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On the other hand, they introduced measures aimed at increasing the cost of operating offshore, including more comprehensive supervision, higher penalties on offshore activities, abrogation of tax-treaties with OFCs, and intensified pressure on the latter to enhance their supervisory regimes.

These measures resulted in a convergence of the tax and regulatory regimes between domestic and offshore centers, and a blurring of frontiers between onshore and offshore markets. The extensive financial liberalization that occurred throughout the industrial world in the late s and s, partly in response to the migration of firms and capital to offshore centers in the s and early s, is documented in Table 11 Goldstein and Mussa, Besides the financial liberalization, the shift of financial activity to OFCs induced a decline in tax rates in the major OECD countries during the past twenty years Table Withholding tax regimes were abolished in three large domestic bond markets during the s the United States in July , France in for nonresidents and for residents, and Germany in which resulted in a significant loss of business for OFCs.

For instance, after the repeal of the U. Reserve requirements, which are implicit taxes, have also diminished sharply in recent years, and for the United States, Japan, Germany, France, Canada, and Switzerland stand well below their levels. After the Eurocurrency reserve requirements in the United States were reduced to zero in December , the incentive of foreign banks to book loans to U. The share of deposits of branches of U. During the s, the United States and Japan enacted legislation to make their domestic financial centers more competitive in conducting banking activities with nonresidents.

The authorization enabled U. The IBFs were successful in halting the growth of offshore loans by U. The principal losers from the establishment of IBFs were booking centers in the same time zone in particular, the Bahamas and Panama and continental European centers, rather than London. The JOM together with the progress toward deregulated interest rates and increased use of market-based lending rates in Japan has had a significant impact on the reduction of the size of Japanese operations in offshore centers. In consolidating regulations, the authorities stressed that it was the only reliable way of assessing the soundness of banking groups and their potential risk to the financial system.

The Basle Committee recommended that home-country authorities should be responsible for monitoring the risk exposure of internationally active banking groups on the basis of all of their business activities wherever they may be conducted. Also under consideration is a proposal to redesignate the concept of home-country to denote the main place of business rather than the country of incorporation.

While broadening their supervision, some countries also took measures aimed at curbing the involvement of their domestic firms in offshore activities. These measures essentially centered on the repeal of tax treaties and changes in domestic tax provisions. Tax Reform Act eliminated most of the provisions that allowed U. In , both Britain and France passed a Finance Act designed to put an end to the use of offshore subsidiaries to circumvent the taxation of undistributed income.

The new regulations stipulated that resident companies holding shares at least 10 percent in the case of Britain and at least 25 percent in the case of France in foreign companies registered in low-tax jurisdictions would be subject to domestic corporation tax Doggart, In , following the BCCI affair, the British government passed additional laws to curb offshore business; British residents were no longer allowed to defer or avoid taxes by setting up trusts to hold their assets offshore, and capital gains taxes would be payable on assets sold from a trust even if the latter was domiciled offshore.

In recent years, Spanish and Portuguese authorities took action to halt the use of offshore companies by foreigners to own property in their countries. The pressure on highly taxed and stringently regulated jurisdictions to reduce their taxes and regulations was accompanied by pressure on offshore centers to raise their supervision to more acceptable international standards. During the s, investors became more aware of the costs and consequences of operating in loosely regulated centers, as a number of scandals associated with offshore centers surfaced.

In response to these pressures, some OFCs tightened their screening of companies moving to their jurisdiction and stepped up their monitoring of illegal activity. For instance, the Cayman Islands began to share records with U. Drug Enforcement Agency in , signed a treaty of mutual assistance with the United States and Britain in covering all non-tax criminal matters, and recently tightened reporting requirements, lending guidelines, and performance reviews. Luxembourg agreed that its banking secrecy laws do not apply when there is evidence of criminal activity and that they will no longer license banks or holding companies that do not conduct business in the country.

The Channel Islands imposed drug-trafficking laws similar to the ones in the United Kingdom, and the Bahamas toughened its banking laws and cracked down on drug smugglers. Due to this convergence in regulation and taxation, the structure of a modern financial center lies somewhere between that of the traditional financial center and the offshore center, offering low taxes, a flexible and friendly regulatory environment, and sound prudential system. As to the future, the high integration of the financial industry and the ease of substitutability of financial products are likely to prevent significant divergences in the regulatory and tax environment of the major international financial centers from occurring.

Mutual and pension funds, which control a growing share of the capital that circulates in the international financial system, operate on a worldwide basis, are performance oriented, and would shift funds swiftly from less attractive jurisdictions to more attractive ones. In view of the mobility of capital and the facility to arbitrage major discrepancies in tax and regulations, governments would be increasingly weary of taxing financial services, burdening companies with excessive regulations and reimposing capital controls.

