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OFFSHORE BANKING – REGULATORY ASPECTSS. SRIDHARExecutive DirectorExport-Import Bank of IndiaThis paper is organised into four parts, First a brief overview of the role ofoffshore banking and the rise of offshore financial centres (OFCs). Second, recent trends in regulation of offshore banking. Third, the status of offshore banking in India as we make a cautious beginning. Fourth, theway forward in the Indian context. The treatment is non-exhaustive, coming as it does from a market participant and not a regulator. I Offshore Banking and rise of Offshore Financial CentresIn today’s highly integrated global network, international offshorefinancial centres (OFCs) have come to play a vital role in facilitating investment worldwide. An offshore centre exists by usage. It is recognisedby an amalgam of features which, taken together, offer particularadvantages for investment by non-residents. OFCs are jurisdictions whereoffshore banks are exempt from a wide range of regulations, which arenormally imposed on onshore institutions. Specifically, deposits are not subject to reserve requirements, bank transactions are mostly tax exempt

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from regulatory scrutiny with respect to liquidity or capital adequacy. Information disclosure is also low. A summary description of regulatory and tax regimes applied to offshore banks in select OFCs is presented in Table 1. Types of Offshore Financial CentresOffshore Financial Centres can be classified into three main groupsdepending on the offshore banks’ sources and uses of funds, the liquidityof markets, and type of transactions.Primary OFCs – Primary OFCs are large international full service centreswith advanced settlement and payment systems, operating in liquid regional markets where both the sources and uses of funds are available.London, the US International Banking Facilities (IBFs) and the JapaneseOffshore Market (JOM) belong to these category. Secondary OFCs – Secondary OFCs differ from Primary OFCs in that

they intermediate funds in and out of their region, according to whether the region has a deficit or surplus of funds. Such OFCs include HongKong and Singapore Asian Currency Units (ACUs) for South East Asia, Bahrain and Lebanon for the Middle East, Panama for Latin America and Luxembourg for Europe.

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Booking OFCs – Booking OFCs do not engage in the regional intermediation of funds, but rather serve as registries for transactionsarranged and managed in other jurisdictions. These OFCs are sometimesreferred to as tax havens and include most Caribbean OFCs. Activities of OFCsOFCs conduct a wide range of business, chiefly banking, but also, insurance, securities transactions, trusts, and some non-financial activitiessuch as shipping registries.Offshore banks deal mostly with other financial institutions and transactwholesale business denominated in currencies other than that of thecountry hosting the OFC. Offshore banking is carried out typically through offshore establishments, which are offshore branches or subsidiaries. Offshore branches are legally indistinguishable from parent banks onshore, which facilitates intra-branch transfers. Shell branches or booking offices are a particular case of offshore branches. They collect deposits from various markets and channel them for various uses as per dictates of their parents. Offshore activities may also take place through what are called parallel-owned banks which are banks established in

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different jurisdictions that, while having the same owner(s), are not subsidiaries of one another. Offshore banks engage, inter alia, in eurocurrency loans (includingsyndicated loans) and deposits, the underwriting of eurobonds, and over-the-counter (OTC) trading in derivatives for risk management and speculative purposes. Eurocurrency transactions are the bulk of offshorebanking operations. These include transactions between banks and theoriginal depositors, between banks and ultimate borrowers, and between banks themselves on the inter-bank market. The underwriting ofeurobonds floated in international capital markets is also a significant part of offshore banking activities. Private banking is a major service offered to high net worth persons. Specialised services provided include asset management, estate planning, foreign exchange trading, custodian and

trustee services. Another area which has seen major growth in recent years has been thesetting up of Special Purpose Vehicles (SPVs) in the OFCs which are used by banks for asset securitization and by non-financial corporations to lower the cost of raising capital by utilisation of the tax advantages.

