I.  Introduction

1.  The purpose of this paper is to consider how the Fund should extend its work to include assessments of the vulnerabilities stemming from the use of offshore financial centers. The paper responds to the International Monetary and Financial Committee's Communiqué of April 16, 2000, which noted the reports of the Financial Stability Forum (FSF), including the recommendation that the Fund take on assessments of offshore financial centers.¹

2.  Offshore finance can be defined as the provision of financial services by banks and other agents to non-residents, including the bank intermediation role of taking deposits from non-residents and lending to non-residents. Other services provided include fund management, insurance, trust business, asset protection, corporate planning and tax planning.

3.  Amongst the many definitions of Offshore Financial Centers (OFCs), perhaps the most practical characterizes OFCs as centers where the bulk of financial sector transactions on both sides of the balance sheet are with individuals or companies that are not residents of OFCs, where the transactions are initiated elsewhere, and where the majority of the institutions involved are controlled by non-residents. Thus many OFCs have the following characteristics:

• Jurisdictions that have financial institutions engaged primarily in business with non-residents;

• Financial systems with external assets and liabilities out of proportion to domestic financial intermediation designed to finance domestic economies; and

• More popularly, centers which provide some or all of the following opportunities: low or zero taxation; moderate or light financial regulation; banking secrecy and anonymity.

4.  A companion Background paper provides insights into the business of OFCs, together with information on a broad range of international initiatives relating to OFCs.

5.  The Interim Committee, together with the FSF and the G7, have expressed concerns about offshore finance and offshore financial centers. ² These reflect anxieties about ineffective financial supervision, strict bank and corporate secrecy rules that hinder investigation, arrangements that facilitate money laundering and other financial crimes, and loss of tax revenues onshore. On supervision, concerns about offshore centers include weaknesses in licensing, "know your customer" requirements, and other supervisory weaknesses that make more difficult consolidated supervision by countries whose financial institutions have operations in OFCs. Evidence of these problems can be seen in the crises in Venezuela, Ecuador, and Thailand (see Section II.A below) and in the results of the Basel Core Principles Assessments where, out of 21 countries assessed on the score of consolidated supervision, serious weaknesses were found in 14.³

6.  Analysis of the risks posed by offshore finance (see Section II.A below) is hindered by a lack of statistics in many areas. As Section II.B of the Background paper shows, only some on-balance sheet activities of banks are reported; most other activities are not, including the size of funds managed in OFCs, nor those held in OFCs by trusts. There is a good case for seeking more information, and increased and better participation by OFCs in BIS reporting and in the Fund's Coordinated Portfolio Investment Survey.

7.  The potential for financial system instability in an onshore country underscores the need to better understand the nature of OFC activities and interlinkages with the global financial system. In this regard, there are three main concerns about OFCs. First, the existence of some lightly supervised OFCs encourages regulatory arbitrage that has resulted in the establishment of rogue financial institutions. Second, there are impediments to consolidated supervision in the OFCs and/or it is not practiced effectively by the home country supervisors, resulting in supervisory gaps over important activities of a consolidated financial institution. Third, there is a lack of information about the volume and type of activities conducted in OFCs.

8.  In a recent report, the FSF has proposed that the Fund take responsibility for developing and carrying out assessments of OFCs.⁴ Box 1 summarizes the recommendations of the FSF. The FSF has also published its categorization of OFCs for the purpose of establishing priority jurisdictions for assessment.⁵ The Financial Action Task Force (FATF) has published its list (primarily OFCs) of noncooperative jurisdictions with respect to the implementation of measures to control money laundering. The OECD is planing to release shortly a report listing tax havens. In addition, a report by KPMG commissioned by the UK authorities and by the six main UK overseas territories is expected to be published shortly. The Fund would be able to draw on this and other experiences (see Annex for details) once the Board has come to decisions.

9.  The Fund held a Consultative Meeting in April, in order to hear the views of outside experts, from onshore and offshore centers and from international agencies, on a possible role for the Fund with regard to offshore finance. The meeting was attended by some 30 external representatives, and by observers from the offices of some Executive Directors. At the meeting there was a general welcome for Fund involvement in conducting assessments, but a deep concern about the FSF's intention to publish a ranking of OFCs in three categories.

10.  This paper suggests how the Fund can take forward work on OFC assessments, on technical assistance, and work on statistics. Following an outreach exercise to offshore and onshore centers to explain the content and procedures of the program, a three module approach is proposed:

Module 1   Self-assessments by OFCs, assisted by outside experts

Module 2   Stand-alone Fund assessments of all relevant supervisory standards, e.g., Basel observance of Core Principles

Module 3   Overall FSAP/FSSA analyses, covering all significant risks and vulnerabilities, building on Modules 1 and 2, and providing a link to Fund Article IV surveillance.

The assessment initiatives can be launched simultaneously, though the timing and choice of modules need to be flexible, depending on the circumstances of each OFC. Much of this work will have resource implications for the Fund: requiring extra resources or displacing existing commitments.

11.  In addition to technical assistance to undertake these assessments, the paper suggests ways of developing, in cooperation with other providers, a program of technical assistance designed to help OFCs improve supervisory standards, and of improving the collection of statistics by OFCs, especially their participation in international statistical data collection.

12.  The paper does not address the issues of "harmful tax competition."⁶ FAD has a role in providing technical assistance to improve tax policy and tax administration.

13.  After noting the Fund's interests in financial stability, the growing concerns about the use of offshore finance, and the work of the FSF, the paper considers how far these concerns are justified, and sets out the main considerations relevant to the Fund's response. A central element is how in practice the Fund is able to carry out such assessments, and what they would cover. This provides some basis for looking at resource costs, the need to involve other agencies, and how the output from work on OFCs fits into the existing financial sector work of the Fund.

