The Jersey cow, a small, honey-brown bovine that is prized by farmers for the abundance of buttery, high-fat milk it produces, is one of the fastest-growing breeds in the world. From its origins in Jersey, a rocky island 14 miles (22km) off of the western coast of France, it now wanders fields in over 100 countries from South Africa to Latin America. It is Jersey’s most famous export. But the island’s real cash cow is financial services. Jersey’s 46 banks, 1,055 investment funds and over 200 trusts administer over £700 billion in assets on the island. In St Helier, Jersey’s capital, they compete for office space with more than two dozen law firms, 50 accountancy outfits and 20 insurance companies.
Jersey’s transformation into an OFC was not part of a grand plan. After the second world war Jersey’s low taxes attracted the bank deposits of British expatriates living in the former colonies. The island’s maximum rate of income tax of 20% had remained untouched since 1940 when it was set by the German occupiers.
But tax was only the beginning. Jersey used its role as a low-tax repository of cash to build up a sophisticated private-banking and trust business. More recently it has moved into the corporate business — structured finance, the administration of investment funds, the management of company share plans and the like.
Other OFCs developed in similar ways. Many of them are small territories that were once part of Britain (a number of them are still dependencies). Often they had a history of low or no taxes long before they began to attract the deposits of British expatriates and others. As money flowed in, the cleverer ones began to diversify into more sophisticated businesses. They also began to promote themselves as broad financial centres, not just banking ones. This suited Britain, because it meant its protectorates could become self-sufficient. It also suited the jurisdictions themselves. Financial services are lucrative and provide a much more stable income than crops and fickle tourists. Mauritius hoped to diversify away from sugar, textiles and tourism and attract skilled labour when it launched itself as a financial centre in 1992. Barbados, a poor country reliant on sugar, received help from the IMF and other agencies when it established its financial industry in the 1970s.
Given the attractions, why are there not even more OFCs? After all, cutting taxes to attract foreign capital seems an easy way out of poverty. A study published last December by Mr Hines and Dhammika Dharmapala of the University of Michigan looked at 209 countries and territories, including 33 tax havens, to see why some jurisdictions become tax havens and others do not. Those that do, they found, are overwhelmingly small, wealthy and, especially, well governed, with sound legal institutions, low levels of corruption and checks and balances on government. Badly run jurisdictions cannot attract or retain foreign capital, so many do not even try. Slashing tax rates is not nearly enough.
This may explain why the British empire spawned so many successful OFCs. These jurisdictions inherited strong legal and governmental institutions that reassured investors. Lingering ties to Britain probably helped, too. The appeals process in the BVI and Jersey, among other OFCs, ends up in Britain. Other jurisdictions that have tight cultural or linguistic ties to nearby large financial centres also benefit from a ready clientele happy to do business in a familiar place. Liechtenstein, for instance, does well out of being perched next to Switzerland and using the Swiss franc as its currency.
Whiter Than White
Being a successful OFC is tougher than it used to be. The best-run of them compete not only with offshore rivals but also, in certain industries, with onshore ones. Bermuda’s biggest competitors in captive insurance (of which more below) are Vermont and South Carolina.
The costs of running OFCs have also increased. Complying with the raft of international standards for financial services introduced since the late 1990s involves a lot of effort. And as standards rise, more is expected of the public companies that use OFCs as well. They must not only make profits, but be good corporate citizens too: paying bosses enough but not too much, for instance, making sure their operations in poor countries are run ethically (no child labour, no sweatshops) and steering clear of shady jurisdictions. So OFCs that are careless about their reputation may find themselves shunned by the big, listed multinationals that are their lifeblood.
OFCs complain that the bar is set higher for them than for their onshore counterparts. When Stanley Works, an American toolmaker, announced in 2002 that it was moving its headquarters to Bermuda, it caused a furore. Along with other firms that had moved to tax havens, including Tyco and Ingersoll Rand, it was pilloried as “unpatriotic”, even though it was acting entirely legally. Partly as a result, new American captive-insurance businesses now often stay onshore. A regulator in Europe comments: “Tax havens have to be whiter than white. It is the only way to shake off their bad reputation — which some of them deserved not too long ago.”