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IITrends in Regulation of Offshore BankingSince offshore banking emerged and grew in response to restrictiveregulatory regimes, there are certain inherent risks that can potentially affect international financial stability. Three can be readily identified. First, the contagion effect with the increasing integration of financial markets worldwide and the explosive growth in cross-border capital flows,problems in a bank in a OFC can be transferred rapidly to other market jeopardising the stability of those markets. Second, the lack of reliabledata on activities in OFCs may hinder effective supervision. Third, competitive liberalisation may lead to lowering regulatory standards in OFCs in order to attract a higher share of global business. Internationally regulators have been addressing the systemic issues posed by offshore banking. The `Basle Concordat’ of 1975 was implemented onbest efforts basis for almost two decades. The bankruptcy of Bank ofCredit and Commerce International (BCCI) in 1992 hastened the adoption of international supervisory standards. BCCI was a landmark in the sensethat thereafter, it has become difficult for a bank incorporated in ajurisdiction with limited domestic market to carry on business in other countries. The standards adopted by the Basle Committee for BankingSupervision are as follows:

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• All international banks should be supervised by a home country authority that capably performs consolidated supervision; • The creation of cross-border banking establishments should receive the prior consent of both the host country and home country authority; • Home country authorities should possess the right to gatherinformation from their cross-border banking establishments; • If the host country determines that any of these three standards is not being met, it could impose restrictive measures or prohibit theestablishment of banking offices.This was followed by the Report of a Working Group of the Basle

Committee which, inter alia, aims at improving access of home and host regulators to data necessary for effective consolidated supervision and ensuring all cross border banking operations are subject to home and host supervision. Subsequently there have been several international and regional supervisory and regulatory initiatives. These are aimed, inter alia,at curbing involvement of OFCs in financial crime such as money laundering, tax evasion, lax financial regulation including inadequatesupervision.

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Financial Stability Forum (FSF) set up a Working Group on OFCs (report published in 2000) to review the uses and activities of OFCs and their significance for global financial stability. FSF’s approach has been to develop and implement standards internationally ensuring cross-bordercooperation. Compliance by various OFCs is also sought to be assessed aswell as means of incentivising compliance. The International Monetary Fund (IMF) was brought in to carry out assessments of the OFCs and such a programme has since become a standard part of IMF’s financial sectorwork. As per latest data available, 41 of the 44 OFCs have been assessed. While publication of assessments is voluntary, a large majority have opted to publish the reports. The assessments have been largely `Module 2’ assessments, i.e. the observance of supervisory and regulatory standards in the banking sector, effectiveness of the anti-money laundering andcombating the financing of terrorism. Some OFCs have voluntarily subjected themselves for a more comprehensive assessment of risks tomacro economic stability on account of the vulnerabilities of the domesticfinancial system. The Financial Action Task Force (FATF) was established to help protect financial systems from money laundering, drug related, financial crime.

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Regional groups have also been formed. A statement of best international practices to combat money laundering has been published. OECD has also been in the forefront creating several fora to step up international cooperation. III Offshore Banking in the Indian contextIndia has made a cautious beginning in offshore banking by permitting for the first time Offshore Banking Units (OBUs) to be set up in Special Economic Zones (SEZs). The SEZs have been set up with a view to providing an internationally competitive and hassle free environment for

export production. SEZs will be specially delineated duty free enclave and deemed to be a foreign territory for the purpose of trade operations and duties / tariffs so as to usher in export-led growth of the economy. TheOBUs virtually would be foreign branches of Indian banks located in India. These OBUs, inter alia, would be exempt from reserve requirements and provide access to SEZ units and SEZ developers to international finances at international rates. The Reserve Bank of India (RBI) haspermitted banks operating in India, whether Indian, public/private sector or foreign, to set up OBUs in the SEZs. The OBUs would carry out essentially wholesale banking operations. The OBUs will be set up as

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branches of the banks and therefore no separate assigned capital will berequired. All prudential norms applicable to overseas branches of Indian banks would apply to OBUs. Thus, the necessary risk management practices that are in vogue internationally, would have to be adopted bythe OBUs. The OBUs will be regulated and supervised by RBI. They will be required to scrupulously follow “Know Your Customer” and other anti-money laundering directives of RBI from time to time. Unlike the OFCs in other developing countries which conduct offshorebanking in a significant manner, the OBUs in India have a limited mandate. In fact, the approach appears to be facilitating the SEZ policy rather than introducing offshore banking in India. This is in line with thecautious policy stance adopted by the regulators in regard to the openingup of the financial sector. Notwithstanding the limited scope for offshorebanking in the light of the relevant regulations, many Indian banks haveset up OBUs in SEZs. Available feedback is encouraging.Over the years, India has tightened the legal framework to combat money laundering and other cross border financial crime. These include thePrevention of Money Laundering Act 2002, passed keeping in view the