II.  Key Issues

14.  There have been a number of failures of offshore banks in addition to the well-known cases of Bank of Credit and Commerce International (BCCI) in 1991 and Meridian International Bank in 1995. All have been relatively small banks, and of no systemic importance. Because of advances in prudential and supervisory frameworks under the auspices of the Basel Committee on Banking Supervision as well as increased international awareness,⁷ it is now unlikely that a bank owned and incorporated in an OFC could establish operations in other major financial markets on anything like the scale achieved by BCCI, or even Meridian Bank.

15.  Offshore banking operations have, however, played a role in the recent financial crises of Latin America and Asia.⁸ In Latin America, offshore establishments were used as alternatives to domestic financial institutions that were often subject to strict prudential regulations and high reserve requirements. Moreover, tax advantages as well as political and economic uncertainty onshore fueled the use of offshore establishments. The absence of effective consolidated supervision by onshore supervisors proved to be the most important factor in permitting the exploitation of regulatory arbitrage offered in some OFCs through the transfer of assets and liabilities between offshore establishments and parent banks onshore. In Asia (for example in Thailand), regulatory and fiscal advantages as well as lower borrowing costs, offered in some OFCs induced many Asian banks and corporations to tap international capital markets through offshore establishments (as an illustration, see Chart 2 of the Background paper). Large, undetected, and poorly accounted for offshore funds contributed to credit expansion in the region, led to increasing exposures to liquidity, foreign exchange, and credit risks, and had systemic effects on the financial systems of individual countries concerned. In addition, the failures of BCCI and Meridian Bank have resulted in substantial damage to the banking sectors of certain smaller countries involved. Another noteworthy case with an OFC involvement was the hedge fund Long-Term Capital Management (LTCM) whose incorporation offshore did not prove to be an issue in the course of the workout, but there were concerns that any bankruptcy of LTCM would have been complicated by its offshore status.

16.  The cases of Argentina (1995), Venezuela (1994), and, more recently, Ecuador, show that a large, leveraged, and, in the worst case, insolvent offshore establishment designed to escape the reach of supervisory authorities onshore may disrupt the operation of its onshore affiliated bank. In other instances, offshore establishments may become substantially larger, in terms of assets and liabilities, than affiliated banks onshore (as in the case of some private banks in Costa Rica). Because offshore banks may exploit such opportunities for regulatory arbitrage, transferred funds can be used to finance connected onshore activities—real estate and construction, for instance—further concentrating onshore risks in offshore financial centers, some of which are inadequately supervised. The solution lies not only in better supervision in OFCs, but also in more effective consolidated supervision by home countries. Attempts to deal with it only at the OFC level are likely to lead to the movement of such business to other places, where information may be even more difficult to obtain.

17.  The Fund, in collaboration with other international organizations and relevant standard-setting bodies, has stepped up efforts aimed at strengthening member countries' capabilities for the implementation of effective consolidated supervision, including through the Financial Sector Assessment Program, Basel Core Principles Assessments, as well as technical assistance activities. National supervisory authorities, on their part, have been implementing a number of practical safeguards and countermeasures, partly as a result of the negative experiences described previously, to deal with risks surrounding the use of OFCs. Box 2 provides examples of such practical measures.

18.  Notwithstanding these efforts, implementing effective consolidated supervision becomes an even more difficult task than is normally the case when OFCs are involved. Many OFCs offer opportunities for the exploitation of complex corporate structures and relationships among various jurisdictions involved for the purposes of complicating, or even impeding, consolidated supervision in practice. For instance, "shell branches" (i.e., booking offices that serve as registries for transactions arranged and managed from other jurisdictions) can be used to exacerbate the already complex coordination problems arising in normal cross-border banking where two supervisory authorities (i.e., the home and host country supervisors) are involved, by adding a third one.⁹ Moreover, so-called "parallel" banks (i.e., banks established in different jurisdictions that have the same owner(s) but are not affiliated within the same corporate structure) can be used to transfer business and risks to offshore banks which are not directly related to the onshore establishment but are under the control of the same shareholders (often individual or family controlling shareholders) to make the detection of overall risks and consolidation of financial accounts very difficult to achieve. The use of parallel-owned banks was a feature of the 1994 crisis in Venezuela, for example.

19.  Some OFCs give rise to, or exacerbate, financial vulnerabilities both on- and off-shore in so far as: (1) they create greater challenges than normal cross-border banking for the implementation of effective consolidated supervision; (2) standards of financial supervision in many OFCs—not only in banking, but also in other financial services—are perceived to be inadequate; and (3) insufficient statistics and hard data are available to form a comprehensive view on the size of activities taking place and the risks involved in the financial and corporate sectors. To the extent that such risks materialize, they may affect some OFCs themselves if there are no effective firewalls which ensure that offshore business does not impact on domestic firms. Moreover, the risks may affect individuals and businesses from other countries when activities are routed through some OFCs. There is also serious risk of reputational damage to an OFC economy, for example, a loss of business and employment, if it is perceived not to supervise adequately, nor to guard effectively against money laundering.

20.  Therefore, despite the lack of major systemic problems to date, some OFCs and offshore operations have the potential to become the source of more serious vulnerabilities, nationally as well as globally. There is a need for a better understanding of the operation of OFCs and surrounding risks. In order to prevent or limit these potential vulnerabilities, there is, therefore, a case for the Fund to include the provision of offshore financial services in its assessments of financial vulnerabilities, in both on and offshore centers.

21.  Many of the concerns about offshore financial activities are already being addressed by a wide range of international initiatives.¹⁰ Table 3 in the Background paper lists 15 such initiatives which cover standards-setting; technical assistance; and assessments of observance of standards, which can be undertaken through peer review, self-assessment, or by an external agency. In this last category, which is perhaps most relevant to the possible work of the Fund, are the activities of the Financial Action Task Force (FATF), and the OECD.

