UN IT INTERNATIONAL FINANCIAL

2 CENTRES, OFFSHORE BANKING

UNITS, SEZs

STRUCTURE
2.0 Objectives
2.1 Introduction
2.2 Rationale
2.3 Characteristics
2.4 Types of Offshore Financial Centres
2.5 Benefits
2.6 Reasons for Growth
2. 7 What are the Ingredients that Make an Offshore Centre Successful?
2.8 Tax Havens - Tax Evasion/Avoidance/Planning
2.9 Freedom from Regulations
2.10 Safe Haven for Flight Capital
2.11 Anonymity and Confidentiality Considerations
2.12 Main Offshore Financial Centres
2.13 International Banking Facilities: The US Answer to Offshore Banking Centres
2.14 Special Economic Zones (SEZs)
2.15 Regulatory Concerns

Let Us Sum Up
Key Terms
Terminal Questions
2.0 OBJECTIVES
After reading this Unit, you will be able to understand:
The tenn "offshore" financial centres and their rationale.
Types of offshore financial centres.
Benefits of these centres.
Reasons for their growth and the ingredients of their success.
Main financial centres.
Problems of regulation.

2.1 INTRODUCTION
The term "Offshore" conjures before the mind's eye the images of sun, salty seas, sand, sea-shells and
ships. However, the expression has acquired its own special meaning in the world of finance. People who
moved their residence or their business affairs from some political land mass to a nearby tax-efficient
base were usually moving to the nearest convenient "heaven" within reach. It was literally offshore -
the British to the Channel Islands, the Americans to the Bahamas, the Chinese to Hongkong and the
Australians to the New Hebrides. In time, however, the term acquired a wider significance and was used
to apply to any centre where international business may be done in favourable, congenial, hospitable tax
and regulatory climate. This may be an on-shore independent state, e.g., Liberia, Panama, Liechtenstein
but it may also be a state within a state - usually a situation where a country allows international business
to be conducted free from the burden of its own official regulation including taxation and controls over
the portfolio decisions of banking units. For example, non-resident companies may operate in Jersey free
from Jersey's own income-tax laws and in a number of countries it is possible for overseas nationals to
conduct business in a way which is reasonably free from local fiscal legislation. Indeed, it is argued that
the UK is one of the best "offshore centres" in the world because there is more international business
conducted there, not hampered by British taxation or other restrictions.

2.2 RATIONALE
Offshore financial centres exist primarily to facilitate international transfer of funds in a business
environment supportive of that goal. They tend to enjoy the following advantages over other banking
centres, a regulatory climate in which controls are flexible enough to permit the unrestrained transfer of
capital among non-residents, minimal taxation and relatively small reserve requirements. Historically
those offshore centres that have been most successful have benefited from the political stability of host
countries and from flexible regulatory policies that permit easy adaptation to new circumstances. They are
most frequently and most productively used for funding syndication, booking and administering loans.
They are also employed to a lesser extent, for the management of non-residents' tax-sheltered trusts.
The distinctive characteristic of the offshore centre is that it provides an intermediary service for foreign
borrowers and lenders, takes place outside the centre's own financial market, the service provided here
is one of external financial intermediation.

2.3 CHARACTERISTICS
The offshore financial centres include markets where one or more of the following characteristics prevail:
1. There is a large foreign currency (eurocurrency) market for deposits and loans, (e.g., London).
ii. The market is a large net supplier of funds to the world financial markets, (e.g., Switzerland).
 iii. The market is an intermediary or pass-through for international loan funds, (e.g., Bahamas, Cayman
Islands).
iv. The market may offer tax-breaks.
In the past, financial centres grew in countries whose stage of development permitted them to be net
suppliers of capital net capital exporters. In contrast, international financial centres offer their financial
institutions and expertise to the international community to both import and export of capital, that is, they
act as entrepot financial centres. Such a centre can be a net capital exporter or a net capital importer
the important feature is that the institutions and regulations enable and encourage foreign investors and
borrowers to participate in their financial markets.

2.4 TYPES OF OFFSHORE FINANCIAL CENTRES

There are broadly two types of offshore financial centres - functional centres and paper centres.

1. Functional Centres
Functional Centres are those where actual deals are struck with customers in respect of the obtaining
of deposits and the negotiating of loans. Markets exist for banks to borrow and lend deposits to other
banks and to issue certificates of deposits. Among the functional or fully operational centres a distinction
exists between "international" and "regional" financial centres. International centres cater to regions
extending far beyond the boundaries of the country or area in which the centre is located and they cater
to the financial needs of customers worldwide. On the other hand, regional financial centres derive their
role primarily from a combination of geographical proximity to the countries in which customers operate
and the safety and ease of operations of subsidiaries, branches and agencies of foreign banks whose head
offices lie in international financial centres, in other parts of the region through their own national size and
international power and the competence of their own national banks in international financial business.
Typically, an individual or company will maintain an offshore account in a low-tax jurisdiction (or tax
haven) that provides financial and legal advantages, such as:
• Greater privacy,
• Little or no taxation, (i.e., tax havens)
• Easy access to deposits (at least in terms of regulation),
• Protection against local, political, or financial instability.
2. Paper Centres
Paper centres also known as "booking", "shell", "brass plate", "routing" or "suitcase" centres are locations
where transactions are legally booked but they are really a set of ledgers maintained by an agent, the
intermediation occurs elsewhere. A booking financial centre serves as a location of record keeping and
there is no or very little actual banking activity. Branches of US Banks in the Caribbean and Bahamas are
a prominent example. For many US banks without full-service branches in London and other financial
centres, such locations offer low-cost access to the euro-currency markets.

