Offshore Financial System
In 2007, the IMF offered what has become a generally-accepted definition of offshore financial centers (OFCs): “An OFC is a country or jurisdiction that provides financial services to nonresidents on a scale that is incommensurate with the size and financing of its domestic economy.” In this usage, the word “offshore” refers to the relative prevalence of non-resident financial activity in an economy, not to a physical location. OFCs can be found in countries big and small, arid and tropical, land-locked and ocean-bordering.
OFCs are categorically distinct from other kinds of financial centers, such as international financial centers (IFCs). While IFCs are characterized by strong regulatory structures, substantial participation in the domestic economy, and diverse funding sources, OFCs are distinguished by weak regulatory and supervisory checks, financial services that appeal to corporations and individuals looking to avoid taxation, and large amounts of banking secrecy and shadow banking.*
Though OFCs serve a handful of legitimate business purposes (in addition to providing economic boons for their countries), they also serve a slew of dubious–and often overtly criminal–purposes. Because financial operations in these jurisdictions aren’t subject to robust beneficial ownership requirements, tax evasion and money laundering processes are rampant in OFCs, siphoning away billions of dollars from domestic tax bases and buoying global criminal enterprises. OFCs also contain financial structures that allow corporations to shift profits made in high-tax jurisdictions to low-tax jurisdictions, and costs incurred in low-tax jurisdictions to high-tax jurisdictions. This process, often called base erosion and profit shifting, enables corporations to circumvent the tax laws of countries in which they actually conduct business.
Researchers who study OFCs use a range of measurements to determine whether a country or jurisdiction is an OFC. Such measures include:
- ratios that compare the size of domestic economies to their net exports of financial services;
- ratios that compare the size of domestic economies to the amount of bank- and shadow bank-assets existing therein; and
- the number of “custodian entities,” or firms that manage the wealth of non-resident clients, located in a country or jurisdiction.
In a 2018 working paper, the IMF lists the following countries as top OFCs (also called “pass through economies”): the Netherlands, Luxembourg, Hong Kong, the British Virgin Islands, Bermuda, the Cayman Islands, Ireland, and Singapore. Each of these jurisdictions house an astronomical amount of shadow banking assets. The value of assets managed by shadow banks in the Cayman Islands in 2016, for example, was 2,118 times greater than its GDP. In other words, the Cayman Islands provide a home to more than US$10 trillion in shadow bank assets. In the same year, Luxembourg’s shadow bank assets (US$15 trillion) were 247 times greater than its GDP, and Ireland’s shadow banks held assets worth US$4 trillion, or 1,333 percent greater than its GDP.
*Though they are technically not banks, shadow banks are financial structures that offer services that mimic commercial banking activity, such as credit intermediation (using depositors’ money to finance loans). Their nominal non-bank status–and the fact that shadow banks are often domiciled in secrecy jurisdictions–makes them subject to separate, less thorough supervisory frameworks that enable them to accept money from dubious investors. Additionally, shadow banks are often not required to disclose the nature of their reserve assets, making it impossible for prospective investors to adequately gauge risk. The opacity necessitated by shadow banking increases the amount of systemic risk in the global financial system.