22.  FATF has established a program for mutual evaluations of FATF member countries and their compliance with the 40 recommendations. These go into much greater detail than the Basel Core Principles Assessments with regard to anti-money laundering practices relating to law enforcement and justice ministry matters and include making money laundering a crime, methods for confiscation of assets, and international cooperation among the international law-enforcement community, including mutual legal assistance in criminal matters between countries.

23.  The mutual evaluation is a peer review process whereby teams of evaluators conduct a peer review of member countries. An outgrowth of the mutual evaluation exercise is that regional subgroups modeled after FATF are conducting similar mutual evaluations among their member jurisdictions. More recently, FATF has assessed the extent to which countries and territories are cooperating in the fight against money-laundering. FATF published on June 22, 2000, a list of fifteen jurisdictions (mostly OFCs) judged to be non cooperative with FATF rules.¹¹

24.  Tax advantages are generally perceived as the single biggest reason for the use of OFCs. The OECD is conducting an exercise to review OFCs and other jurisdictions to determine whether they engage in "harmful tax competition." The OECD is planning to release on June 27 its own list of tax havens. OECD member countries may take counteracting measures against uncooperative tax havens, but these defensive measures will not be undertaken before July 1, 2001.

25.  Related to the money-laundering issues are concerns about what are known as International Business Companies (IBCs) or nonresident companies, and of nonresident trusts, for which some OFCs have separate arrangements.¹² The complicating aspect of the IBCs and nonresident trusts is that by design they have been created to provide an important degree of confidentiality for the beneficial owners. While IBC and trusts may serve legitimate purposes—see the Background paper—they can also be used for improper ones, including (i) their use to engage in illegal activities directly or (ii) holding the proceeds of illegal activities. There are no international standards for regulating directly IBCs and nonresident trusts, which now number in the hundreds of thousands, nor is there a consensus developing as to how individual IBCs and nonresident trusts could be regulated, in offshore or onshore centers. That said, some OFCs in the Caribbean and the UK Crown Dependencies have begun what should prove to be a useful process of registering and regulating providers of services to those establishing trusts and companies.

26.  The main approach used in OECD countries to thwart the improper use of IBCs and nonresident trusts by financial institutions is to impose controls over how the vehicles interact with the financial system. In this regard, the regulatory agency requires that a financial institution imposes so-called "know your customer" (KYC) requirements on IBCs and nonresident trusts to ensure that the financial institution has some level of knowledge of the ultimate beneficial owner controlling the accounts. The FATF recommendations, as well as the methodology for the Basel Core Principles Assessments, include criteria for reviewing the efficacy of KYC requirements.

27.  In the area of statistics, the BIS collects data from selected offshore financial centers which are included in the coverage of the BIS' international banking statistics; efforts have been made to improve the quality and timeliness of these data for use in balance of payments compilation and in the assessment of external vulnerability. Under the auspices of the Fund, an international statistical initiative--the Coordinated Portfolio Investment Survey--is being undertaken to improve data on countries' external liabilities on the basis of creditor-country data, including those pertaining to offshore financial centers. The Fund also collects and disseminates balance of payments and monetary statistics for some offshore centers.

28.  The mandate of the Fund, in exercising the powers conferred by the Articles of Agreement, includes financial assistance (use of Fund resources), surveillance, and technical assistance.¹³ Executive Directors have agreed that the FSAP has an important role to play in bringing considerations of financial system stability into the Fund's Article IV surveillance of member countries.¹⁴ Most OFCs (see below) potentially come within the scope of the work of the IMF, which can feed into surveillance.

Dependencies of Members

29.  According to Article XXXI, Section 2(g), a Fund member is responsible for its dependent territories' compliance with membership obligations: "By their signature of this Agreement, all governments accept it both on their own behalf and in respect of all their colonies, overseas territories, all territories under their protection, suzerainty, or authority, and all territories in respect of which they exercise a mandate." While there may not be separate consultation in respect of such territories, the consultation with the member should in principle cover them and, if so agreed between the Fund and the member, there could be a separate Staff Report (e.g., Hong Kong, SAR) as part of the consultation process with the member. Although the proposed assessments by the Fund, as set out in Section III.B, will initially be done on a voluntary basis, and not in terms of its formal surveillance mandate under Article IV, the consent of the Fund member concerned will have to be obtained in respect of the assessment of an OFC which is a dependency of that member.

30.  Of the list of 42 OFCs considered by the Financial Stability Forum, in its press release of May 26, 2000, 23 OFCs are members of the Fund, and 13 OFCs are dependencies or territories of members of the Fund (see Table 2 of the Background paper).

Nonmembers

31.  Nonmembers are not subject to any obligations under the Fund's Articles of Agreement. The Fund, however, can provide policy advice and technical assistance to the authorities of nonmembers, including nonmember OFCs, if requested to do so; and has done so in the past. Therefore, engagement with nonmember OFCs could take place in the context of technical assistance-type arrangements. Of the 42 OFCs considered by the Financial Stability Forum, only six, all small, are nonmembers of the Fund.¹⁵

32.  The FSF has recommended that the Fund take responsibility for developing, organizing and carrying out an assessment program for OFCs. In selecting the OFCs for assessment, the FSF recommends that priority be placed on those centers where procedures for supervision and cooperation are in place, but where there is substantial room for improvement. Priority would also be given to those jurisdictions with the most significant financial activity. The FSF published its list of priorities in a press release dated May 26. This classified 42 OFCs into three groups and recommended that Fund assessments concentrate on Group II.¹⁶

33.  The FSF intention is that assessments would measure observance by OFCs of a series of individual priority standards selected by the FSF (see Box 3). These priority standards were drawn from sets of standards developed by international bodies (e.g., the G7, Basel Committee on Banking Supervision, the International Organization of Securities Commissions (IOSCO), the International Association of Insurance Supervisors (IAIS), and the Financial Action Task Force). The standards focus on cross-border cooperation and information sharing; essential supervisory powers and practices; and anti-money laundering measures. As well as financial supervision, the FSF emphasizes a review of standards pertaining to law enforcement and other crime interdiction activities related to financial transactions.¹⁷

34.  The FSF proposed a menu of incentives to enhance adherence to international standards. Five main types of incentive were proposed:

• Disclosure, including OFC progress in implementation;

• Membership of international groupings, such as IOSCO;

• Provision of technical and financial assistance;

• Supervisory incentives, such as market access, increased reporting or capital requirements; and

• Other official incentives, such as restrictions on financial transactions with counterparties located in problematic OFCs.