3. Difference between Functional centres and Tax Havens.

Functional Centres Tax Havens
(a) Physical presence. Name plates.
(b) Less sensitive to local taxes/levies. Highly sensitive.
(c) One centre is not a substitute for another. All centres substitute for one another.
(d) Operations cannot come to sudden Operations would come to
end if incentives withdrawn. sudden end.
Three categories of off-shore centres
1. New York, Singapore, Tokyo, Bahrain offshore markets are all of a kind. Under their mles, special
accounts are established separately from domestic ones and can then be exempted from restrictions
that apply in the domestic financial market. Regulatory and tax-related concessions are available
only to transactions between non-residents.
11. That sort of offshore market stmcture is only necessary in countries where the domestic financial
system is highly regulated. In the second category of offshore centres, e.g., London, Hongkong and
other places where transactions are liberalised for both residents and non-residents the "offshore"
market is simply the onshore transactions between non-residents.
111. The third category of offshore market is the tax haven. Because of the tax breaks these markets
offer, they are used almost exclusively for transactions between non-residents. Cayman Islands,
the Bahamas, Isle of Man and Jersey fall into this category.

2.5 BENEFITS
Offshore banking is a lucrative business. Offshore business generates foreign exchange, licence fee
income, tax revenues, employment, travelling facilities, infrastmctural development as well as indirect
benefits like development of regional capital market and image building. It offers a change of economic
diversification and is far more profitable than tourism once the necessary infrastructure is in place requiring
less manpower and foreign exchange spending.
Some offshore banks may operate with a lower cost base and can provide higher interest rates than the
legal rate in the home country due to lower overheads and a lack of government intervention. Advocates of
offshore banking often characterize government regulation as a form of tax on domestic banks, reducing
interest rates on deposits. However, this is scarcely true now; most offsh01e countries offer very similar
interest rates than those that are offered back home.

2.6 REASONS FOR GROWTH

Since the Second World War the demand for offshore financial services has grown rapidly as a result
of high taxation and proliferating regulations in the industrialized countries combined with political
instability elsewhere. There has been growth of multi-national companies whose primary allegiance is
to shareholders rather than to any particular country. Along with this, the expansion of the world trade
and cross-border investment and the increase in personal and corporate wealth helped to stimulate this
growth. Further this has been made possible by revolutionary advances in communications technology
erasing the barriers of time and space for even the most remote locations.
The low tax investment has attracted hedge funds to set-up their offices. Further there has been attempts
to utilize these off-shore financial centres for purposes of tax planning through holding companies. The
absence of any Exchange Control Regulations have also ·assisted in these types of activities.

2.7 WHAT ARE THE INGREDIENTS THAT MAKE AN OFFSHORE CENTRE

SUCCESSFUL?
They are:
1. The territory should levy no direct taxes. (However, there does appear to be room for low tax
jurisdictions such as Barbados and the Netherland Antilles, where double-tax treaties with other
countries can be used to advantage).
ii. There should be no restrictions on the use of foreign exchange or the free movement of funds in
and out of the territory.
 111. There should be guarantees of client confidentially, preferably enshrined in legislation and enforced
by local courts.
IV. The governments should welcome and encourage offshore business by making it relatively easy for
intermediaries to function and by providing flexible regulations, minimal constraints and formalities
and simple, speedy processing of official documentations.
v. There should be professional staff to look after the business including lawyers, accountants and
bankers together with some well-known major international institutions and the major labour force
should be well-educated.
vi. There should be an adequate physical infrastructure including good telecommunications, back-up
facilities, skilled help to maintain and repair equipment and adequate office space.
vii. The legal system should be sound, reliable and impartial and relevant legislation should be clear
and unambiguous minimizing uncertainty and arbitrary administrative rulings.
v111. The territory should be conveniently located and easily accessible by plane from major cities with
suitable hotels and meetings facilities.
IX. The jurisdiction should enjoy political and social stability in order to inspire confidence among
investors and their agents.
Over and above these basics other factors may come into play such as the use of the US Dollar as the
local currency, the territory's cost structures and whether or not it has a proven track record and offers
a variety of services.

2.8 TAX HAVENS - TAX EVASION/AVOIDANCE/PLANNING

Until recently offshore financial centres were commonly described as tax havens, a term that many
offshore players dislike. Tax haven is a term suggesting an element of escape, bolt hole or at least refuge
and many of the Tax Havens prefer to be called Financial Centres. Offshore banking has often been
associated with the underground economy and organized crime via tax evasion and money laundering,
however, legally, offshore banking does not prevent assets from being subject to personal income tax
on interest. Except for certain people who meet fairly complex requirements, the personal income tax
of many countries makes no distinction between interest earned in local banks and those earned abroad.
Persons subject to US income tax, for example, are required to declare, on penalty of perjury, any foreign
bank accounts-which may or may not be numbered bank accounts, they may have.

