When Barclay’s Bank opened Cayman’s first commercial bank in 1953, nobody could have imagined that less than a quarter of a century later the Cayman Islands would be a leading offshore banking centre.
Even in the mid-1960s, when the government passed several key pieces of legislation – including the Banks and Trust Companies Regulations Law, the Trusts Law and an amended Companies Law – few could have imagined the scale of was about to happen.
But as fortune would have it, just as the Cayman Islands was starting to establish itself as a banking centre, the Bahamas – at the time a predominant player in the offshore finance world – began its journey to independence.
The Bahamas impending independence from the United Kingdom made nervous investors look for alternative jurisdictions close to the United States and some of that ‘flight capital’ started arriving in the Cayman Islands.
By the early 1970s, there were more than 100 banks doing business in the Cayman Islands and by 1985 there were close to 500 banks.
During its rise to prominence, the Cayman Islands began to get noticed by overseas regulators, particularly in the United States, which saw Cayman as a haven for tax evasion and money laundering.
By the mid-1970s, the US started harassing bank officials from the Cayman Islands when they travelled to or through the US, insisting they give information about their American clients.
Although the Cayman Islands had built some of its banking reputation with confidentiality laws intending to keep clients’ names anonymous, it eventually had to yield to the US pressures. Formal cooperation began with 1984’s Narcotics Agreement – designed to indentify financial information of those suspected to be trafficking in the illegal drug trade – and then increased with 1986’s Mutual
Legal Assistance Treaty, which broadened the scope of cooperation to other criminal activities.
Thus began Cayman’s transition from a tax haven that did not look too closely at those with whom it did business to one of the most highly selective financial jurisdictions in the world. The road hasn’t always been smooth.
Although Cayman’s financial industry steadily grew from the early 1970s, it exploded in the 1990s, thanks in large part to the Mutual Funds Law of 1993, which paved the way for Cayman’s rise to the world’s largest domicile of hedge funds.
Former president of the Cayman Islands Bankers’ Association Eduardo D’Angelo Silva came to Cayman in 1994 as part of a movement that brought about 25 banks here from Brazil. Most of the banking business here was traditional in nature at the time.
“It was still mostly private banking, catering to American and European customers, and some South American and Asian business that wanted to be able to tap into the New York market without having to be totally in the US,” he said.
As the number of banks licensed continued to rise through the 1990s – peaking at 594 in 1997 – overseas regulators started taking more notice and putting pressure on Cayman. That pressure eventually led to Cayman’s Proceeds of Criminal Conduct Law, which was first passed in 1996 and has been amended many times since then.
“The PCCL really changed the game plan,” said Silva.
“The banks really had to know their customers after that because there were criminal penalties possible.”
The PCCL established strict know-your-customer and anti-money laundering regimes, which raised the costs of doing business for banks.
At the time, Silva said Cayman’s financial industry was becoming increasingly sophisticated and moving toward doing more business with institutional clients. “Even before the compliance requirements, Cayman was moving toward the more profitable side of the business,” Silva said.
Soon, private banking, the mainstay of Cayman’s banking industry for more than three decades, would become just a small segment of the financial industry.
Despite Cayman’s actions to fight money laundering, in June 2000, the Financial Action Task Force listed the Cayman Islands as one of 15 non-cooperative jurisdictions in the fight against money laundering. As a result of the so-called black listing, Cayman was pressured into implementing know-your-customer regulations retroactively, which it did at great cost even though countries like the United States later decided such an exercise was too expensive.
Things became even more difficult the following year after the 9/11 terrorist attacks in the United States. “That was a game changer,” said Silva. “The US definitely became more concerned with offshore financial centres after that.”
The US responded to the 9/11 attacks with The Patriot Act, which included provisions aimed at stopping terrorist funding through money laundering. “Some of the provisions, if they had remained, would have killed the banking industry everywhere, even in the US,” said Silva.
“They would have required clearance for every single transaction. It would have created a bureaucracy that would make it impossible to operate in.”
After two years of negotiations, a compromise was reached with regulations that were workable. But it caused banking costs to increase.
“It started becoming more and more expensive for the banks to do business and as a result they preferred to do business with larger and larger clients,” Silva said.
“They moved almost entirely from small clients to institutional clients to justify all the expense and work you have to do to comply with all of the requirements.”
The next big challenge occurred in 2008, with the financial crisis.