The magnitude of the shift would depend, however, on how much bank capital can move to an OFC in support of foreign exchange transactions without increasing sovereign risk i. In the event that banks conclude that shifting such an amount to an OFC would not increase their sovereign risk significantly, capital controls on foreign exchange transactions would be ineffective even with full cooperation among the major financial centers.

The growth in the use of derivative financial instruments to manage risk has been one of the most spectacular developments in finance during the last decade. In their search for profitable activities and for instruments that facilitate hedging and position-taking, banks have gradually reduced their reliance on traditional interbank markets and have expanded their activities in derivatives markets. During this period, almost all of the derivatives trading took place in the major financial centers, with organized exchanges in the United States, Europe, and Japan accounting for more than 93 percent of exchange-traded instruments.

Regional OFCs, essentially Singapore, played a minor role in the derivatives markets while booking centers did not play any role. The main reason behind the lack of development of derivative markets in offshore centers is the fact that the trading of derivative instruments entails higher risks credit, liquidity, settlement and legal risks than interbank activities and requires more available liquidity than that needed in traditional banking operations.

The risks are primarily attributed to the complexity of derivatives which are well understood by only a limited number of participants and the intricate linkages between market participants in a given derivative transaction, which significantly complicate the evaluation of counterparty risk. In view of the greater risks involved, derivatives trading has been limited to a few trading centers, which offer a high level of prudential supervision, sufficient liquidity resources, and sophisticated settlement systems; and to a small group of highly rated institutions, whose general exposure to risk is known and which have the human and technological ability to handle these complex transactions around the clock.

The dismantling of capital and exchange controls together with the liberalization of financial markets have increased the clustering of financial activity and financial intermediaries in a small number of large financial centers, each a leader in its time zone. Financial activity tends to cluster in the large financial centers due to the economies of scale generated from their deep and liquid markets, which reduce the cost of searching for counterparties with whom to trade and lower trading transaction costs, their efficient clearing and payment systems, and their skilled labor force.


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This heightened concentration of financial activity has decreased the likelihood that a large number of financial firms will relocate from a major financial center to a secondary offshore center. On the other hand, the cost of relocation has substantially increased in recent years, as the financial sector has become more complex and reliant on advanced hardware and software systems, expensive electronic and automated trading systems e. The disintermediation process of the past decade has also increased the concentration of finance in the major financial centers and away from small offshore centers.

Institutional investors in OECD countries—pension funds, investment funds, and insurance companies—only operate in large and liquid financial markets and invest most of their assets in government securities, bonds issued by large and highly rated corporations, and very liquid equity markets. As such, they prefer to operate in the centers which offer the shortest settlement cycle, allowing them a more flexible management of their portfolios across international markets and a lower risk exposure.

Finally, as capital flows increased between industrial countries, major financial centers extended their trading hours in order to overlap with each other, thereby reducing the need for firms to operate in regional OFCs to cover different markets. It is not a matter of coincidence that the three major trading financial centers New York, London and Tokyo cover a different time zone allowing round-the-clock trading. However, within a time zone, some trading activities may shift from a major financial center to a smaller OFC when transaction fees, turnover taxes, fixed commissions, and general cost-of-living expenses become unduly high.

For instance, some banks have relocated their regional treasury operations from Tokyo to Singapore, due to the high costs in Tokyo. However, as seen elsewhere, the shift of activity tends to be reversed as soon as the major financial center re-establishes its competitiveness.

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The dynamics between onshore and offshore economies over the last three decades can be characterized as follows. Initially, when a sector of an onshore economy became uncompetitive due to higher taxes or stricter regulations, it would splinter off from the rest of the financial industry and migrate to offshore centers. The migration would either be to an international offshore center such as London or to smaller OFCs, which compensated for their size and lack of sophistication by offering low taxes and attractive regulatory incentives. In response to the magnitude of the flows to OFCs, domestic financial centers gradually reversed the tide by deregulating their economies, lifting their capital controls, lowering their tax burdens, and increasing their supervisory cooperation.

In that sense, offshore centers were instrumental in instigating the tide of deregulation and liberalization of financial markets during the last decade.

Financial intermediation services indirectly measured (FISIM) in the UK revisited

This process led to the consolidation of some financial centers and the downfall of others. London consolidated its role as the most important international financial center and as the heart of European financial activity, while a small number of OFCs emerged as financial hubs for their region e. The success of these small centers was attributable to their proximity to a growing region, their stable macroeconomic and political environment, their modern infrastructure and communications network, and their high level of regulatory rectitude.

