difficult aspects of supervision to implement in practice. For this reason, it is generally weakly implemented in many countries, according to a recent study by the staff,¹⁷ which shows that most of the countries so far assessed were rated non-compliant or materially non-compliant with regard to Core Principle 20 dealing with consolidated supervision. Indeed, out of these countries for which consolidated supervision was relevant, only 28 percent were rated fully or largely compliant, with 72 percent found seriously wanting. One contribution to this weakness is the absence of consolidated accounting and reporting, together with differences in accounting standards. Supervisory coordination is shown to be another vital element, somewhat better implemented but still weak in many instances.

Recommendations for action following the 1998 Basel Committee's survey to assess implementation of the Core Principles are currently being considered by the Basel Committee. The Committee is now considering, against the evidence from implementation, how far the gaps referred to above and any others should lead to an updating and/or fine-tuning of the 29 recommendations of the 1996 Report.

The Financial Action Task Force (FATF) was established to help protect financial systems from criminal use for the laundering of the proceeds of drug related and other serious crime.¹⁸ More recently, the emphasis has been on the extension of the FATF's work to crimes other than those associated with drugs, including some fiscal crimes. ¹⁹ The FATF's 40 recommendations have come to be recognized as a statement of best practice in the combat against money-laundering. The Task Force has also encouraged the formation of regional groups, the first of which was the Caribbean Financial Action Task Force (CFATF), and which includes the major OFCs in that region. The CFATF has also published a list of 19 recommendations in addition to the FATF's 40, many of which deal with aspects germane to business in OFCs. A similar group has been established in the South Pacific. The FATF's Ad Hoc Group on Non-Cooperative Jurisdictions was established in 1998 to develop a common process for FATF members to evaluate whether jurisdictions are cooperating with FATF anti-money laundering initiatives. This work was finalized on June 22, 2000, when the FATF published a report which included a list of 15 non-cooperative jurisdictions.²⁰

The U.N. Offshore Forum is a 1999 initiative of the U.N.'s Office for Drug Control and Crime Prevention to deny criminals access to OFCs for the purpose of laundering the proceeds of criminal activities. The Forum's program seeks political commitment from OFCs towards the adoption of minimum performance standards.²¹ In return, the Forum will provide technical assistance that will aid OFCs in coming into compliance with the standards. The Forum's program was set out to the global financial community in March 2000 during its Plenary Meeting in the Cayman Islands.

The OECD Committee on Fiscal Affairs (CFA) has established the Forum on Harmful Tax Competition under the aegis of the G-7, which, since the Birmingham Summit of May 1998, placed a greater emphasis on the need to step up international cooperation to enhance the effectiveness of attempts to prevent the erosion of the ability of major countries' tax authorities to tax the income and capital of their residents. The OECD's Forum was created as the result of the OECD May 1998 report on Harmful Tax Competition and it was assigned responsibility, inter alia, for undertaking an ongoing evaluation of existing and proposed preferential tax regimes in OECD member and non-member countries, and examining whether particular jurisdictions constitute tax havens.²² The OECD has informed some 49 jurisdictions that they are considered to be "tax havens." They will be classified in three categories according to their willingness to cooperate with OECD countries' tax authorities: a group of "non-cooperative" OFCs against whom sanctions may be taken; a second group which are committed to "reform," but where such reforms have not been set in train; and a third group which are in the process of implementing reforms. The names of those falling in the first two categories are expected to be published.

There have also been assessments and surveys other than those carried out by recognized international bodies. For example, the U.K. authorities have published a review of the offshore business of the Channel Islands and the Isle of Man, which provides considerable information on the nature of the business carried out in those jurisdictions.²³ The U.K. authorities are also sponsoring a study by KPMG of the main overseas dependent territories which provide facilities for offshore business. The work is expected to be completed by mid-2000 and the results will published.

All these international initiatives aimed at OFCs relate in various ways to the Fund's heightened focus on assessments of financial stability, including under multilateral and bilateral surveillance, and more recently notably through the implementation of the joint Bank-Fund Financial Sector Assessment Program (FSAP).²⁴ These issues are, inter alia, discussed in a companion Policy paper.