Although Silva said every financial institution in the world was affected by this crisis in one way or another, Cayman weathered it well. Because of the conservative approach of Cayman banks, they weren’t heavily involved in leverage of sophisticated synthetic assets.
“Basically, we weren’t making the profits, but didn’t suffer the losses either.”
Still, liquidity became a problem, which affected investments and ultimately profits as banks became very cautious with their lending, something which continues even now. “Banks continue to be careful both locally and internationally because they’re unsure where the next crisis will come from.”
Dodd-Frank and FATCA
The next crisis could come from two pieces of US legislation: The Dodd-Frank Wall Street Reform and Consumer Protection Act and The Foreign Account Tax Compliance Act.
The former will likely cause the closure of some Cayman Class B banks, particularly if they were set up primarily to hold sweep accounts to get around the US prohibition on paying interest on business checking accounts. Dodd-Frank has repealed this prohibition.
The latter legislation will require financial institutions all over the world to report information on US citizens and others subject to US taxation or face 30 per cent withholding taxes on any fund transfers coming out of the United States.
Current president of the Cayman Islands Bankers’ Association Gonzalo Jalles doesn’t think either piece of legislation is terrible for Cayman.
“Banking in Cayman is a big bag of very different things,” he said.
“It’s first separated into Class A banks, which primarily provide services to residents. Its core is local banking. That isn’t going to change or be affected in any significant way by Dodd-Frank, FATCA etc.”
But as was the case with previous legislation, there will be an increase in costs on all banks because of the new systems that must be put in place as a result.
With regard to Dodd-Frank, Jalles said it’s difficult to predict the final impact because it’s a very large piece of legislation and only 10 per cent of the regulations have been written so far.
Nevertheless, he thinks that the ultimate impact of the legislation will be minimal because the money that goes into the sweep accounts isn’t actually transferred here.
“It doesn’t flow through Cayman,” he said. “It comes to a US account of a Cayman entity.”
Although Dodd-Frank could cause some Class B banks in Cayman to close, resulting in a reduction of license fees paid here, Jalles thinks it could actually help improve Cayman’s image in the global media.
He said the idea that there’s money laundering going on in Cayman occurs partially because people wonder how a little island in the Caribbean can be the world’s third or fourth largest financial centre.
He said losing the sweep account business would take Cayman from being third or fourth in the world in terms of volume of transactions, to 30th or 40th, a position that would attract much less media exposure.
“I think you would see a lot of overseas regulatory pressure turned down,” he said. “Being third or fourth in the world through this sweep operation, that creates very limited jobs and revenues, does more harm than good in my opinion.”
Jalles, who is the CEO of HSBC in Cayman, said the country should be proud of its strict KYC regime, which leads to his bank rejecting business almost on a weekly basis. “But we still have the karma of the past.”
Jalles believes financial industry regulation will continue to evolve. “Clearly, we live in a world where we’re going to see more substance over form,” he said.
“I think we’re going to continue to see international pressure in that direction. Overseas regulators are going to be asking, is the business really being done in Cayman? I think that’s a good thing.”
The numbers of banks in Cayman has declined steadily since the 1997 peak and as of the end of September, 2011, there were only 250 banks licensed here in total. Part of the reason is consolidation.
“Banks have merged all over the world; banks have closed all over the world,” Jalles said. “As a result, the numbers have reduced here as well.”
Mergers are occurring for a number of reasons, but rising costs is one big factor. Not only is it expensive for banks to establish systems to deal with regulatory reporting requirements, it’s also very expensive to keep pace with the technology needed to provide the services demanded to stay competitive in today’s market.
“Banks that are only in one or a couple of countries will continue to have a challenge to invest in the systems that are needed,” Jalles said.
“I think we’ll continue to see mergers because the smaller banks can’t amortise the costs.”
Mergers can have an impact on Cayman banks. Caledonian Bank Managing Director Jim O’Neill, who was previously the managing director of the Bank Austria in Cayman, said his former bank’s merger with the Italy-based UniCredit Group caused the company to close its Cayman entity.
He said that in Austria, banks don’t have to pay local taxes for subsidiaries in other countries, but in Italy they do. “There was no longer a benefit to being here,” he said.
Jalles said there is still a need for banks from other countries to have Cayman entities in certain circumstances. For instance, banks in Brazil and Mexico can’t take foreign currency deposits from local residents, so banks in those countries have branches here. “As long as they have those regulations, those banks will remain here.”
