Offshore chokepoint?

Paul Byles

De-risking” by individual institutions will lead to higher risk and exposure at the jurisdictional level.

The recent challenges to correspondent banking relationships is based on the idea that certain types of sectors and services should be viewed as being high risk and relates partially to the so-called “Operation Choke Point.” This was a U.S. Department of Justice initiative launched in 2013 which identified several areas of industry as being high risk for fraud and money laundering and discouraged banks from offering services to these sectors. Money remittances services, for example, were included in the list of high-risk sectors.

Subsequently the Federal Deposit Insurance Corporation clarified that they expect a risk-based approach from U.S. banks and not necessarily a severing of ties with all sectors. But it is appears that the practice of cutting ties with banks based in the Caribbean or in those jurisdictions regarded as “tax havens” continues among the U.S. banks.

This presents a unique challenge in that:

Individual U.S.-based banks are telling their offshore banking clients that the reasons for severing ties with them is due to pressures from the U.S. regulators and the need for the U.S.-based banks to avoid heavy fines and sanctions.

On the other hand, the U.S. regulators have stated that they expect the banks to take a “risk-based” approach and have not directed banks to sever ties with any specific type of entity/sector.

In this “good cop, bad cop” scenario, there is little transparency and, ultimately, no true source to attack the issue.


Regulatory/systemic risk 

Notwithstanding the economic consequences (employment and government revenue impact), there are also some serious (and somewhat ironic) regulatory implications of the recent “de-risking” activity among banks.

The first of these is that there will be a larger concentration of assets held with a smaller number of banks in each country, be it in the Cayman Islands or elsewhere. This presents a systemic risk to their respective domestic financial systems as each of the remaining banks may become “too big to fail.”

The second is that each country faces the risk that it now overlies on multinational banks as these are the banks with sufficient leverage to withstand the pressures from U.S.-based correspondent banks, and there will be fewer local banks in each country, unless they have unique relationships that garner similar leverage. But the over reliance on the international banks exposes each country to the possibility that at any point in time one of these banks will make a commercial decision to withdraw from the country or even the region, as a few have in recent years. Then what?

The third is that the de-risking by individual banks ironically leads to a higher risk exposure for the country at the macro level. If certain sectors are not allowed access to the formal banking system, then there is a higher chance that financial transactions are not flowing through a regulated institution, which poses higher exposure to fraudulent activity. If there is an incident of money laundering or fraud later, this harms the country’s reputation and, ironically, the “newly de-risked” individual banks themselves.

In fact, one of the observations is that the banking sector traditionally is among the most robustly regulated sectors. So it would seem to make sense to encourage financial transactions via the formal banking system and where there is presumably a higher chance of high risk activities being detected. This conflicts with an individual bank’s wish to de-risk, but it’s a far better model for the jurisdiction than one where banks reject certain sectors.

De-risking is therefore not a simple matter of individual entities taking commercial decisions. It’s a jurisdictional issue because it leads to higher country-wide risk and exposure. That makes de-risking a policy issue begging a number of questions:

What is the potential exposure of having a concentration of clients’ assets held in fewer banks?

What is the potential anti-money laundering risk associated with an increase in financial transactions occurring outside the formal banking sector?

How can one regulated institution reject doing business with another when both are seemingly regulated at the same standard and by the same regulator?

What does or should it mean for government policy if the domestic financial system cannot function properly because entities are no longer able to conduct business with each other due to an external threat caused by the U.S.-based correspondent banks?

The Cayman Islands is not unique in facing these challenges – it is impacting the entire Caribbean region. And while there is scope for regional efforts, it is also important for countries like the Cayman Islands to prepare their individual cases to protect correspondent banking relationships.

Having a regulatory framework that complies with global standards is a prerequisite to any advocacy campaign to address the de-risking issue. Countries that don’t have the required standard of regulation will have little success in efforts to advocate for leniency on the part of U.S.-based correspondent banks. This should be an advantage for a jurisdiction like Cayman in terms of being able to demonstrate that we have the necessary controls in place and that all banks are regulated to the same high standards, whether retail or offshore etc.

Efforts by individual banks to meet with U.S.-based banks would also benefit from the proactive sharing of information on how the jurisdiction regulates its banking sector. Each country should be preparing their cases and making urgent efforts to protect their domestic financial sectors, and frankly their economic livelihoods, from what is fast becoming a sort of “offshore choke point.”

As applied to the focused objective of maintaining correspondent banking relationships, the term de-risking is a deceptive concept. It achieves a worthy but narrow commercial objective in the short term, but ultimately leads to higher regulatory and economic risk and exposure at the jurisdictional level. It’s difficult to see how any individual institution currently attempting to de-risk (or feels it has successfully done so), would take any comfort in that result.


About the author: Inside Offshore is a syndicated column on topics relating to international financial services. Paul Byles is managing director of First Regents Bank & Trust. He also serves as an independent director and consultant to financial services firms. He is an economist and former regulator who has worked in the offshore sector for more than 20 years. He is author of”Inside Offshore” and “Introduction to Offshore Financial Services: A BVI text.”