Monaco has been described by some as a ‘a sunny place for shady people’. Small tax havens like this sun-drenched principality often double up as offshore banking centres because of their relaxed regulatory environment, low taxes and ability to attract wealthy clients.
But the true risks of offshore banking are becoming clear as the world digests the failure of Credit Suisse. From the Cayman Islands to Singapore and Hong Kong, the essential problem is the same: small populations with big financial liabilities.
This wasn’t too much of a problem before the advent of digital banking and social media. Today, it’s all too easy for investors to become aware of previously hidden problems in distant locations and rapidly move their money away. Wealthy clients pay a premium to protect their capital and don’t want to worry about its safety.
Despite the assurances of its central bank and meeting the latest regulatory standards, Switzerland was unable to convince markets that it had the financial resources to support its second-largest financial institution. Bern’s only option was a forced, clumsy merger of Credit Suisse with larger rival, UBS, which has its own history of problems.
Bailed out by the Swiss government in 2008, UBS was itself the product of another ‘shotgun wedding’ in 1998, in the wake of losses.
This raises a troubling question: if Credit Suisse was too big for Switzerland to nationalise, what does this mean for the enlarged UBS with combined assets approaching 2.5-times gross domestic product (GDP)? As Basel Institute on Governance founder Mark Pieth put it in the Wall Street Journal: “If Swiss banking means one huge bank, what if something goes wrong with that? Then the entire country and its financial stability is at stake.”
When even the world’s premier offshore banking centre cannot convince investors not to panic about a systemically important bank, what does this mean for smaller and newer locations, such as Singapore or Dubai?
Warning signs
The warning signs have been there for more than a decade. Iceland, Cyprus, Ireland and other nations have been brought to their knees by their banks’ offshore liabilities. In Iceland, the banks’ liabilities were 10 times the country’s GDP. In Cyprus, potential liabilities were more than five times its GDP.
Despite this, many banks and banking supervisors did not learn their lesson. Buoyed by extraordinarily loose financial policy since the last financial crisis, they continued to build up massive potential liabilities.
Offshore financial centres participated in — and arguably led — the rapid post-2015 rapid expansion in global credit flows. The Bank for International Settlements calculates there is now $80tn of ‘hidden’ US dollar-denominated debt held off banks’ balance sheets and often booked through these offshore locations for tax reasons.
When even the world’s premier offshore banking centre cannot convince investors not to panic, what does this mean for Singapore or Dubai?
The risks are obvious when you look at the numbers. Hong Kong’s foreign liabilities are fully 12 times its own GDP. And these are the numbers we know about: many centres make a virtue of keeping the true scale of their potential liabilities secret.
For example, the Cayman Islands claim $500bn of offshore assets despite a population of only 60,000, but very little detail exists as to the liabilities attached.
Often, this is because investors use fund or legal structures that they believe will insulate them from any localised problems. But this is a mistake.
Very few investors, or even private bankers, understand the complex system that creates the illusion that, for example, US assets can somehow be held offshore.The reality is these assets do not actually move: the process relies instead on a chain of back-to-back claims.
Like all chains, it’s only as strong as its weakest link. Other banks refused to trade with Credit Suisse when it got into difficulty, which meant its clients were unable to transfer their business away or liquidate investments.
The system is also subject to political interference. As Russia discovered to its detriment, it’s very easy to freeze these assets at their true source — such as a depositary at the US Department of the Treasury — should a certain jurisdiction or class of investors fall foul of international regulations.
Erosion of trust
But it’s not just the potential financial risk that can unsettle clients in this digital age. Credit Suisse had amassed an impressive $11bn of fines over the past decade, many related to the activities of its private bank.
Banks operating in these jurisdictions are often seen as complicit in these activities — a view that has been enhanced by revelations such as those in the Panama Papers data leak. This further erodes trust in the banking system.
The EU has been cracking down on tax havens and offshore banking for years. The EU Savings Tax Directive has been successful in reducing the number of people using offshore banking to evade taxes, which is leading to more risk for offshore centres.
This is because two classes of investors are emerging: those who can legally remain offshore but legitimately move their capital to the bigger, mainstream financial centres such as London or New York, and those that can’t.
That poses a tricky question for smaller financial centres: as legitimate clients leave, do you want to be stuck with a bigger proportion of the world’s financial untouchables? This seems like a recipe for more regulatory and reputational problems.
So, Credit Suisse’s demise heralds a new era for offshore financial centres. Despite regulators’ best efforts, the fallout from the 2008 financial crisis — combined with the move to digital banking and the rise of social media — means banks now operate in a very different environment.
Bank runs that in the past might have taken place over the course of months can now happen in a few days. With rising interest rates and tighter financial conditions, we suspect there’ll be revelations that many more banks have flown too close to the sun in pursuit of fickle deposits or yield.
Despite the good weather usually enjoyed by offshore financial centres, sunlight hasn’t proven to be the best disinfectant. For the stability of the financial system as a whole, this has to change.
Andrew Hunt is chief executive of analysis service Hunt Economics and Ben Ashby is head of investments for investment management company Henderson Rowe.