2.9 FREEDOM FROM REGULATIONS

Tax efficiency is not the only reason for using an offshore centre. Freedom from regulation is another
major attraction as individuals and businesses seek to escape what they regard as onerous, unreasonable
or capricious restrictions imposed by governments. Offshore centres provide legal mechanisms, through
which business like banking, insurance and ship registration can avoid costly and time-consuming
regulation in certain circumstances.
More generally, offshore centres are often used to avoid foreign exchange and capital controls restrictions
on foreign investments and other domestic constraints such as the prohibition against interest payments
in some Islamic countries.

2.10 SAFE HAVEN FOR FLIGHT CAPITAL

Another source of demand for offshore service has been the need for a safe haven. Today the greatest need
for a safe haven is probably felt by the more affluent high-net-worth citizens of developing countries.
Having accumulated some liquid capital their principal goal is to preserve and protect their savings often
from rampant inflation. This phenomenon usually known as the "capital flight" stems from the collapse of
confidence in governments, institutions and currencies due to political instability and economic disarray.

2.11 ANONYMITY AND CONFIDENTIALITY CONSIDERATIONS

Finally, many clients use offshore centres to achieve anonymity and confidentially over their affairs
for personal or business reasons. Offshore centres are however not foolproof. The US government
has successfully cracked their secrecy barriers in some criminal cases through court action or inter
governmental co-operation. But many regard the confidentiality available in offshore locations as being
far better than in their own countries. Although offshore banks may decide not to report income to other
tax authorities, and have no legal obligation to do so as they are protected by bank secrecy, this does not
make the non-declaration of the income by the tax-payer or the evasion of the tax on that income legal.
Following the 9/11 attacks, there have been many calls for more regulation on international finance, in
particular concerning offshore banks, tax havens, and clearing houses such as Clear stream, based in
Luxembourg, being possible crossroads for major illegal money flows.

2.12 MAIN OFFSHORE FINANCIAL CENTRES

London
London offers many attractions to foreign enterprises wishing to conduct offshore business. One obvious
advantage which the City possess over possible rivals on the continent such as Paris is that English is
the lingua franca of modem finance. At the same time, English law is considered to provide a superior
framework to continental Law for international financial transactions. A further attraction is that the
Square Mile of the city lies at the hub of an infrastructure of world communications. However, the City's
trump card in becoming the main centre of the Euromarket was the particular appropriateness of its long
tradition of financial freedom. A liberal financial regime free of political interference acts like magnet
to funds charged by the twin forces of fear and greed. Due to time zone advantage it acts as a bridge
between Asia and US market.
The emergence of the so-called 'Eurodollar market' in London in the late 1950s marked the first episode
towards increased liberalisation of the international financial markets. The City of London the financial
district located around the Bank of England - became an 'offshore' financial centre in the respect that
it was made possible to conduct non-sterling transactions nearly completely without state regulations.
Most of the transactions were carried out in dollars, therefore the term 'Eurodollars' emerged. However,
this was also possible with other currencies, such as the Swiss franc or the Deutschmark, hence a more
general term is 'Euro markets'.

Switzerland
Swiss bankers talk of their neutral country as the natural haven of safe money for the world on account
of its image as the world's safe deposit vault - the home of "Swiss Gnomes" and the progenitor of the
numbered account. Many Swiss are proud of their banking secrecy law because it reflects the national
passion for privacy and has admirable origins (it was passed in the 1930s to help persecuted Jews protect
their savings).
After years of lobbying by law enforcement agencies (particularly U.S.), Switzerland has agreed to co-
operate with authorities in cases involving money derived from drugs and other criminal activities. The
Swiss, however, stood firm on the matter of tax evasion and still reluctant to supply foreign governments
with information on suspected evaders. Although the Swiss insist their secrecy provisions are as strong as
ever, the very idea that foreign governments might get a look-in has been enough to scare away investors
with more to hide than common tax evasion. Switzerland remains the "biggest private banking financial
centres for cross border wealth management" with assets worth over CHF 2.11 trillion ($2.2 trillion), as per
the study conducted by the Swiss Bankers Association (SBA) and the Boston Consulting Group (BCG).

Singapore
Singapore has grown rapidly as an offshore financial centre since it became the centre of the Asian Dollar
market which was officially launched in 1968 when the Singapore branch of Bank of America applied
to the government of Singapore for permission to establish a separate currency section or unit called the
Asian Currency Unit (ACU). The impetus of this development was the realisation that with the economic
development of Asian countries and the increasing number of international corporations active in Asia,
there existed a pool of hard currencies, mainly US Dollars that could be tapped in Asia. Furthermore,
US Banks wanted to tap the potential source of excess Dollars existing in the Asia-Pacific region at the
height of the Vietnam War and to offer investors in the area the opportunity to invest their accumulated
Dollar holding locally rather than investing in London.
An ACU is an integral part of a licensed banking operation conducted in Singapore. Other than the
separation of its activities for accounting, fiscal and reporting purposes, together with the exemption of
. certain of its activities for regulatory and fiscal requirements, an ACU has no separate identity from the
bank within which it is situated.
The growth of the Asian Dollar Market was helped by the active support of the Singapore government
and especially the Monetary Authority of Singapore (MAS). The government supported the market's
development by gradually removing various restrictions, allowing more access to the domestic market
and expanding the areas of tax concessions. Restrictions on non-resident activities in ACU are minimal
and are increasingly being liberalised.