Jalles said HSBC took a different approach in order to be competitive in Cayman. “In a small economy with five or six entities doing traditional banking, we felt that was enough,” he said.
“We saw an opportunity to differentiate the services we offered. There are some clients who don’t want to deal with tellers, who are familiar with electronic channels and who want to do banking that way, and who also want to take advantage of the international opportunities that we offer.”
The business model isn’t based on price, but on differentiated service. “In certain aspects, it’s more expensive, but in other areas it’s cheaper and much better than other banks,” he said. “We’re in 78 countries. Others can’t offer the opportunities the way we can. We have a competitive advantage that others can’t easily replicate.”
Jalles thinks there will be a growing need for international banking. “Globally, I think we’ll see more and more people operating in more than one jurisdiction and more and more international trade. We see those customers increasing.”
Silva, however, still believes there’s a niche for small banks. “The bigger a bank becomes, it gets more difficult to pay attention to the small opportunities,” he said. “That leads to more opportunities for smaller banks, which in turn can lead to a regeneration of the industry.”
O’Neill said small banks were still relevant and noted that Caledonian was purchased in 2011.
“We’re a small bank and someone wanted to buy us and they paid a premium,” he said.
“There’s an interesting phenomenon going on right now. Five years ago, if you were a small bank, no one wanted to talk to you. Now people like it because they’re not being pulled by the big banks.”
The recovery from the financial crisis that began in 2008 still has a ways to go, said Silva, who has now moved on from the banking business. “I don’t think we’ve recovered fully yet,” he said. “I think with everything happening in Europe… there are a lot of concerns in the market.”
Silva thinks the number of banks in Cayman will continue to decline until their numbers level off somewhere between 150 and 200. “The times when we had 600 banks here certainly won’t come back,” he said.
But despite the uncertainty, Silva believes banking is still strong in Cayman.
“Banks in Cayman are well positioned to survive any crisis that may come,” he said. “Banking is the backbone of the economy and the financial industry in Cayman. You cannot have all of the various sectors of the financial industry without some level of banking here.”
Nevertheless, Silva sees the banking business becoming increasingly expensive to run and that low-margin operations will either merge or sell their assets.
Having followed serious potential US legislation threats in the past, Silva isn’t overly concerned about FATCA or Dodd-Frank. “These kinds of legislation always start out as a big dragon and come back an iguana,” he said. “Clearer heads prevail and in the end the legislation is demanding, but not prohibitive for the banks to do business.”
Although FATCA will likely be a headache for banks in terms of its wealth management clients, Silva believes that it, like other legislation imposed by foreign countries, won’t deliver the results the US expects.
“FATCA won’t accomplish anything,” he said. “The people who are trying to hide money have already left Cayman or are invested in such sophisticated structures that FATCA won’t catch.”
O’Neill said that foreign countries seem to have an illusion that there’s a pot of gold that their legislation will allow them to collect in places like Cayman. “But there isn’t,” he said, noting that the European Union Saving Tax Directive ultimately netted EU countries very little after it was agreed to by Cayman in 2004.
In the end, O’Neill doesn’t think FATCA will impact banks in Cayman too much, although it’s still too early to say for sure. “Fortunately, because we’re so regulated, we have all the information already,” he said.
Dodd-Frank, on the other hand, has already caused two banks under Caledonian Group umbrella to close.
O’Neill said the banking model isn’t static and changes are part of the business.
“We have to become more creative,” he said, adding that to remain competitive, Cayman banks have to offer modern banking services – like internet banking, debit/credit cards and life insurance – and more. He said that there’s still a need to offer private banking, but only if it comes with superior service.
One of Cayman’s biggest banking challenges is the interest rates, O’Neill said. He noted that borrowing is still expensive, which is one of the reasons the recovery of the local economy has taken so long.
“Despite interest rates being low, banks aren’t standing in line to lend money,” he said. “That’s why things aren’t happening as quickly as they should be.”
But O’Neill sees new opportunities arising, including some from the double tax treaty with Canada that came into effect in 2011, which he thinks will lead to more business from that country.
“And the Chinese seem to want to do business here,” he said. “Ten years ago, they were nowhere to be seen.”
Recruitment of top talent is another challenge facing Cayman, O’Neill said. “The one thing Cayman doesn’t have is the superstars; the deal closers I call them,” he said. “They are still in New York and London.”
Regardless, O’Neill agrees there will still be a place for Cayman banking in the future. “People still like having their assets in an offshore vehicle,” he said. “It’s a mental thing.”