35.  Most of these incentives are matters, not for the Fund, but for supervisory groupings, for individual supervisory agencies, or for other international agencies. A feature common to virtually all proposals is that they require knowledge—which could be in summary form—of the results of the assessments; and most if not all of the incentives would lead to public disclosure of the assessment results. Hence, it is necessary to consider the implications of these incentive proposals against the policies adopted thus far for disclosure of the Fund=s financial vulnerability studies, particularly the FSSA.¹⁸

36.  The report of the FSF provided a "very preliminary estimate" of resource costs to the assessment program.¹⁹ It envisaged that 25 OFCs would be assessed by outside experts within a three-year time period, with each assessment needing between 2 and 4 experts working about five weeks each, i.e., some 10–20 staff weeks for each assessment.²⁰ In terms of the timetable for the 25 OFCs, the FSF suggests that five OFCs are assessed in the first year, followed by ten in each of the following two years.

37.  The objective of the suggested Fund assessment exercise for offshore finance is to complete, through a step-by-step process, a wide-ranging set of voluntary assessments of vulnerabilities, observance of standards and establishing priorities for strengthening supervision and regulation. The program, managed by the Fund, includes close collaboration with agencies such as the Basel Committee, the World Bank, FATF, UN, IOSCO, and IAIS.

38.   Initial outreach exercise: In order to launch the program in a uniform way and to explain its content and assessment process, as an introductory step, there is a need for the Fund to invite all relevant offshore and onshore centers to consultative meetings. Based on the outcome of these meetings and further discussions, the work in individual OFCs would be organized according to three modules:

Module 1: Assisted self-assessments, with technical assistance from experts, as needed, to help OFCs assess their compliance with particular standards. Such experts could be drawn from supervisory agencies, central banks, consultants, or Fund staff.²¹ The resulting "assisted self-assessment" would be the responsibility of the OFC concerned, not the Fund. These assisted self-assessments would be most useful as precursors to the Fund assessments in Module 2, and to the fuller assessments of Module 3, and making use of agreed methodologies. (Evidence from Basel Core Principles Assessments points to self assessments being useful only under rigorous conditions.)

Module 2. Stand-alone staff assessments of standards: these would be based on the financial specialization of the jurisdiction concerned—e.g. Basel Core Principles if banking; IAIS supervisory principles if insurance, but would cover an entire standard, not just parts of it (as proposed by the FSF). Where standards assessment relates to BCP, IAIS, or IOSCO, it would be desirable to have, in parallel or in advance, a FATF module to serve as source material and amplification to underpin the assessment of anti-money laundering measures and information exchange in Basel, IOSCO and IAIS principles. Stand alone Fund assessments could draw on Module 1 and constitute a technical input to a comprehensive assessments using the FSAP Model. Where external assessments of jurisdictions have already taken place,²² these would be reviewed to ensure consistency of methodology and could be a precursor to a Fund led assessment under Module 2.

Module 3. Comprehensive assessments of risks and vulnerabilities, institutional preconditions, and standards observance prepared by the Fund—and where appropriate in collaboration with the Bank. Such assessments, within the framework of the FSAP/FSSA, would cover all relevant supervisory standards in the OFC; the extent to which onshore centers carry out effective consolidated supervision in respect of off-shore jurisdiction; vulnerabilities and risks arising from linkages between OFCs and onshore centers; and the extent to which standards observance helps address the risks. These assessments for OFCs could provide a link to Article IV surveillance.

39.  Technical assistance (TA) should be available to OFCs to help them implement improvements in supervision and in law, as well as to help with self-assessments. Such TA could be made available rapidly, and at any point in the sequence: before, during, or after any one of the assessment modules. See also Section D.

40.  The timing and choice of modules needs to be flexible, taking account of the particular circumstances of each OFC. For a particular jurisdiction, these three modules could be implemented sequentially; or jurisdictions with important systemic issues and a large scale of operations could have comprehensive assessments through an early FSAP to be followed up by a commitment by the OFC to a program of reform priorities, including technical assistance where appropriate.

41.  With regards to the issues of disclosure under these modules, publication of Module 1 outputs, which would be the property of the commissioning OFC, is a matter for the OFC concerned—some, perhaps many, OFCs would want such reports to be published. Stand-alone assessments under Module 2 would be staff documents that with the approval of Fund management and the OFC concerned could be shared with interested counterparties, and if agreed more widely. The assessments under Module 3 yield FSSA reports, including ROSC modules, which follow existing Fund publication guidelines.

42.  To date under the FSAP program, there have been reviews of two member countries, Lebanon and Ireland, that are considered to be an OFC or have significant activities involving offshore finance, respectively. These assessments did not focus on the linkages between the offshore and onshore jurisdictions, because these activities did not appear to represent a material source of vulnerability to the stability of the domestic financial sector or economy. In fiscal year 2001, the Fund and the Bank intend to conduct up to 24 FSAPs of member countries, (which on present preliminary plans could include two jurisdictions regarded as OFCs). To increase the number of OFC assessments beyond the two within the current FSAP schedule for FY2001, the program for that year would need to be expanded. The completion of FSAP work for additional OFCs, and the initiation of preparatory work in the form of Modules 1 and 2, all have resource implications, discussed more fully in Section E.

