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MAE lecture: Financial consultant calls for better regulation, improved standards for offshore centers

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
January 2000
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Offshore financial centers provide financial services primarily to nonresidents. Some are seen as offering low taxation, light financial regulation, and banking secrecy. In April 1999, the Financial Stability Forum (see box, page 224) asked a working group to consider the implications of offshore financial centers for global financial stability and to make recommendations for addressing any concerns. The report of the Working Group on Offshore Financial Centers was publicly released on April 5, 2000, and on May 26, the Forum released a list of offshore financial centers, in three broad groups, designed to set priorities for assessments.

Speaking at a seminar arranged by the IMF’s Monetary and Exchange Affairs Department on June 19, Andrew Edwards, a consultant on financial and governance issues, discussed the Forum’s initiative for offshore financial centers, the implications of the initiative for the IMF, and the best way to carry the initiative forward. Edwards, previously a senior official in the U.K. Treasury, has had firsthand experience with assessment of offshore financial centers, having been commissioned by the U.K. Home Secretary to conduct a review of the regulation of the international financial centers in the three crown dependencies—Jersey, Guernsey, and the Isle of Man. Edwards’s report was published in November 1998. Although the review was met initially with resistance from the concerned centers, Edwards said the overall results were positive.

“Offshore financial centers do have the right to exist,” Edwards said, and to do business like everyone else. But, he added, they do not have the right to break every rule, commit economic crime, or “rock the good ship of international stability.” Our job, he said, is to make sure these centers play fair and straight. For this reason, Edwards said, he was encouraged by the Forum’s willingness to “grasp the nettle” of offshore financial center regulation.

IMF Board to discuss Forum proposal

The IMF Executive Board was asked by the International Monetary and Financial Committee in April to assess the relevant recommendations of the Financial Stability Forum; and the Board will shortly discuss the Forum’s recommendation that the IMF take on assessments of offshore financial centers.

Forum initiative

While noting that offshore financial centers have not played a major role in creating systemic financial problems, the Forum’s report nevertheless cautions that these centers have featured in some crises, and, as national financial systems grow more interdependent, future problems in offshore financial centers could have consequences for other financial centers. Offshore financial activities, however, need not be a disruptive element that threatens global financial stability, the report points out, provided they are well supervised and the supervisory authorities cooperate, as is the case for some offshore centers. At the same time, offshore financial centers that are unable or unwilling to adhere to internationally accepted standards for supervision, cooperation, and information sharing do create a potential systemic threat to global financial stability. Such centers, the report suggests, are weak links in an increasingly integrated international financial system.

To address the concerns posed by some offshore financial centers, the report recommended a framework to encourage these jurisdictions to adhere to relevant international standards. The framework identifies priority standards for offshore financial centers and recommends that the IMF take responsibility for developing, organizing, and carrying out a process for assessing the centers’ adherence to these standards.

The Working Group on Offshore Financial Centers began by conducting a survey of banking, insurance, and securities supervisors in both onshore and offshore jurisdictions to obtain information on the quality of supervision and the degree of cooperation in jurisdictions with significant offshore financial activities. The purpose of the survey was to help set priorities for the standards assessment process recommended by the working group in its report. Based on the survey, the jurisdictions were arranged into three “merit categories” reflecting their perceived quality of supervision and degree of cooperation. The findings of this survey were released to the public—a decision that Edwards said was “constructive.” There has to be some form of accreditation, he said, and the public ranking of jurisdictions is a good start.

Edwards was also encouraged by the Forum’s recommendation that the IMF take the lead in carrying out the initiative. An international agency is needed to monitor and direct the accreditation process, Edwards said, to allow us to move beyond the “imposition of standards and sanctions by major countries that take the law into their own hands through special penalty taxes or scrutiny of the financial activities of private citizens.” The IMF, with its expertise in the area of financial markets and its near-universal membership, is well suited to such a task, he said.

Remaining challenges

Despite these encouraging first steps taken by the Forum, Edwards voiced several concerns about the ability of the initiative to succeed. For one thing, international standards are not yet well defined, even for financial institutions and markets. For example, there is little guidance on the ability of local centers to service or regulate particular activities; the conduct of business in all sectors; reinsurance and the solvency of insurance operations; regulation of conglomerates; and division of responsibilities and relations between home and host supervisors outside the banking industry.