Hongkong
Initially Hongkong had been unique among the world' financial centres due to its status with the United
Kingdom, proximity to mainland China and connection with South East Asia, Australia and Japan. Its
geographical location, modem communications and transportation, plus its free-enterprise system have
made Hongkong as one of the most prosperous centres in the Pacific Basin. Even after cessation of
Hongkong to China by U.K. the centre has retained its attraction as an offshore financial centre.
Hongkong's economic prosperity is primarily based on real estate, manufacturing, foreign trade activities
and the diversityofbanking and financial institutions. The huge amounts of trade financing in Hongkong
includes trading not only for the colony but also for the Third World countries in the Pacific region.
Foreign banks are very active in this type of financing. The funding of the loans come from local deposits
as well as foreign borrowing.

2.13 INTERNATIONAL BANKING FACILITIES: THE US ANSWER TO OFFSHORE

BANKING CENTRES
In December 1981 the US launched an assault on the offshore banking centres of Caribbean by creating
International Banking Facilities (IBF). This was designed to offer US banks many of the advantages
available offshore without actually leaving home. New York banks are permitted to conduct an international
market in Euro currency in their own cost without its dominant US Dollar constituent being constrained
within the domestic regulation of the US.
IBFs are simply a set of books kept in the office of a US or foreign bank in the US. They can only be
used for transactions with non-US residents, other IBFs and the parent bank. They are free from normal
US reserve requirements, interest rate ceilings and deposit insurance premiums. In addition they receive
favourable tax treatment in several US states.
IBFs are aimed at enhancing the competitive position of U.S. offices of depository institutions and Edge
Act Agreement Corporations and U.S. branches and agencies of foreign banks. With respect to non-bank
customers located outside the United States, IBFs are permitted to accept only deposits that support the
customer's operations outside the United States and extend credit only to finance the customers' non-US
operations.
IBFs are permitted to accept time deposits from foreign residents and to borrow from foreign banks or
other IBFs.
No separate organizational structure is required for an IBF. It operates primarily as a record keeping entity
similar to an offshore shell branches. No approval of the Federal Reserve Board is required to establish
an IBF. However, an institution that desires to establish an IBF is required to notify Federal Reserve
Bank in its district at least 14 days in advance.
There has been decline in business with foreign customers in Caribbean apparently caused by the
introduction of IBFs. In fact, much of the management and book-keeping related to bank accounts in the
Caribbean had been handled in the US. For many customers the move to IBFs merely simplified matters.

Tokyo's Offshore Banking Market

Modelled on New York's IBFs Japan's offshore banking centre is a market for deposits and loans free
of most domestic regulations and of withholding tax on interest. The Japanese version was set up with
a view to allowing banks resident in Japan to conduct offshore business with non-residents without the
need for reserve requirements and deposit insurance and with the additional hope that this could help the
Yen to be used as an international currency.

The Cayman Islands

The Cayman Islands is one of the largest financial centres in terms of assets held, after London, Tokyo,
New York and Hongkong.
The following factors account for the island's success:
i. Political and economic stability
11. Responsive and responsible government
u1. Sound judicial system
1v. Sound legislative framework
v. Sound regulatory environment
vi. No taxation
vii. No exchange control
viii. Good infrastructure and communication
1x. Good professional services
x. Good accessibility
Cayman Islands is a "Brass Plate" variety of offshore centre.

Bahamas
The Bahamas has grown rapidly as an offshore financial centre since the mid-1960s when it was an
offshore tax haven with little more than a few branches of foreign banks.
 IONAL'BA ING

Key factors in its success are:

1. Absence of personal or corporate income taxes and capital gains tax.
11. Strict banking secrecy.
iii. Political stability.
1v. Proximity to the US.
v. Accommodating International Business Co. Act which provides the offshore financial sector with
a corporate vehicle that is administratively flexible and cost-effective.
vi. Low fees.
vii. Developed business infrastructure of lawyers, accountants and so on.
viii. First class transport and communication.
1x. The Islands are renowned for their blue shallow seas and spectacular beaches.
Bahamas, like Cayman Islands, is a "Brass Plate" centre.

Bahrain
Bahrain is the financial centre for the Middle East and has been since the 1970 when the oil price of 1973/74
stimulated economic growth. The enormous concentration of wealth in the Gulf area, has promoted the
growth of local financial centres in the Gulf area.
Factors for the success of Bahrain are:
i. No personal or corporate taxes.
n. State of the art telecommunications.
111. Linked by 13-mile causeway to eastern border of Saudi Arabia.
1v. Subsidised fuel, water and power supplies.
v. Political stability.
v1. Educated workforce and English is widely spoken.
v11. No restriction on the repatriation of capital, profit or income.
I
v111. No duties on imported raw materials and semi-manufactured goods. I
1x. Freedom from excessive bureaucracy.