The critical mass of technical expertise and the economies of scale acquired by these centers will probably give them a sustainable and lasting competitive advantage over other centers. On the other hand, the majority of OFCs were unable to attract significant financial activity to their jurisdictions e.

Many others suffered sudden and severe losses of financial activities due to domestic or regional political problems e. As to the future of OFCs, in light of the trends mentioned in the previous section, namely, the decline in regulatory and tax burdens, the decline in the importance of interbank markets and the increased cost of switching from domestic centers to OFCs, the recent proliferation of small offshore centers e.

In a liberalized and highly competitive environment, the likelihood that these centers acquire the necessary critical mass that would induce firms or markets to relocate from primary financial centers to their jurisdictions is remote. In this regard, the registration of financial transactions e. On one hand, major financial centers are unlikely to extend the full array of tax and regulatory incentives that tax havens provide.

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On the other hand, offshore centers offer foreign companies complete discretion and flexibility in the management of their assets. Moreover, individuals, who value secrecy and confidentiality, engage in illicit activities or fear having their assets confiscated, would continue to use tax havens for incorporating their trusts and for tax planning or tax evasion.

In addition to their booking activities, offshore centers may begin to attract back-office operations—settlement work, share registration, processing of credit card billing and other labor intensive activities—from primary centers. With the technological revolution of the last decade, shifting the physical location of less sophisticated tasks from high costs financial centers to countries with cheaper labor is feasible. Industrial countries have already moved their back-office activities to less expensive regions or cities Citicorp moved its back-office operations to South Dakota, Salomon Brothers moved its settling transactions to Florida and in the United Kingdom, credit card processing shifted to Manchester and Southend ; the move to developing countries could be the next step.

There are several factors that explain the emergence of Bahrain as a regional offshore center in the Middle East over the last two decades. With Saudi Arabia, the largest economy in the region, lacking the physical and financial structure necessary to absorb these flows, combined with its conservative attitude towards banking, Bahrain began to operate as the regional financial center.

Finally, the emergence of Bahrain coincided with the beginning of the Lebanese civil war and the consequent decline of Beirut as the main banking center of the region. In addition, OBUs were exempt from corporate income tax and no withholding tax was applied to interest income. Local commercial banks—referred to as Full Commercial Banks—were authorized to operate offshore if they obtained OBU licenses for nonresident transactions, and maintained separate accounting records for such transactions.

Between and , interbank assets accounted for about 70 percent of OBUs total assets, whereas their lending to nonbanks multinationals and government enterprises was around 25 percent.

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Banks transactions were of a short-term nature liabilities of up to six months represented more than 90 percent of total liabilities and were primarily conducted in dollars 68 percent. The lack of medium- and long-term lending was ascribed to the difficulty encountered by foreign firms in assessing local credit risks and profitability of projects, combined with a legal bias against lenders which made loan recoverability highly uncertain.

As such, the extension of medium- and long-term facilities had to be secured against collateral e. Moreover, in order to increase their fee income while spreading risks among a number of institutions, OBUs engaged in Euro-loan syndications as lead managers or co-managers, lending primarily to Arab borrowers, but also to Latin American, Eastern European, and Chinese borrowers.

In the late seventies, Bahrain accounted for about 10 percent of the lending volume in the international syndicated loan market. These transactions were extremely profitable and encouraged the establishment of numerous OBUs whose main interest was to capitalize on these easy foreign exchange gains.

The rapid growth of Bahrain during period came to a halt in the mids, as the region was struck by a major recession, the international debt crisis unfolded, and structural weaknesses in the offshore sector appeared. As the bulk of OBUs regional lending went into construction-related projects, the collapse of the oil market left the banks with a huge portfolio of nonperforming loans, primarily from Saudi companies, which had to be provisioned against for many years. During the early part of the s, many syndicated loans were floated in Bahrain to lend money to Kuwaiti traders.

These loans were fully secured by either land or shares. After the Souk-el-Manakh crash, the values of these collateral assets plummeted, causing major losses to OBUs e.

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In addition to the regional problems, OBUs suffered from the international debt crisis in , as OBUs had large exposures to Latin American countries e. As such, as the second wave of Arab and foreign banks arrived in Bahrain in the early s, the oil surpluses had dried up, investment opportunities in the region were diminishing, and the loan syndication business was curtailed. The majority of the OBUs leaving Bahrain were branches of large foreign banks e.

Although the recession and political tensions of the region prompted the decline in offshore activities in Bahrain, they also exposed three underlying weaknesses in the conduct of banking in Bahrain.