The banking crisis in Cyprus could easily be eclipsed by a blow-up in the banking sector of the Cayman Islands, which with its size represents a deadly threat to the world economy, at least according to Jeffrey Sachs, director of The Earth Institute at Columbia University. Speakers at the Offshore Alert conference in Miami argued this view is too simplistic.
The banking crisis in Cyprus has sparked renewed fears over contagion in the banking sector. The islands quasi-offshore status, particularly for depositors from Russia, has led some to argue that the “unnatural” size of banking sectors in offshore financial centres could lead to new global financial crises.
Cayman as one of the largest banking centres in the world by assets and liabilities is a popular target as an alleged source of potential financial instability.
“The Bank for International Settlements reports that the Cayman banking system has roughly $1.4 trillion in liabilities and assets, or $24 million per resident”, wrote Jeffrey Sachs, economist at Columbia University, in a letter to the Financial Times and concluded, “this house of cards (Cayman) is a mortal threat to the world economy”.
“A blow-up in the Caymans’ finances would make Cyprus’s crisis look like child’s play,” he added.
Gonzalo Jalles, the CEO of Cayman Finance, responded also in a letter to the FT that the headline figures Sachs quotes do not reflect the true size of Cayman’s banking industry or the different structure it has from Cyprus.
It is undeniable that the banking sector in Cayman is largely unrelated to the economic activity of the three islands which have an estimated gross domestic product of $3.1 billion. Instead the size is much more indicative of the global economy and financial activity underpinned by service providers in the Cayman Islands.
Cayman’s banking system is separated into Class B banking licence holders which are prohibited from carrying out business in Cayman, and banks with a Class A licence which can but do not always operate locally.
The 15 legally independent Class A banks represent roughly $39 billion in assets and liabilities. Seven of the 15 Class A banks are carrying out retail activity with customers in Cayman. The asset and liabilities of seven retail banks is in the region of $12 billion. They made $3.6 billion in local loans and have $6.1 billion in local deposits, said Tim Ridley former chairman of the Monetary Authority at the Offshore Alert conference in Miami in May.
“If you look at the $1.4 trillion in assets and liabilities, 55 per cent of that is represented by 12 banks. Three of those banks are from the US, two are Swiss, two are Brazilian, one is Canadian, two of them are Dutch, one of them is German and guess what two are French,” he said.
Of that 55 per cent, more than half are interbank bookings, between onshore banks and their Cayman Islands branches or subsidiaries, he said. CIMA’s website even estimates that up to 80 per cent of the deposits booked through the Cayman Islands are inter-bank bookings.
The significant share of inter-bank bookings are also the reason the Cayman Islands cannot be compared to Cyprus, said Jalles.
“A significant part of the banking assets registered in Cayman are US banks placing overnight deposits in their own Cayman registered branch. The money is effectively being transferred between accounts in NY and not being exposed to how a local banker in Cayman decides to invest it. That is the significant difference with Cyprus.”
But what are these overnight deposits? The sole purpose of certain Cayman Islands branches, which hold class B banking licences, is to facilitate overnight investments for large US-based commercial customers through Eurodollar sweep accounts.
Sweep accounts are a common cash management service that connects commercial depository accounts to an investment account. Eurodollar sweep accounts pool the group-wide cash reserves of a bank’s US customer in an offshore deposit account where the consolidated funds gain interest or can be invested into money market instruments and other investments.
In a common set-up, account balances exceeding a predefined balance are transferred automatically to the investment account for overnight investment, before depository account balances in the checking accounts are readjusted to the required levels the following day. As a result, excess cash can earn interest rather than sit idle in non-interest bearing demand deposit accounts.
In practice, sweep accounts are not only a convenient way to invest excess cash but they also offered a way around Regulation Q of the US Code of Federal Regulations, which prohibited the payment of interest on US checking accounts, until it was repealed by Dodd-Frank in July of 2011. Following the repeal of Regulation Q banks have the opportunity to offer interest on business checking accounts, which depending on the cost-benefits can make some offshore overnight deposits redundant.
Other corporate funds of a bank’s corporate customers are kept permanently offshore.
“Most of the [non-interbank bookings] are corporate banking relationships with major multinationals that are holding their funds offshore,” says Ridley. “The amount of individual business in that 1.4 trillion is tiny, whatever the Tax Justice Network will tell you.”
US multinationals have an incentive to keep their foreign earned income offshore. US tax laws allow US-based multinationals to defer tax payments on earnings generated from investments abroad as long as the earnings do not enter the United States and are kept abroad for reinvestment overseas.
If repatriated to the US, the earnings, which have already been taxed in the country where they originated, would be taxed again, typically the difference between foreign and US corporate tax rates.
Naturally, US companies are not inclined to bring those earnings back into the US, particularly not if they have opportunities to grow their operations outside internationally. But even if the money is not strictly needed for immediate reinvestment, it would be disadvantageous in most cases to repatriate the funds.
Even if firms need to borrow funds in the United States, it often makes sense not to bring foreign earnings back. Apple, which holds more than $102 billion in cash and short-term investments abroad, raised $17 billion in a bond sale in May, rather than repatriate some of its of foreign earnings. It is thus not surprising that large US companies grew their offshore earnings by 15 per cent last year to $1.9 trillion. Research firm Audit Analytics said overseas earnings of US companies in the Russell 3000 index have increased by 70 per cent over the past five years.
Many US firms “park” funds in offshore financial centres like the Cayman Islands, because this will not add another layer of tax, before making further decision on how to invest it abroad or to repatriate it to the United States at a later stage.
Bank bailouts in Cayman?
If one of the Class B licence holdings banks were to default, it would be up to the parent company onshore to bail out its offshore subsidiary or branch.
In the case of Class A licence holders, the likelihood of the UK government bailing out one of Cayman’s retail banks is remote, said Ridley, and the Cayman Islands government simply does not have the funds to do so. CIMA also does not have the means to stage a European-style bailout because it is not a central bank and it does not have the ability to print money. This means that in the case of a bank default of one of Cayman’s retail banks, the only plausible scenario is a bail-in, where creditors, shareholders and ultimately depositors, rather than tax payers, pay for the bank’s losses.
Cayman Finance’s Jalles, who is the former CEO of HSBC in the Cayman Islands, said offshore financial centres are different from other countries and any financial stability measures should be designed with these differences in mind. “If you are a financial centre, be very careful not to implement solutions that are designed for countries that are not OFCs,” he said.
Offshore financial centres receive deposits from many countries around the world and their investments are directed into another set of countries. In this context it is important to understand where funds are coming from and where they are going. In Cayman, he said, the banking system is compartmentalised. There are for instance large segments of banks from Brazil and from the US. The funds from banks in the US go back to the US and funds from Brazil go back to Brazil.
“Because there is no deposit insurance, there is no contagion mechanism between those two segments,” said Jalles. “If something happens in Brazil that affects the Brazilian banks, there is no reason why that would affect depositors in the Cayman branches of US banks.”