OFCs are good.

Swiss and Caribbean bank accounts evoke images of illegal activity. In Offshore Financial Centers: Parasites or Symbionts?, Rose and Spiegel analyze the causes and consequences of these offshore financial centers (OFCs) to determine the accuracy of this characterization. They find that OFCs encourage bad behavior in source countries by serving as a shelter for money laundering and as a tax haven. However, they also discover that OFCs have unintended positive effects for neighboring countries in the form of competition for the domestic banking sectors. Rose and Spiegel conclude that these institutions are better characterized as “symbionts.”

The authors begin by using bilateral data from over 200 source and host countries from the Coordinated Portfolio Investment Survey to examine the determinants of cross-border asset holdings for 2001 and 2002 using a gravity model. The gravity model factors out the positive function of the economic masses of the countries and the negative function of the distance between them. Population and real GDP per capita approximate economic mass. Later the authors factor in additional variables like colonial history, geographic features, common language, and common currency. Then rule of law, political stability, and regulatory quality are added, and then finally, the authors add three indicators on tax havens, provided by the OECD, CIA, and Hines and Rice (1994). By adding the different variables in a sequential order, the authors determine whether the variables have an impact on the probability of becoming an OFC.

From this first set of data, they find:

1. Higher population and GDP per capita in either the source or host countries encourage greater cross-holdings.
2. The closer the distance between countries, the greater the cross-holdings. Also, sharing a land border, language, or money raises cross-holdings.
3. Interestingly, neither the rule of law nor the political stability of host countries seems to be relevant. However, politically unstable countries and those with a strong rule of law are both more likely to send funds overseas.
4. Although regulatory quality in the source country has little effect on cross-holdings, host countries with higher regulatory quality are much more likely to attract assets.
5. Using measures of money laundering and tax haven status s from the OECD, Hines and Rice, and the CIA’s World Factbook, the authors deduce that money laundering and tax haven status is associated with an increase in cross-border flows. This correlation is the strongest found in the data, and it suggests that the desire to circumvent local taxes or other local laws plays a role in the decision to move assets to OFCs.

Essentially this data supports intuition. The key finding is point 5: OFCs are clustered around places with “high taxes and demand for nefarious activity.” (Page 12).

Rose and Spiegel ask whether OFC’s make good neighbors to source countries. The encouragement of tax evasion and nefarious activity promotes the idea that OFCs are bad neighbors. The authors find that OFCs can also have intended positive effects as a neighbor. The authors develop a theoretical model to explain how OFCs can improve the competitiveness of the source country’s financial institutions. They then test this model empirically.

The major finding of the theoretical model is that OFCs improve banking in the source country by eroding the monopolies which would exist otherwise in the source country. Their model suggests that home country bank profits decline with proximity to the OFC, while overall local lending is increasing in OFC proximity.

They realize that their model does not provide a definitive answer because it can be interpreted several ways. On one hand, the OFC induces the home country bank to behave more competitively, increasing lending and overall welfare. On the other hand, depositors are partially motivated to take their funds offshore for purely redistributive reasons, in particular to lower their taxes. While the redistribution does not affect welfare, the resource cost of moving those assets offshore is a deadweight loss. As a result, the overall impact on domestic welfare of OFC-proximity is ambiguous. From this model, they reason that the empirical study will provide more useful and accurate information.

The empirical data addresses whether OFC proximity is associated with greater domestic banking competitiveness and financial intermediation (loan making). Methods from previous literature are used to quantify banking competitiveness and financial intermediation. They find that a one standard deviation increase in distance to an OFC is associated with an increase between 1.41%-2.21% in the interest rate spread and an increase of 1.77%-8.22% in the share of the banking industry controlled by the five largest commercial banks. These numbers support the idea that OFCs make banks in the source country more competitive, which is a good thing.

They next turn to the impact of distance from an OFC on the depth of domestic financial intermediation using three common measures for intermediation: a) credit to the private sector, b) quasi-liquid liabilities, and c) M2, all three measures normalized by GDP. Because OFC proximity should increase domestic financial intermediation, the coefficient should be consistently negative. The authors do find that the effect of distance to the closest OFC on financial intermediation is consistently negative. As distance increases, there is a negative impact on b) quasi-liquid liabilities, and c) M2, all three measures normalized by GDP, that is significantly different from zero. The one exception is that distance from OFC has a negative effect on the private sector as a percentage of GDP, but it is statistically insignificant.

The authors conclude that at first OFCs appear to be “parasites” because their attraction stems in part from allowing their source-country clients to engage in activities detrimental to the well-being of their homes. However, upon further study, they find that proximity to an OFC is indeed associated with a more competitive domestic banking sector, and greater financial intermediation and therefore “tentatively conclude that OFCs are better characterized as ‘symbionts’” (Page 22). Despite this downside, OFCs have unintended positive consequences such as the fact their presence enhances the competitiveness of the local banking sector. Their model demonstrates how OFCs can increase overall welfare despite the deadweight losses caused by transferring funds offshore to an OFC.