Bermuda I
Bermuda is one of the biggest and most successful of the World's offshore financial centres. In recent I
I
years it has been the number one destination of Hongkong companies looking for a new home after 1997
when Hongkong was handed over to China. More than 50%, by market capitalization, of the companies
listed on the Hongkong Stock Exchange have relocated there.
Apart from this, it has the biggest offshore insurance sector worldwide with more than 1300 insurance
companies registered. Unusually for an offshore centre, however, the banking sector is small and entirely
indigenous.
Another distinction between Bermuda and other offshore centres is its treaty with the United States which
includes an exchange of information agreement on taxes. This means Bermuda is essentially a low-tax
business centre in the mould of Hongkong rather than a traditional tax haven. The island authorities stress
that they let in only such business as will reflect well on the island.
British Virgin lsl'ands
A self-gov,erning British Dependent Territory, the BVI is possibly best known as the world's pre-eminent
offshore cmporate domicile. It has:
i. Excellent stat,e of the art, fibre optic telecommunications system and infrastructure.
ii. An established private sector financial services industry and community.
iii. A government commitment to the continual development and growth of financial services.
iv. Established regulatory and supervisory procedures and practices.
v. Priority given to business niches where common factors allow economies of scale to be realised.
v1. No or low taxes.
vii. Con1fidentiality.
viii. Stable Politics.

Jersey
Jersey is a British offshore centre that provides itself on the quality of the financial institutions that have
chosen to make the island their home nearby. All the banks on the island are wholly or partly owned by
banks within the world's top 5100 when ranked by capital size.
Main factors contributing to Jersey's stature as an offshore centre are:
1. A long tradition of economic and political stability.
11. Good business infrastructure.
111. Convenient location for Brita in and Europe.
1

1v. Low tax centre.

Luxembourg
Bankers estimate the Grand Duchy is home to some 3000 equity, bond and currency funds and sub-funds
which manage investment capital in excess of Pound 200 billion.
There are no formal offshore legislation or rax breaks designed specifically to attract institutions. But non-
residents pay no capital gains tax, no withho lding tax or inheritance tax on assets held in the jurisdiction.
1

Liechtenstein
Liechtenstein, the world's smallest sovereign state situated on the east bank of the Rhine between
Switzerland and Austria is rapidly overtaking Switzerland as Europe's number one tax haven. A series
of scandals involving Swiss banks and the subsequent willingness of the government in Bern to succumb
to pressure and weaken the country's banking secrecy rules have played into Liechtenstein's hands.
The core attraction of Liechtenstein's private banking industry which sets it apart from Switzerland and
other offshore banking centres is its long experience in offering Anstalt and foundation service to the
mega-rich. The Anstalt is widely considered the ultimate in banking secrecy. Unlike in Switzerland where
bankers are legally obliged to be aware of account holders identities this is not required. A lawyer signs
a due diligence agreement with the authorities and when both are satisfied that the money involved is
clear the customer is referred to one of the local banks.
Liechtenstein is primarily for those clients who want an additional element of secrecy and protection
for their assets. It is very strong because of its proximity to Switzerland. The principality tends to serve
traditional wealth more than the new money coming out of places like Latin America.
Panama
Panama's location and its historical role as a centre of international trade and transport make it a natural
site for offshore financial activities; other attractions are that it uses the dollar as its currency. There is
complete freedom to move funds in and out of the country and the foreign income of companies and
banks is exempt from tax (including withholding tax when it is redirected abroad). In addition Panama
maintains tight bank secrecy, has little red tape and is not expensive.

Other Offshore Centres

In Europe Malta is one of the new centres making a pitch for funds to manage from Italian and other
central Mediterranean investors. Cyprus considers itself a natural haven for Middle East money as Arab
countries traditionally used the island as a springboard to Europe. Since 1989 Dublin has been making
a determined effort to compete with Luxembourg. Other offshore centres include Anguilla, Barbados,
Madeira, Puertico Rico, Gibralter, Aruba, Turks & Caicos Islands, Netherland Antilles, Monaco, etc.

2.14 SPECIAL ECONOMIC ZONES (SEZS)

A Special Economic Zone (SEZ) is a geographical region that has economic laws that are more liberal
than a country's typical economic laws. The category 'SEZ' covers a broad range of more specific zone
types, including Free Trade Zones (FTZ), Export Processing Zones (EPZ), Free Zones (FZ), Industrial
Estates (IE), Free Ports, Urban Enterprise Zones and others. Usually the goal of a structure is to increase
foreign direct investment by foreign investors, typically an international business or a multinational
corporation (MNC).
• Fundamentals of SEZs
• SEZs (special economic zones) are fundamentally different from the traditional free zones.
• They are much larger in size; offer broader range of activities such as
- a single - window management,
- streamlined procedures,
- duty free privileges,
- also access to the domestic market on a duty - paid basis.
• The revised Kyoto Convention of the World Customs Organisation defines free zone as "outside
the customs territory".
• Whether the enclave is termed an EPZ, FTZ or SEZ, the cardinal factor is the provision of
• appropriate infrastructure and transport facilities,
• low factor cost,
• flexible labour laws,
• a low degree of tariff protection,
• convertibility of currency,
• stable legal and administrative regime, and
• a commitment to the canons of an open economy.
The World Bank created the following table to clarify distinctions between types of special economic
zones:
 Typical
Activiti~s
<50 Entrepots and Domestic,
FTZ Support trade Port of entry
hectares trade related re-export
Export <100 Manufacturing,
EPZ (traditional) None Mostly export
manufacturing hectares processing
EPZ (single UniU Export No Manufacturing,
Countrywide Mostly export
free enterprise) manufacturing minimum processing
Export <100 Manufacturing,
EPZ (hybrid) None Export, domestic
manufacturing hectares processing
Integrated >1000 Internal,
Free porUSEZ None Multi-use
development hectares domestic, export
Urban enterprise Urban <50 Domestic
Urban/rural Multi-use
zone revitalization hectares