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FATF deliberations and recommendation and international initiatives at the United Nations and others. There are other laws such as The Smugglers and Foreign Exchange Manipulation (Forfeiture of Property) Act of 1976, The Code of Criminal Procedures 1973, Prevention ofCorruption Act, 1988, The Narcotic drugs and Psychotropic Substances Act of 1985. IVWay Forward

In general, the regulatory regime in respect of offshore banking may beexpected to move forward on the basis of following four broad principles: • First, consolidated supervision of banking operations through greater co-operation between home country and host country regulators;• Second, higher transparency with reference to supervisory systems and programmes including dissemination of guidelines, publications ofdata of OFCs; • Third, technical assistance to upgrade regulatory systems, supervisory policies and procedures through adoption of `best in class’ processesand policies.• Fourth, setting up systems for independent monitoring of activities ofOFCs and complying with supervisory standards.

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What is the scope for offshore banking in India? The favourable factorsfor an OFC in India are well known. These include availability of skilled and quality banking, legal professionals, vastly improved telecommunication systems ensuring connectivity, the time zoneadvantage. The benefit by way of fillip to local economy is also well understood. However, clearly the regulatory regime governing it would becritical. Accordingly the proponents of offshore banking would need to address the key concerns of the regulator. Apart from the apprehension ofoffshore banking being used for dubious ends and in financial crime, theregulator would also be concerned about the systemic risks to the financial system. It would perhaps not be inappropriate to evolve a regulatory framework with a road map for informed public debate. Such a frameworkwould need to address issues such as• First, should only offshore banking be permitted or other activitieswithin the umbrella of an OFC? Some of the other activities may appear as meeting specific needs such as insurance, fund management, trusts, etc.• Second, for an OFC being set up should there be a single regulator for all the activities of the OFC or different regulators mirroring the

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pattern in the corresponding onshore sub sectors? Also, should there asingle regulator for onshore and offshore banks?• Third, should there licensing of firms in the OFC as it is currently stipulated for OBUs in SEZs? Or should it be simple incorporation asis the practice in most OFCs? Or should licensing be restricted to

financial intermediaries?• Fourthly, granted that licensing would be required for OBUs, who would be the eligible parties – not just banks operating in India as per current policy, but also foreign banks, their subsidiaries/ affiliates?What would be the permissible activities? Here again the regulator would need to strike a balance between the fundamental objective ofensuring financial stability and the business growth compulsions of theOBUs. For instance, if private banking were to be permitted, therequirements of confidentiality would need to temper the anti-money laundering safeguard measures. The RBI is today well respected in the international community as aproactive regulator in the adoption of international standards and themaintenance of financial stability while at the same time, aiding development and growth. A slew of policies adopted by RBI in the last

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few years have been aimed at strengthening the banking system. Theseinclude adoption of prudential norms, consolidated supervision, connected lending, using technology to upgrade settlement systems, payment systems, widening and deepening the various segments of the financial markets, the unrelenting emphasis on upgradation of risk management systems of financial intermediaries. The gradualist approach to financial liberalisation has paid rich dividend. The way forward appears to involveat the first step, an assessment of the robustness of the existing legislativeand regulatory framework may be done keeping in view the principles ofcross border cooperation, information sharing transparency, ongoingmonitoring. Perhaps certain overseas jurisdictions with whom India can have reciprocal arrangements can be identified, that will ensure proper duediligence while licensing OBUs and subsequent supervision. In sum, thequestion before us may not whether to have an OFC, but how can we set up a well regulated OFC that will be beneficial to the Indian economy. Thank you. (The views expressed in this paper are technical and do not represent theviews of the institution to which the author belongs).