Being whiter than white does not come cheap. Introducing anti-money-laundering and other regulations, beefing up bank supervision and tracking down financial crooks takes money and expertise. A paper published last August by the Commonwealth Secretariat, a group of 53 former members of the British Empire, estimated that in 2002-05 the direct cost of new regulations for Barbados was $45m and for Mauritius $40m — big numbers for tiny islands with small budgets. The indirect hit could be even bigger. For example, the number of offshore banks in Vanuatu plummeted to 7 from 37 in a year after new rules required banks to open a permanent office with at least one full-time employee on the island. The paper concludes that for these three jurisdictions, “the costs involved in meeting the new standards have exceeded…identifiable short- to medium-term benefits.”
The start-up costs for new OFCs are also much higher than they used to be. As one regulator in a tax haven explains, in the old days jurisdictions were able to build a critical mass of business before turning their attention to legal and regulatory structures. Many OFCs that opened their doors in the 1960s and 1970s have put in place anti-money-laundering systems only in the past few years, for instance. This means that some bad money came in with the good that had to be flushed out later.
These days new OFCs must invest in regulation, legislation and enforcement up front. That explains why some of the newer ones are wealthy countries that can afford to do this. Dubai, for example, has spent billions of dollars setting up the legal and supervisory systems to underpin its new financial centre. A big chunk of this money was spent on hiring regulators, mostly from Britain.
Some countries have decided that all this is more trouble than it is worth. Tonga, Niue and Nauru, three miniscule islands in the Pacific Ocean, have quit offshore banking to avoid the cost of meeting international standards, as, in effect, have the Cook Islands.
Getting Down to Business
So what does it take to run a successful OFC? First and foremost, you need a tax system that foreign capital finds attractive but still pays the bills. The model that most OFCs choose keeps corporate taxes low or does away with them entirely but makes up for this through a combination of indirect taxes and fees, which are in any event easier to collect.
Regulation, too, is critical. It must be “necessary, appropriate and proportional…and benefits [must] outweigh costs,” asserts Timothy Ridley, chairman of the Cayman Islands Monetary Authority. That applies not only to OFCs but also to big financial centres such as New York and London. The job is never easy, but a risk-based supervision regime, which most OFCs use, is more manageable in small jurisdictions because supervisors tend to know most of the movers and shakers. Moreover, in such places regulators tend to be easy to reach and take the gripes of the business community seriously. Regulators in Singapore, for instance, habitually consult local businesspeople to see how they can improve co-operation. Their clients say this is not just public relations. “They are willing to listen and change. They are not rigid like regulators in Japan and Korea,” says one banker at a British firm.
In the nature of things regulation in small OFCs can also be simpler than in big countries. In America, for instance, a national insurer may find itself being regulated by each of the 50 states. In Bermuda, by contrast, “you can focus simply on running a sound business and making money — not on red tape,” says Karole Dill Barkley, an insurance consultant.
More importantly, many OFCs are involved mainly in wholesale rather than retail business. Of the Cayman Islands’ $1.3 trillion in bank deposits, 93% are interbank bookings, not personal or corporate accounts. The 8,000-plus hedge funds domiciled in Cayman cater only to rich, sophisticated investors able to look out for themselves, so regulators do not have to worry about protecting widows and orphans and can streamline procedures. In the BVI hedge funds can be set up and registered within a couple of days.
The two pillars of Bermuda’s insurance industry — captive insurance and reinsurance — also cater to sophisticated businesses only. Captives are set up by companies (or groups of them) to lower their insurance bills by covering predictable risks themselves. British Airways, for instance, until recently had a captive in Bermuda that insured its aviation and other risks. Because no third parties are involved, regulators in Bermuda apply a lighter touch. Reinsurers underwrite part of the risks of other insurance companies. They are subject to stricter disclosure rules in Bermuda because, under many contracts, unrelated third parties are at risk.