SEZs have been implemented using a variety of institutional structures across the world ranging from
fully public (government operator, government developer, government regulator) to 'fully' private (private
operator, private developer, public regulator). In many cases, public sector operators and developers
act as quasi-government agencies in that they have a pseudo-corporate institutional structure and have
budgetary autonomy. SEZs are often developed under a public-private partnership arrangement, in which
the public sector provides some level of support (provision of off-site infrastructure, equity investment,
soft loans, bond issues, etc.) to enable a private sector developer to obtain a reasonable rate ofreturn on
the project (typically 10-20% depending on risk levels).

India
Considering the need to enhance foreign investment and promote exports from the country and realising
the need that a level playing field must be made available to the domestic enterprises and manufacturers
to be competitive globally, the Government of India had in April 2000 announced the introduction of
Special Economic Zones policy in the country, deemed to be foreign territory for the purposes of trade
operations, duties and tariffs.
India passed special economic zone act in 2005. In India, the government has been proactive in the
development of the SEZs. They have formulated policies, reviewed them occasionally and have ensured
that ample facilities are provided to the developers of the SEZs as well as to the companies setting up
units in the SEZs.
All these SEZs are in various parts of the country in the private/joint sectors or by the State Government.
But this process of planning and development is under question, as the states in which the SEZs have
been approved are facing intense protests, from the farming community, accusing the government of
forcibly snatching fertile land from them, at heavily discounted prices as against the prevailing prices in
the commercial real estate industry.
The SEZ Act 2005 envisages key role for the State Governments in Export Promotion and creation
of related infrastructure. A Single Window SEZ approval mechanism has been provided through a 19
member inter-ministerial SEZ Board of Approval (BoA). The applications duly recommended by the
respective State Governments/UT Administration are considered by this BoA periodically. All decisions
of the Board of approvals are with consensus.
The SEZ Rules provide for different minimum land requirement for different class of SEZs. Every SEZ
is divided into a processing area where alone the SEZ units would come up and the non-processing area
where the supporting infrastructure is to be created.
India was one of the first in Asia to recognize the effectiveness of the Export Processing Zone (EPZ)
model in promoting exports, with Asia's first EPZ set up in Kandla in 1965. With a view to overcome the
shortcomings experienced on account of the multiplicity of controls and clearances; absence of world-
class infrastructure, and an unstable fiscal regime and with a view to attract larger foreign investments
in India, the Special Economic Zones (SEZs) Policy was announced in April 2000.
The SEZ Rules provide for:
• Simplified procedures for development, operation, and maintenance of the Special Economic Zones
and for setting up units and conducting business in SEZs;
• Single window clearance for setting up of an SEZ;
• Single window clearance for setting up a unit in a Special Economic Zone;
• Single Window clearance on matters relating to Central as well as State Governments;
• Simplified compliance procedures and documentation with an emphasis on self certification.

Approval mechanism
The developer submits the proposal for establishment of SEZ to the concerned State Government. The
State Government has to forward the proposal with its recommendation within 45 days from the date
of receipt of such proposal to the Board of Approval. The applicant also has the option to submit the
proposal directly to the Board of Approval.
The Board of Approval has been constituted by the Central Government in exercise of the powers
conferred under the SEZ Act. All the decisions are taken in the Board of Approval by consensus. The
Board of Approval has 19 Members.

Incentives and facilities offered to the SEZs

The incentives and facilities offered to the units in SEZs for attracting investments into the SEZs,
including foreign investment include:
• Duty free import/domestic procurement of goods for development, operation and maintenance of
SEZ units.
• 100% Income Tax exemption on export income for SEZ units under Section 10AA of the Income
Tax Act for first 5 years, 50% for next 5 years thereafter and 50% of the ploughed back export profit
for next 5 years.
• Exemption from minimum alternate tax under section 115JB of the Income Tax Act.
• External commercial borrowing by SEZ units upto US $ 500 million in a year without any maturity
restriction through recognized banking channels.
• Exemption from Central Sales Tax.
• Exemption from Service Tax.
• Single window clearance for Central and State level approvals.
• Exemption from State sales tax and other levies as extended by the respective State Governments.
The major incentives and facilities available to SEZ developers include:
• Exemption from customs/excise duties for development of SEZs for authorized operations approved
by the BOA.
• Income Tax exemption on income derived from the business of development of the SEZ in a block
of 10 years in 15 years under Section 80-IAB of the Income Tax Act.
• Exemption from minimum alternate tax under Section 115 JB of the Income Tax Act.
• Exemption from dividend distribution tax under Section 1150 of the Income Tax Act.
 • Exemption from Central Sales Tax (CST).
• Exemption from Service Tax (Section 7, 26 and Second Schedule of the SEZ Act).
sEZs - leading to the growth of labour intensive manufacturing industry
Many of the approvals are for sector specific and multi product SEZs for manufacture of Textiles &
Apparels, Leather Footwear, Automobile components, Gems and Jewellery, Engineering, etc., which
would involve labour intensive manufacturing. SEZs are going to lead to creation of employment for large
number ofunemployed rural youth. Hyderabad Gems SEZ for Jewellery manufacturing in Hyderabad has
already employed 2145 persons. majority of whom are from landless families, after providing training
to them. They have a projected direct employment for about 2267 persons. Apache SEZ being set up
in Andhra Pradesh will employ 20, 000 persons to manufacture 10,00,000 pairs of shoes every month.
Current employment in Apache SEZ is 5536 persons. Brandix Apparels, a Sri Lankan FDI project would
provide employment to 60,000 workers over a period of3 years. Even in the services sector, 12.5 million
sq meters space is expected in the IT/ITES SEZs which as per the NASSCOM standards translates into
12.5 lakh jobs. It is, therefore, expected that establishment of SEZs would lead to fast growth of labour
intensive manufacturing and services in the country.