Scope of Assessments

43.  In each of the three modules, compliance should be assessed with the supervisory standards applicable to the financial sector. In the broader FSAP approach, Module 3 should also identify vulnerabilities and the conditions under which offshore finance can contribute to sustainable economic growth in OFCs. The proposed scope of FSAP assessments of OFCs is summarized in Box 4, which differs from the FSF proposal in Box 3 in the following main ways:

1) Supervisory standards: Box 4 envisages coverage of all standards relevant to the particular OFCs being assessed, because a licensing jurisdiction has an obligation to ensure an appropriate level of supervision of all those entities that it licenses, and because full assessments are more suited to surveillance type work. So under Modules 2 and 3 all standards relevant to a particular jurisdiction would be assessed, as in Box 4. This contrasts with the partial coverage of standards envisaged by the FSF: within each standard, the FSF advocated selective coverage, for example 7 out of 25 Basel Core Principles for banking supervision, and 6 out of 25 insurance principles.

2) The FSF proposal in Box 3 envisages a wider coverage of financial crime, including law enforcement efforts to combat money laundering; whereas in Box 4, all supervisory aspects of money laundering covered by Basel, IOSCO, and IAIS are included in the assessments, but this work will not cover law enforcement aspects, handled by FATF.

3) Box 4 envisages assessments of vulnerabilities and work on linkages between OFCs and relevant onshore centers, which are responsible for licensing and supervising many of the financial institutions set up in OFCs; whereas the FSF proposal in Box 3 is limited to assessments of standards in OFCs. Box 4 also ensures that assessments of OFCs would cover areas like company registration and trusts, where international standards have not been developed

44.  In each of the assessments, Module 1, 2, or 3, flexibility will be required as to which sets of standards would be considered. Not all sets of standards will be relevant for all OFCs. For example, most OFCs do not have capital markets activities, so in these cases the IOSCO principles will have little relevance. In some other cases, the level of activity in the OFC may be so small as to make an assessment unnecessary. This flexibility can be governed by the particular circumstances of each OFC—case by case.

45.  In reviewing relevant sets of standards for the assessments of OFCs, under modules 1, 2, or 3 there are four key concerns: (i) licensing practices for the establishment of financial entities; (ii) proper "know your customer" and other anti-money laundering requirements; (iii) institutional arrangements in place—both onshore and offshore—to ensure a properly functioning mechanism for consolidated supervision and information sharing; and (iv) reporting requirements, especially with regard to prudential supervision. There is an important role for financial sector supervisors in ensuring that financial institutions are not used for money laundering. For each of the sets of supervisory standards developed by the BCBS, the IAIS and IOSCO there are specific principles to which assessors should pay particular attention.²³ The most developed among the standards are the Basel Core Principles for Effective Banking Supervision and the accompanying methodology, which were prepared by the Basel Committee on Banking Supervision (BCBS). Specifically, core principle 15 draws on the 1988 BCBS document: "Prevention of Criminal Use of the Banking System for the Purpose of Money Laundering," but also refers to the FATF 40 recommendations to combat money laundering. Core principle 15 specifically includes criteria for "know your customer" requirements, suspicious transaction reporting, and sharing of information with other supervisors and law enforcement agencies, both domestic and foreign.

What Should Be Assessed?

46.  The assessment of relevant codes and supervisory standards, through Modules 1, 2, or 3, will in almost all cases include banking supervision, but may also include securities and insurance regulation as well. In addition, given the fact that most financial institutions in OFCs are branches and affiliates of foreign institutions, particular attention needs to be given to arrangements for the exchange of information with other supervisors. For example, assessments will need to be made of compliance with the Basel Committee's 1996 Report on the Supervision of Cross-Border Banking.²⁴

47.  As noted previously, there have been cases where financial institutions, or their shareholders and affiliates, have been able to use operations in OFCs to avoid scrutiny by supervisory and other authorities in their home country with the result that the financial stability of the country concerned has been significantly affected. In most cases, material use of such arrangements should be captured by the exercise of effective consolidated supervision by the supervisory authorities in the country concerned (the home supervisor in the onshore center). But for such supervision to be effective, the host supervisor for any foreign branch or affiliate, including one in an OFC, needs to play the role assigned to it under the Basel Concordat, as subsequently elaborated by the 1992 Standards²⁵ and the 1996 Report on the Supervision of Cross Border Banking published by the Basel Committee. The will and capacity of the supervisory authorities in OFCs to provide information and to allow access to records by the home supervisor, including for the purpose of anti-money laundering practices, is therefore one element that will need to be assessed with particular care.

48.  In the case of many institutions in many OFCs, the primary records and the decision making management are not present in the OFC but in the institution's head, or parent, office, or in another center. It will be necessary, therefore, for assessors to visit relevant home country authorities to establish their views as to the extent to which standards for the exchange of information and record keeping are adequately met in practice. It may be convenient to carry out this aspect of the assessment by one visit to each major home country in respect of a number of OFCs.

49.  It will also be necessary to carry out assessments of the extent to which onshore centers carry out effective consolidated supervision in respect of the offshore centers selected. There are serious gaps because—as often found in the Basel Core Principles Assessments—many supervisors do not practice effective consolidated supervision. In the review of onshore centers, the assessors' emphasis will be directed to four key concerns largely similar to those identified earlier for offshore centers: (i) licensing/authorization practices of the home country supervisor for the establishment of branches, subsidiaries and other affiliates of financial entities outside of the home country including OFCs; (ii) whether the financial institutions in the home country impose proper "know your customer" and other anti-money laundering requirements on their foreign affiliates; (iii) whether the home country supervisor has proper institutional arrangements in place to ensure a properly functioning mechanism for consolidated supervision and information sharing; and (iv) are reporting requirements back to the home-country supervisor, especially with regard to prudential supervision, sufficient to monitor material activities conducted by branches, subsidiaries and other affiliates outside of the home country.

