By Gillian Tett From Financial Times

What the heck is happening in the Cayman Islands? That is a question often asked in relation to corporate tax. This week, for example, the OECD called for an end to the loopholes that let global companies cut their tax bills in places like the British overseas territory.

As the debate bubbles on, there is another facet of globalisation that merits more discussion: the financial flows associated with offshore centres, particularly between banks and non-bank entities. Until recently, this activity seemed like a mystery wrapped in an enigma for investors. Yes, regulators have long published data about the onshore activities of regulated banks. But there was little information available about the financial flows around non-banks, least of all when they were based in murky offshore locations.

This is starting to change. One reason is that the Financial Stability Board, a Basel-based entity created in the aftermath of the 2008 crisis, has now been publishing data about non-banks (or “shadow banks”, as they are popularly known) for nearly a decade. Last month the Bank for International Settlements also started publishing data on cross-border financial flows between banks and non-banks — even for opaque offshore centres.

This is very good news, since the two data sets shed a little light on the reality of 21st-century finance. The FSB research, for example, shows that the non-banking world has grown in recent years, as activity has moved out of regulated entities. “Non-bank intermediaries’ share of total financial system assets increased from 31 per cent to 36 per cent” between 2007 and 2017, observes a report from the IESE Business School, using this FSB data.

Meanwhile, the BIS data shows that banks’ cross-border dealings with non-bank entities has been swelling too. One reason is that banks are increasingly funding governments (by buying their debt.) But their exposure to non-financial companies is also rising noticeably, both to onshore and offshore subsidiaries. “Banks lend significant amounts to non-financial corporations located in financial centres . . . [providing] credit to the financing arms of multinational corporations located there,” the BIS notes, adding that banks’ claims on NFCs in the Cayman Islands are larger than on those in Italy. (Yes, really.)

Cross-border lending by banks to non-bank financial institutions, such as hedge funds, has also jumped, from $4.8tn in 2016 to $6.6tn in 2019. More striking, those non-bank institutions have quietly “become important sources of cross-border funding for banks, particularly in international currencies,” the BIS notes.

Yet again, those offshore financial centres feature: almost 20 per cent of banks’ cross-border dollar funding is now supplied by entities based in the Cayman Islands, a ratio only topped by those in the US, while entities based in Luxembourg and the Caymans are crucial in the euro markets. Or as the BIS concludes, “Banks’ positions with [non-banks] are concentrated in few countries, particularly financial centres.”

Should we worry about this? Not in the short term, perhaps. After all, the non-bank entities that banks deal with in offshore centres tend to be subsidiaries of the same asset managers or companies they deal with inside their home markets. There is no evidence that these exposures pose significant threats now.

But there are three longer-term issues that investors and politicians should ponder. First, it is distinctly unnerving that the shadow banking sector is swelling, given that it played such a key role in the 2008 financial crisis. After all, as the IESE report notes, while we do not know where the next crisis will hit, “if the past is any predictor of the future, we can be sure that entities that perform the functions of banks, but are outside of the regulatory perimeter, will play an important role.”

Second, it is also unnerving that the cross-border dealings between banks and non-banks appear to be so concentrated around offshore financial centres, particularly in relation to dollar financing. This could be a stress point if turmoil erupts in currency markets.

Third, the efforts that the BIS and FSB are making to produce better data on modern finance need to be supported by politicians and expanded (particularly since the data still has holes). After all, it is not just the technology companies that are engaged in cross-border arbitrage games; the BIS data suggests that arbitrage is endemic in the modern finance and business world.

We need to shed light on this if we want to build a fairer and more resilient corporate system. Those Cayman Islands might be one place to start.

Copyright The Financial Times Limited 2019. All rights reserved.

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