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Table1 : Offshore Banks : Regulatory Framework in Selected Offshore Financial Centers Offshore FinancialCenterActivities and RestrictionsPrudentialRegulations

Tax PrivilegesRole of RegulatorsAnguillaBoth private and publiccompaniesmayoperate onshore and offshore. All fourdomestic banks offer offshorebanking servicesn/aNo taxes are leviedOffshore (and onshore) banks areunder the oversightof the OffshoreFinance Committeechaired by the Governor with representatives ofboth theGovernment and private sector.The EasternCaribbean CentralBank does not supervise the offshore sector.Antigua &BarbadosOffshore banks maybe legallyestablishedundertheInternational Business Center(IBC) Act (1982) and aredefined ascorporations licensed to carry out bankingbusiness in currencies otherthan those of Caricom.Minimumpaid-in capital is US $ 1 million.Licensingincludes information onshareholders, directors, and officers with satisfactoryevidencethatthe latterhavethenecessary educationand experience, and

recentfinancialinformation on theapplicant.Offshore banks must submit quarterlyreturns and an annual audit must besubmittedtotheInspector of Banks in theMinistryofFinance, which has the ability to carryout on-siteinspection.Offshorebanks have a 50 year reprievefrom taxes on profits.Thereare noincome,capital gains, or otherwealth taxonindividuals. Offshore banks areregulated by theSupervisor ofBanking and Trust Corporations and the Ministry ofFinance.The EasternCaribbean CentralBank does not supervise the offshore sector.

Page 1515Bahrain Deposits from nonbankinstitutions are allowed only ifthey are atleast equivalent toUS $ 50,000. Offshore banks cannot extend loans to residents of Bahrain; cannot offer current accounts. Locally incorporated

offshore and onshorebanks must follow thesame rules. Offshore institutions arerequired to disclose fullytheir ownership structure.They are subject toregular reportingrequirements to theBahrain MonetaryAuthority (BMA) on a monthly, quarterly, semiannual and annual basis. Prudential requirements are appliedon a consolidated basis. Taxation is minimal.Offshore banks must be licensed by the BMA, which alsosupervises them.A deposit insurancescheme is in place for all commercial banks.The BMA has the ability to providelender of the last resort (LOLR) facilities to onshore banks. Offshorebanks are excluded from LOLR support. BarbadosOffshore banks must belicensed under the OffshoreBanking Act of 1979 as aneligible company under the Companies Act or as aqualified foreign bank. Offshore banks are allowed todo business with residents such as the internationalbusiness companies (IBC) andthe foreign sales corporations (FSC).Prior to licensingsupervisors investigatethe applicants, the networth of principals and capital adequacy, as wellas background information on shareholders, directors and senior officers. Applicant institutions must provide financialstatements from shareholders controllingmore than 5% of votingstock, information on corporate structure and

approval of the parent supervisor. Offshore banks arerequired to submit quarterly returns , the Basle capital adequacycriteria for country and individual risk exposureapply.Low tax jurisdiction with an extensive web of bilateral tax treaties.Offshore banks must be licensed by the Central Bank ofBarbados, which also regulates andsupervises them. BelizeIBCs are allowed to carry outoffshore banking with appropriate licence. IBCs are prohibited fromowning shares or assets in alocally incorporated company.They cannot sell shares orborrow from a Belizeanresident.N/aTaxation is minimal. A one-off fee of US $ 100 is leviedwith registeredcapital upto US$ 50000.Offshore banks must be licensed by the Central Bank ofBelize under the 1996 Offshore BankingAct. The CentralBank also supervisesoffshore banks.

Page 1616Malaysia Offshore banks are allowed tooperate only in theInternational Offshore Financial Centre (IOFC) on the island of Labuan offBorneo.Offshore banks cannot acceptchecking accounts and extendloans denominated in the Malaysian currency to both non-residents and Malaysian

residents.No exchange controls are in place. There are stringent banksecrecy rules.Taxation is minimal.Offshore banks operating in the IOFCare not regulated bythe Banking andFinancial Institution Act of 1989, but aregoverned by separatelegislation monitored by a regulatory bodyknown as the Labuan Offshore FinancialServices Authority. Singapore Typically offshore banking is operated through Asian Currency Units (ACUs).These are operational unitswhose function is to conductbusiness in the Asia Dollarmarket. ACUs may also beoperated by onshorecommercial banks and merchant banks. In thesecases, ACUs are distinctaccounting entities separatelylicensed by the MonetaryAuthority of Singapore (MAS)ACUs accept deposits andmake loans in foreign currencies and are prohibited from doing business denominated in Singaporedollars. They cannot accepttime deposits of less than SGD 250000; operate savings account; have more than onelocation (no branches).Total credit facilities toSingapore non-bankcustomers must be less thanSGD 50 million.ACUs are exempt from several prudentialregulations, most notablythe reserve requirements(normally 6 percent), theminimum liquid assetratio (normally not less than 18 percent),limitations on investments , limitationon acquisition ofimmovable property and some of the limitationson credit facilities (limits