Benefits derived from SEZs

Benefit derived from SEZs is evident from the investment, employment, exports and infrastructural
developments additionally generated. The benefits derived from multiplier effect of the investments
and additional economic activity in the SEZs and the employment generated thus will far outweigh the
tax exemptions and the losses on account of land acquisition. Stability in fiscal concession is absolutely
essential to ensure credibility of Government intensions.
Exports from the functioning SEZs during the last few years are as under:
Year Value (Rs. Crore) Growth Rate (over previous year)
2003-2004 13,854 39%
2004-2005 18,314 32%
2005-2006 22 840 25%
2006-2007 34,615 52%
2007-2008 66,638 92%
2008-2009 99,689 50%
2009-2010 2,20,711 121%
2010-2011 3,15,868 43.11%
2011-2012 3,64,478 15.39%
2012-2013 4,76,159 31%
2013-2014 4,94,077 4%
2014-2015 4,63,770 -6%
2015-2016 4,67,337 .80%

2.15 REGULATORY CONCERNS

Regulation is a much debated subject that affects offshore communities throughout the world. Offshore
countries have supervisory bodies and in some cases central banks governing the financial sector. But they
walk a tightrope between imposing regulation and maintaining secrecy. The pressure is on from outside
authorities to stamp out illicit money laundering and tax evasion and money which funds acts of terrorism.
Supervisory officials agree without question that money laundering particularly, terror and drug-related,
calls for immediate co-operation with authorities. But questions of tax evasion are more difficult- offshore
centres will not enforce the revenue laws of another country.

Let Us Sum Up
The expression "Offshore" is used in the world of finance, to apply to any centre where international
business may be done by an offshore, independent state but it may also be a state within a state - usually
a situation where a country allows international business to be conducted free from the burden of its
official regulation including taxation and controls over the portfolio decisions of banking units.
The offshore financial centres include markets where one or more of the following characteristics prevail:
1. There is a large foreign currency (euro-currency) market for deposits and loans, (e.g., London).
2. The market is a large net supplier of funds to the world financial markets.
3. The market is an intermediary or pass through for international loan funds, (e.g., Bahamas, Cayman
Islands).
4. The market may offer tax-breaks.
There are broadly two types of offshore financial centres:
1. Functional centres where actual deals are struck with customers in respect of the obtaining of
deposits and the negotiating of loans.
2. Paper centres also known as "booking", "shell", "brassplate", "routing" or "suitcase", centres
where transactions are legally booked on they are really a set of ledgers maintained by an agent,
the intermediate occurs elsewhere. Examples include Bahamas, Cayman Islands.

Offshore centres can be grouped in three categories

1. New York, Singapore and Tokyo Offshore market are all of a kind. Under their rules, special
accounts established separately from domestic ones can then be exempted from restrictions that
apply in the domestic financial market. Regulatory and tax-related concessions are available only
for transactions between non-residents.
2. London, Hongkong and other places where transactions are liberalised for both residents and non-
residents and the offshore market is simply the onshore transactions between non-residents.
3. Tax havens - Because of the tax breaks these markets offer, they are almost exclusively used for
transactions between non-residents.
Regulations of offshore centres is a much debated subject. Offshore centres have supervisory bodies and
in some cases central banks governing the financial sector. But they walk a tightrope between imposing
regulations and maintaining secrecy. Supervisory authorities do not question that money laundering,
particularly drug-related calls for immediate co-operation with authorities. But question of tax-evasion
is more difficult - offshore centres will not enforce the revenue laws of another country.

Special Economic Zones {SEZs)

SEZs have been set up in different parts of the country to generate economic growth, draw new investments
leading to exports and creating employment.

Key Terms/Glossary
Offshore financial centres: any centre where international business may be done in a favourable hospitable
tax and regulatory climate.
Functional centres: centres where actual deals are struck with customers.
Paper centres: also known as "brassplate", "booking's", "shell", "routing" or "suitcase" centres- locations
where transactions are legally booked but they are really a set of ledgers maintained by an agent.
Tax havens: centres having legal mechanisms to reduce or eliminate taxes on income, wealth, profits
and inheritance or to accumulate tax free income offshore pending repatriation to a taxable jurisdiction.
Centres with low tax rates that attract companies, individuals fleeing higher tax rates elsewhere.
Belgian Dentist: Mythical figure regarded as the classic small investor seeking to invest in Euro-bonds
in the most tax-efficient way, who went to Luxembourg to collect his tax free payment.
Edge Act Agreement Corporation: State Chartered banks in the USA are permitted to create "agreement"
corporations. The company "agrees" with the Federal Reserve to limit its activities to those permitted
to Edge Act Corporation. Edge act permits corporations to establish domestic offices outside their home
states to transact only international business.
Gnomes of Zurich: Swiss banks were a powerful force in the foreign exchange market, influencing as
they moved from one currency sector to another, which currency floated up, which down. It was during
that era that angry finance ministers dubbed Swiss bankers the "Gnomes of Zurich".