50.  Assessments in both off- and onshore centers make it possible to analyze institutions in OFCs, by country of origin, and by whether that country practiced effective consolidated supervision. Such analysis would help determine the vulnerabilities in the OFCs and in onshore centers. It is worth stressing that those most at risk are likely to be, not residents in the OFCs, nor in the bigger and better regulated onshore centers, but residents in other onshore centers where consolidated supervision is ineffective.

Who Should Assess?

51.  An assessment of compliance with standards in OFCs, under Modules 1, 2, or 3, is a specialist undertaking. There is a limited number of experts in this field. Some of the work can be done by those familiar with regular on-shore activity, but it is desirable that at least one member of any team has more specialist knowledge. The FSF report suggested that the Fund look to other members of the Forum for assistance in this regard. It also suggested that supervisors from the more advanced OFCs could help. For assessments of offshore centers, Fund-led teams in Modules 2 and 3 need to include: experts from supervisory agencies, including from offshore centers; and relevant World Bank experts, depending on the mix of business in the OFC being assessed. It will be necessary to broaden the range of cooperating institutions, mobilize additional expert support and develop cooperation with FATF. More broadly, and regardless of the precise modules, carrying out the work requires a coordinated and cooperative effort. Hence the suggestion (Section III.B) for a preparatory outreach exercise. For a description of some existing external assessments of OFCs, see the Annex.

Outputs from Assessments of OFCs

52.  If the suggested approach is adopted, the outputs will be as follows. For Module 1, reports depend on, and are the property of, the commissioning OFC.

53.   Reports on Module 2, stand-alone assessments, are staff technical assistance reports which could guide the authorities in implementing reforms, and form part of the more comprehensive work under Module 3. Reports under Module 2 are staff documents that with the approval of both management and the OFC authorities can be published.²⁶

54.  Module 3 is an FSAP and the first output is a report consisting of an overall assessment of the extent to which observed OFC practices may pose threats to the financial stability of the jurisdictions concerned and/or increase the potential for contagion of offshore risks to relevant onshore economies, as well as an assessment of observance of relevant standards on the part of the authorities of the OFCs concerned. A second output from assessments of OFCs under Module 3 is a detailed survey of the effectiveness of compliance with consolidated supervision on the part of the home supervisory authorities of those countries whose financial institutions have affiliates in the OFCs being assessed. Such a survey could document, as far as information is available, the absence of or weaknesses in consolidated supervision; and also document how far the home country supervisors, in practice, extend the scope of their work to affiliates in the offshore centers being assessed.

55.  Based on both reports, a summary paper from Module 3 will be presented to the Fund Executive Board including an assessment of vulnerabilities and risks arising from the use of particular OFCs, an implementation/action plan by on and offshore authorities, and any proposals for follow-up technical assistance, including through Technical Cooperation Action Plans (TCAPs) and other sources. This paper then becomes part of the FSSA report for the OFCs concerned if these are members, or can be treated as additional modules of the FSSAs for relevant member countries if the OFCs concerned are dependencies or territories. Summary assessments of the observance of standards and codes in these FSSAs are the financial sector modules of the ROSCs.

56.  On the basis of past and likely future problems with the use of offshore finance, the approach in this paper addresses the financial stability issues raised by OFCs, in the following ways:

• An early start is made on Fund assessments of financial standards in OFCs, and in providing technical assistance to OFCs in both assessment and implementation.

• Early involvement of, and commitments by, OFCs in the process is encouraged by the initial outreach exercise and by promoting "assisted self-assessments." These reports, the responsibility of the OFC concerned, will be a valuable precursor to independent IMF assessments.

• The coverage of OFCs depends on the number of volunteers; and on experience as the program gets under way. The aim is to convince as many OFCs as possible that it is in their interest to be volunteers.

• Priorities in the assessments of standards in each of the modules would be decided case-by-case on the basis of what business was conducted in each OFC, but for any given standard, the scope of assessment would be comprehensive.

• Priorities among OFCs in the first twelve months would be decided by the needs to make an early start, to secure a wide coverage and to gain experience.

• Fund assessments would include practices in key onshore centers, essential if the defects in consolidated supervision are to be identified and remedied.

• Fund assessments would emphasize anti-money laundering efforts as a necessary component of financial sector supervision, leaving assessments in the area of crime interdiction, seizure and forfeiture of assets to FATF.

57.  On the resource implications for each of the assessment modules, the staff envisions conducting up to four assessments each under Module 2 and Module 3 in the first twelve months.²⁷ (See Table 1 for an estimate of resource implications per assessment). For the Module 1 self-assessments, the Fund could case-by-case consider sponsoring technical assistance advisors to assist in conducting the assessment; however the work performed will remain the responsibility of the OFCs. For illustrative purposes, this paper projects that the Fund will provide assistance under Module 1 for up to four jurisdictions.

58.  On the illustrative assumption that there could be Fund involvement in the first twelve months in four assessments under each of the three modules, the total resource implications could take up to 320 staff weeks, or about 8 staff years, plus travel expenses. In this case, the resource requirements are reduced somewhat because of the current plan to include up to two OFCs under the FSAP program for FY2001. On this basis, staff projects a net resource requirement of up to 240 staff weeks (6 staff years)²⁸ to complete the OFC program as described. In addition, staff anticipates on an annual basis administrative costs to oversee the increased Fund involvement with OFCs assessments of about two staff years; STA estimate an annual resource cost of some two staff years to implement statistical initiatives (see Section G below).