One way OFCs maintain a light touch is to involve auditors and other service providers in regulation. Jeremy Cox, the supervisor of Bermuda’s insurance industry, describes the island’s way of doing things as “practical regulation that tries to use the experience of industry”. Bermuda also puts some of the regulatory onus on independent auditors, who must sign off on insurers’ annual filings and confirm that they meet minimum liquidity and profitability standards.
In Cayman all regulated or licensed professions — including lawyers, auditors, fund administrators and auditors, insurance providers and service providers for trusts — are required to blow the whistle if they suspect that something untoward is going on. This is separate from the money-laundering rules.
Jack Be Nimble, Jack Be Quick
For all OFCs one of the advantages of being small and predominantly reliant on the finance industry is that they can change existing rules and laws quickly to react to new opportunities. Inevitably this takes much longer in big, diversified economies, where any change in the status quo involves difficult negotiations among an assortment of interest groups.
Thanks to its nimbleness, Singapore has been able to score a number of successes against Hong Kong, its slower-moving rival. New trust laws in Singapore that came into effect a year ago have prompted Hong Kong to re-examine its own. Singapore was also ahead of Hong Kong in passing legislation on real-estate investment trusts (REITs), a relatively new investment class in Asia that has been growing rapidly, fuelled by the local property boom. “We are small in a big world. We survive because we stay ahead of the region,” says Kelvin Chan, a former government official who is now with the Partners Group, a Swiss private-equity firm. “In this, being small is our strength.”
Luxembourg manages to move quickly even though it is part of the EU and must comply with all EU directives, which have become increasingly onerous over the years. Luxembourg dominates the market for a type of investment fund called UCIT, similar to mutual funds, that complies with stiff requirements so that it can be sold freely throughout Europe. This is because it was the first country to incorporate the UCIT directive into law in the 1980s.
Being quick on one’s feet is important for OFCs not only because competition is fierce but because many offshore products are easily commoditised. There is nothing particularly special about a Cayman-domiciled hedge fund, for instance; indeed more offshore hedge funds are domiciled there than anywhere else, and lawyers have so much practice that they can quickly set up another one. Hedge-fund managers themselves look for safety in numbers. “You go there because everyone else does,” says one New York investor. BVI companies are popular in Asia for much the same reason: they are familiar, they work, and everybody else uses them.
OFCs with critical mass and expertise in certain niches often act as subcontractors for financial institutions in big onshore centres in the same region. Investment bankers in London, for instance, often work with bankers in Jersey on mergers and acquisitions. Bankers and lawyers in Cayman work with the lawyers of American multinationals on structured-finance transactions.
Such expertise helps OFCs to beat off the competition. Bermuda’s reinsurance market is flourishing because it relies on a network of brokers, underwriters and actuaries that would be hard to replicate. By contrast, fund administration — in essence, the back-office work for investment funds — which thrives in Dublin, Jersey, Luxembourg, the Isle of Man and elsewhere, has become commoditised for run-of-the-mill equity funds. This is one reason why so many OFCs are fighting over hedge-fund business. Administering these funds requires expertise in areas such as valuing illiquid instruments and complex securities such as derivatives, so margins are fatter and clients tend to stick around.
But small jurisdictions sometimes find it difficult to attract and retain the people to provide the expertise. OFCs in balmy climates or close to onshore economies do better than tiny islands floating in the middle of the South Pacific. Proximity to “real” economies makes it easier to lure those experts (almost always expatriates), and clients also like the convenience of being in the same time zone as their OFC and talking to people in their own language.
Some islands are running out of space. Jersey, for instance, imposes strict housing restrictions. Bermuda is facing even greater strains on its capacity. Households are limited to owning one car to cut down on traffic, so affluent businessmen can be seen zipping to work on motorscooters. Getting permanent residency in Bermuda is difficult and house prices are vertiginous, not least because unlike most other OFCs Bermuda is the home base of many huge global businesses with large numbers of employees.
The influx of well-paid expatriates who drive up the cost of living can cause tensions with the local population. Kurt Tibbetts, a government minister in Cayman, says his government works on preserving social harmony by pouring money into education. Bermuda quietly pursues affirmative-action policies that give locals first refusal of any jobs before expatriates can be considered. For the leading OFCs, success comes with its own headaches.