In addition, there are gaps in international standards, and thus no guidance for company registrations, trusts, and providers of financial, company, and trust services, which, Edwards said, made them vehicles for “appalling abuse” by trustees and those setting up trusts. International standards for dealing with conflicts of interest are lacking: Are regulators independent of the politicians? Is the judiciary independent? Prosecution and judicial frameworks are as important as proper regulation, Edwards said, but many centers lack such frameworks. Another major lacuna in international standards is the absence of an effective mechanism to combat economic crime. The Financial Action Task Force, which was established in July 1989 to prevent banking systems and financial institutions from laundering the proceeds of criminal activities, does some work in this area, Edwards said, but it is by no means comprehensive.

A further concern is that even if an offshore financial center nominally observes all international standards, it might still be carrying out risky activities; for example, Edwards said, a center may have adequate banking supervision, but “an appalling record in company registrations, trusts, and international cooperation on economic crime, including tax evasion.”

Role of IMF

The Forum has urged the IMF to lead the effort to assess offshore financial centers’ adherence to international standards. But this task raises several questions, Edwards noted, including how the IMF will approach the task and what the assessments will cover. The Forum report suggests that the priority for assessment be placed on those offshore centers where procedures for supervision and cooperation are in place but where there is substantial room for improvement. The report also suggests a five-stage review process involving public commitment by the center to observe standards; self-assessment, assisted by an external monitor; technical assistance; external assessment; and monitoring. This process, Edwards said, is a good starting point, but the deficiencies and lacunae in international standards are a serious problem. It would be harmful, he said, to give centers a high rating if they satisfied certain standards but fell short in the important ones, such as conflict of interest, economic crime, tax competition and secrecy, and prosecution and judicial frameworks.

Edwards suggested that the best way to proceed is to associate the offshore financial centers with the review process from the beginning—for instance, by setting up a forum for periodic discussion with the centers to counter protests about imposition of standards from above or outside. The IMF is particularly suited to convene such a forum, Edwards said.

Another important component of the review process is division of labor; reviews should be treated as joint efforts with center authorities. Drawing on his experience with the Channel Islands, Edwards said it was of the utmost importance that the review process involve no surprises. It should be completely transparent, and the steps to be followed set out in the early stages of the process.

It is essential, Edwards said, that the assessment results be published: “publication is the most powerful weapon of all to make bad centers good.” Friendly, private negotiations between the center authorities and the IMF will not work, Edwards cautioned; offshore financial centers have to believe that the world will go after them if they do not improve. It is thus also essential that sanctions be imposed. These sanctions could take the form of agreement by major countries to take discriminatory action against noncompliant centers, especially in the tax field, but also in financial areas such as market access, capital requirements, and special permission. The odium for the sanctions, however, would not fall on the IMF, whose function remains to make the assessment and publish the results, Edwards said.

In addition to directing the review process, Edwards said, the IMF should encourage efforts to fill in the remaining gaps and correct the deficiencies in international standards mentioned earlier. In some of these areas, such as economic crime and tax issues, the IMF should keep in close touch with other agencies pursuing similar agendas, such as the Financial Action Task Force and the Organization for Economic Cooperation and Development.

Finally, Edwards said, in time, the review process could be generalized, extending to all financial centers and further protecting the international financial system against instability and disruption.

Financial Stability Forum

The Financial Stability Forum was convened in April 1999, under the chairmanship of Andrew Crockett, general manager of the Bank for International Settlements. The result of an initiative of the finance ministers and central bank governors of the Group of Seven industrial countries, the Forum’s mission is to promote international financial stability through the exchange of information and through international cooperation in financial supervision and surveillance.

The Forum brings together on a regular basis national authorities responsible for financial stability in significant international financial centers and institutions, sector-specific international groupings of regulators and supervisors, and committees of central bank experts. The Forum seeks to coordinate the efforts of these various bodies to promote international financial stability, improve the functioning of markets, and reduce systemic risk.

The report of the Working Group on Offshore Financial Centers is available on the Forum’s website: http://www.fsforum.org/.

Ian S. McDonald

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