59.  As this is a new initiative and in view of the commitments made in the current fiscal year, it calls for additional resources, estimated in Table 1. In the event that no additional resources are made available, implementation of the assessment and TA program requires a redeployment of resources, either within the Fund or within MAE. In the case of MAE, redeployment implies a 5–10 percent reduction in TA delivery or the postponement of up to six FSAPs. Alternatively, the Board may wish to consider asking staff to request institutions of the member countries providing expertise to the Fund not to charge, in which case the resource implication for the Fund is limited to the provision of Fund staff time.

60.  Effective technical assistance has an important role to play in helping bring OFCs into compliance with relevant standards and reduce the vulnerabilities of countries financial systems to the use of offshore finance. Technical assistance may also play an important role to help onshore centers correct weaknesses in consolidated supervision and improve the collection of statistics by OFCs. Over the recent past, the Fund has occasionally, and on an ad-hoc basis, provided member OFCs with some technical assistance in banking supervision, statistics, and fiscal matters.

61.  Technical assistance can be provided before, during, or after each of the three modules of the comprehensive assessment process for OFCs described in section III B. Firstly, OFCs could be provided, should they so request, with technical assistance to help them undertake assisted self-assessments of relevant financial standards constituting Module 1 of the assessment program. The opportunity to receive technical assistance at this stage provides an incentive for OFCs to come forward and volunteer thereby getting the whole process off to a quick start. Secondly, Module 2 in the form of a Fund-led stand-alone assessment of financial standards is a form of technical assistance which could link to subsequent surveillance in the form of FSAPs-FSSAs. Thus, Module 1 and Module 2 provide key inputs to the full-scope Fund-led assessment constituting Module 3. Follow-up technical assistance can also be provided after Module 3 to help bring OFCs into compliance with observed weaknesses in the implementation of financial standards and reduce vulnerabilities identified in Module 3. FAD can provide technical assistance to OFCs to help them address the fiscal consequences, for example in tax policy and tax administration, of implementing measures to improve compliance with international standards. STA can also provide technical assistance—see Section G below.

62.  Technical assistance can be provided by the Fund, the World Bank, or by other multi- or bilateral agencies. For instance, the UNDCCP, through its Offshore Initiative, is prepared to offer technical assistance to establish and/or support implementation of effective anti-money laundering practices, especially legislation. Similarly, the Basel Committee and the OECD have provided in the past technical assistance or training in areas which are relevant to OFCs.²⁹ The design and implementation of well-conceived, practical, and, to the extent feasible, standardized Memoranda of Understandings or equivalent arrangements, to facilitate the exchange of information between the supervisory authorities of onshore and offshore centers and help strengthen effective consolidated supervision, is one aspect of technical assistance programs for OFCs.

63.  To meet extra requests for technical assistance both before and after assessments of OFCs, the Fund needs to step up its efforts at further enhancing coordination and cooperation with all of the above institutions as well as other agencies and donors.

64.  The monitoring of improvements can, in the case of member OFCs, be conducted within the scope of regular Article IV consultations. A Technical Cooperation Action Plan (TCAP) is an appropriate vehicle for coordinating and delivering technical assistance. In some cases, a financial contribution by the OFC itself can reinforce the Fund technical assistance effort.

65.  All examinations of the role of OFCs in the international financial system have been hampered by the lack of adequate data. Any Fund assessment of OFCs should, therefore, consider the need and scope for improving the availability of data so that the potential impact of OFC activity can be more effectively discerned. This section describes the more important initiatives appropriate for the Fund to take.

66.  Because many OFCs have exempted offshore companies from the obligations for statistical reporting that "onshore" companies have to meet, the available statistics are in some cases inadequate for the purposes of assessing OFCs' impact on international banking and securities markets, for cross-country comparisons with investing countries, and for assessing the impact of OFCs on the domestic economy of which they are a part.

67.  More generally, existing statistical collections of OFCs are handicapped by the fact that (i) surveys have to be conducted on a voluntary basis (a consequence of the legal status of offshore companies); (ii) the population of offshore companies to be covered is large; (iii) most of these companies have no physical presence (which means that ways have to be found of getting their accounting centers abroad to respond to the survey); and (iv) there are very limited resources available to the relevant statistical agency. For these reasons, the scope for improving statistical reporting is shaped by two considerations; (i) the need to introduce legislation empowering the relevant statistical agency (for OFCs, this is usually the monetary authority) to collect statistics from offshore companies; and (ii) the need to design data collections so that best use is made of existing data sources.

68.  The scope for improved statistical reporting by the offshore financial sector is very much shaped by the regulatory boundary. Most OFCs have established, or are in process of establishing, regulatory authorities for the oversight of offshore financial institutions, including banks, insurance companies, collective investment schemes, hedge funds, and trust companies. The implementation of international regulatory standards in these areas would establish a basis for improved statistical reporting. This would permit: (i) the treatment of offshore companies as resident in the country in which the OFC is located (consistent with international statistical standards); (ii) the assessment of the contribution of offshore enterprises to value added and thereby their impact on other sectors of the economy; (iii) an understanding of the structure (and over time evolution) of the offshore economy; (iv) the assessment of how the offshore economy is financed; (v) a comparison with the structure of other offshore centers; and (vi) the assessment of the collective impact of OFCs on the rest-of-the-world.

69.  Because of the importance of OFCs as channels for cross-border portfolio investment, the participation of OFCs in the Fund's Coordinated Portfolio Investment Survey (CPIS) is essential to ensure the comprehensive coverage of the second CPIS, now planned for end-December 2001. This is the view of the IMF Committee on Balance of Payments Statistics. The participation of OFCs in the BIS locational international banking statistics reporting system was strongly encouraged in the report of the Financial Stability Forum's Working Group on Offshore Financial Centers. In both cases, the quality of available statistics would be greatly enhanced to the extent that there are regulatory standards that can provide a basis for statistical reporting.