to a single borrower and related party or parties). Foreign ACUs arerequired to provide aguarantee from theirparent institutions ensuring liquidity ondemand to the ACUshould it run intodifficulties.ACUs are required toprovide detailed financialstatements to the MASon a monthly basis. ACUs are taxedat a concessionaryrate of 10 percent (normal corporate taxrate is 26percent)There is nowithholding orincome tax on non resident ACUsdepositors.ACUs must belicensed by the MAS , which alsosupervises them .Inspections on theaccounts of the ACUsare carried out on a regular basis.There is no formaldeposit insurancescheme. The MAShas ability to act aslender of last resort,but not an obligationto do so. In 1996, the BankingAct was amended toallow foreignregulatorsto inspectthe Singaporeanbranches of banks under their over sight. ThailandAllowed to engage in lendingand deposit taking activities in foreign currencies withnonresidents. And allowed toengage in treasury andcorporate finance activities.Cannot engage in transactionsdenominated in Bath with Thai residents.N/a

Offshore banks are taxed at a concessionaryrate of 10 percent(corporateincome tax is 30percent)Offshore banks arelicensed by the Central Bank and are subject to supervision. A deposit insurancescheme for Bahtdeposits is in place. Itis not open to offshore banks.

Page 1717The BahamasNon-resident companies,including offshore banks areallowed to operate freely inforeign currencies. Exchange control approval isrequired to operate Bahamiandollar accounts.Under the Caricom BankSupervision Harmonization Project(CBSHP), offshore banks are subject to applicationrequirements, minimumrequired levels of capitaland reserves, and externalaudits. Like onshorebanks, offshore institutions must meet requirements inthe areas of directors’qualifications, information disclosure and reporting.No income, capital orwithholdingtaxes apply.The Central bank ofthe Bahamas supervises offshorebanks. ThePhilippines Foreign banks can operateoffshore banking units(OBUs).OBUs are permitted toconduct all normal bankingtransactions with non-residents in any foreigncurrency.

Deposits from nonbankinstitutions are allowed only ifthey are atleast equivalent toUS $ 50000.Cannot conduct transactions denominated in pesos. Transactions in foreign currency with residents are strictly limited. Locally incorporatedoffshore and onshorebanks must follow thesame rules. In order to gain approvalfrom the Central bank forthe establishment of anOBU, foreign banks mustprovide a guarantee offinancial support to theOBU if need be and promise to train localcitizens in variousinternational bankingpositions. Taxation is minimalOffshore banks arelicensed by the Central bank and aresubject to supervision. A Deposit Insurancescheme (DIS) for peso deposits is inplace.It is unclear whether offshore banks mayparticipate in the DIS. United Statesof AmericaU.S banks are allowed toengage in cross bordertransactions, includingoffshore banking through headoffice internationaldepartments, foreign branches, foreign subsidiaries andaffiliates and international banking facilities (IBFs).U.S. banks are allowed toparticipate abroad ininvestment banking and otheractivities permitted to banks in many countries, but still prohibited at home.Head office internationaldepartments are subject to U.S. regulations of theirinternational lendingexposure under theInternational LendingSupervision Act.

IBFs are subject to Fedauthorization and are regulated and supervised in the same way as headoffice internationaldepartments. Reserve requirements are applied on foreign currency deposits held with IBFs when these funds are transferred to theU.S. parent institutions orlent to U.S. residents. n/a The Office of the Comptroller of theCurrency (OCC) andthe Fed are largelyresponsible forsupervising theinternational operations of U.S.banks. They carry out off-site inspections ofoffices abroad. The U.S. DepositInsurance Scheme does not apply to IBFs.Source: IMF Working Paper, WP/99/5 “Offshore Banking: An Analysis of Micro and Macro-Prudential Issues”, January 1999.