70.   As there are no international regulatory standards for trust companies, a particular issue is an OFC's capacity to report the value of cross-border portfolio investment assets held in trust for nonresidents. Current practice in most countries is to attribute such assets to the sector of the beneficial owner (likely to be an investing country not an OFC). Hence, the interest of OFCs is essentially that of third parties. The collection of third party data from custodians/trust companies is a potentially useful source for the filling of gaps in the CPIS.

71.  If OFCs take the necessary steps to establish regulatory authorities with an appropriate mandate covering the offshore financial sector, and also empower the relevant statistical agency to require statistical reporting by offshore companies (with the usual protections concerning the confidentiality of reported data), the Fund can provide assistance to OFCs to improve their statistics. STA's work with OFCs can involve three closely coordinated initiatives—(i) enhancement of the coverage of external flows to and from the OFCs together with the related positions; (ii) construction of a useful set of accounts for the offshore banks and other financial institutions operating in the OFCs, including the development of a separate offshore institutional sector for monetary statistics; and (iii) support for full participation in international statistical collections, particularly in the BIS international banking statistics reporting system and the Fund's Coordinated Portfolio Investment Survey. Resource implications of these initiatives may amount, on an annual basis, to two staff years. In view of its resource constraints, STA needs to consider the setting of priorities on a case-by-case basis. In view of the small size of most OFCs, there is also a need to find ways to provide technical assistance on a regional basis.

72.  The views of the Executive Directors are sought on the following issues:

1. Do Directors agree that offshore financial centers, and the use of offshore financial vehicles by institutions in onshore centers, pose risks for financial stability?

2. To the extent that such risks exist, either now or potentially in the future, do Directors agree there is a role for the Fund?

3. Do Directors agree that the Fund should embark on the process outlined in the paper in Section III.B?

4. Do Directors agree that any Fund-led assessments should be limited to those issues and standards relating to financial sector supervision and relevant to financial vulnerabilities as summarized in Box 4; or should other issues be addressed as well, such as law enforcement aspects of anti-money laundering and tax advantages of OFCs?

5. Do Directors agree that technical assistance for OFCs committed to raising supervisory standards should be given a high priority in the Fund's TA program?

6. Do Directors agree that the Fund should endeavor to play the role proposed in the paper in improving statistics on offshore financial activities?

Annex

73.  The Edwards Report "Review of Financial Regulation in the Crown Dependencies," published by the UK Government in November 1998, provided a first comprehensive picture of the offshore business and supervision thereof taking place in Jersey, Guernsey, Sark, and the Isle of Man. The report reviewed the activities of banks, investment and securities business, insurance companies, trusts, and investment services providers. It also assessed compliance of the supervisory frameworks for these offshore business with international standards and best practices, including an assessment of anti money-laundering practices. The report commended the generally high standards of supervision in the Islands. The main recommendations of the report included: (1) requiring the estimated 100,000 offshore companies to make public account filings; (2) ownership disclosure of offshore companies to the islands' regulators; (3) controls on professional offshore advisors and on those assisting with company formation; (4) stricter supervision of lawyers and accountants in both dependencies and onshore jurisdictions involved with offshore structures and services; (5) strict action against trust companies offshore with pressure for greater transparency and documentation of trustees and beneficiaries; (6) stricter regulations (in addition to those already in place) to address money-laundering; and (7) mandatory cooperation with the UK Inland Revenue.

74.  The KPMG Report is an initiative jointly sponsored by the UK Government and the UK overseas territories (OTs) aimed at investigating offshore business practices in the six main UK overseas territories—namely, the Cayman Islands, the British Virgin Islands, Turks and Caicos Islands, Anguilla, Monserrat, and Bermuda—which provide facilities for offshore business. The purpose of this initiative is to assess OTs' performance against international standards and best practices and to make recommendations for improvement where the OTs fall below standards. Assessments will cover the banking, insurance, and the securities sectors, including mutual funds and stock exchanges. Standards to be assessed include the Basel Core Principles for Effective Banking Supervision, the Offshore Group of Banking Supervisors (OGBS) standards, the International Association of Insurance Supervisors (IAIS) standards, the International Organization of Securities Commissions (IOSCO) standards, the Financial Action Task Force (FATF) 40 recommendations; the Caribbean Financial Action task Force (CFATF) additional 19 recommendations; the International Accounting Standards Committee (IAS) principles; the 1998 G-22 Report on Transparency and Accountability; the IMF Guide to Progress in Strengthening the Global Financial Architecture (April 1999); and the OECD Principles of Corporate Governance.

75.  The review will also cover issues such as the degree of independence and effectiveness of OTs' regulatory authorities; international cooperation, including between regulatory and law enforcement authorities; and measures to combat money laundering. This work is expected to be completed by July 2000 and the results will be published.

76.  The Ad-Hoc Group on Non-Cooperative Jurisdictions established in 1998 by the Financial Action Task Force (FATF) developed a common process to enable FATF members to evaluate whether jurisdictions can be viewed as cooperating with FATF anti-money laundering initiatives. This process is based on an assessment of 25 criteria that looks at loopholes in legislation, information sharing, and adequacy of compliance resources. In particular, the exercise involved an examination of laws and regulations, an in-country assessment, the preparation of a report by the assessment team that pointed out specific deficiencies, and a process whereby the jurisdictions assessed had the opportunity to comment on the assessment. The Ad-Hoc Group has assessed 31 non-FATF jurisdictions, mostly OFCs. FATF published a list of 15 non-cooperating jurisdictions on June 22, 2000. FATF has also agreed to a series of measures that FATF and its members may take to encourage non-cooperative jurisdictions to come into compliance with FATF's recommendations to combat money-laundering.