Terminal Questions
1. Define the term "offshore banking centre". What are their distinctive characteristics and what are
the ingredients for making a successful offshore centre?
2. Describe the three categories of offshore banking centres.
3. Which are the main offshore banking centres in the world?
4. Write a short note on the benefits of SEZs.
 PROFITABILITY OF
INTERNATIONAL BANKING
OPERATIONS

STRUCTURE
3.0 Objective
3.1 Profitability and l 0 rospect&' of International Banking

Let Us Sum Up
Terminal Question
3.0 OBJECTIVE
After reading this section you will have an idea of how international banking has grown during the last
50 years and the future prospects.

3.1 PROFITABILITY AND PROSPECTS OF INTERNATIONAL BANKING

During the past 50 years, important changes have taken place in the arena of international banking.
International divisions became very powerful within the large banks throughout the 1950s and I 960s.
The typical experience was for growth in international earnings and for the mix of total earnings to shift
progressively in favour of overseas profits.

a. A period of stability - the 1950s and 1960s

The 1950 - 73 period was relatively free of adversity for firms doing business abroad. Banks owned:
• Cheap sources of funding and the sizeable float.
• Privileged access to liquidity (discount windows, payment services, interbank market).
• Regulatory franchise.
• Informational franchise.
• Relatively limited competition.
Aided by low-cost funds and limited competition, the banks' profitable growth also reflected the increasing
demand for banking services that was fuelled by growth in world commerce, affluence among businesses
and households - savings available for deposit and demand for credit and payment system to support
consumption and investment by government, households and businesses.
Because of limited and "polite" competition as well as the growing demand for their services and credit
facilities banks evolved without being particularly market sensitive. To a significant extent they were
acceptors of deposits and rationer of credit. With such asset and liability opportunities, a principal element
in securing attractive profitability was the avoidance of large credit losses. This gave rise to a general
philosophy of conservatism among bankers in extending credit developing new products, entering new
markets, delivering new services and/or funding themselves.

b. A decade of high risk - the 1970s

This sense of tranquility was disrupted by the first oil shock, war in the Middle East and the failure of
the Herstatt Bank in West Germany. The ensuing global recession of 1974-76 caused severe problems
in overseas markets for the first time in the post-war period.
The mistakes made by bankers in country lending essentially extending credit overseas on the presumed
creditworthiness of sovereign entities - are well known. Lending to both private and public entities abroad
was heavily influenced by the widely held view that "countries do not go bust".
The major US commercial banks, led consistently by Citibank / Citicorp, had developed significant
business links and loan experience in LDCs, especially Latin nations, through the 1950s and l 960s.
Their profit experiences there and the Latin American growth rates had been impressive. Extrapolation,
often the enemy of wise prediction, suggested until the late 1970s that the good times could roll on in
Latin lending. Bankers ignored the red flags - the warning signals of 1979 which brought the second
oil shock and the draconian anti-inflation interest rate actions by Paul Volcker and the Fed. Worldwide
recession, capital flight from LDCs, massive Latin deficits - all were rapidly triggered. The game was
over, but the bankers just could not stop playing.
The banks kept on lending, hostage to their own lack of adequate capital and reserves to cover the
deteriorating LDC loans. Since they could not take the "hit" then without going under, they made matters
worse certainly for the debtors and arguably for themselves. They lent more - massively more.

c. Bankers Blues - 1980s

Mexico's August 1982 announcement that it was broke sent shock waves and brought awareness into the
LDC debt problems and it changed the thinking behind the banks' lending. But in a very real sense it did
not change their direction. The restructuring agreements meant still more lending. Only now the banks
desperately sought to make more money up-front on loans they knew to be questionable. They got stiff
rescheduling fees and usually high spreads above their own cost of funds.
With every restructuring deal, the banks made more short-term money yet increased odds, they ultimately
would lose money and lose big.
On top of the fall-out from LDC lending came the bursting of the real-estate bubble of the late 1980s,
souring of the loans to the oil patch and the stock market crash of 1987. Merger mania, a major source
of earning burned itself out, leaving junk bonds living up to their names. The banks that were hardest hit
were those that expanded their global presence and their lending most aggressively assuming that profits
would take care of themselves. Several top US banks, it was said, were technically insolvent.

d. 1990s - the era of consolidation, capitalization and return to profitability

There can be few industries that have changed as much in the last decade of 20th century as banking.
The period beginning 1990s has been a period of astonishing (and almost unpredicted) success for banks.
The world's top banks now have open to them a range of options much larger than they have enjoyed
before. In 1990 a big US bank for instance had little room for manoeuvre. It was basically barred for
securities business. The struggle to write off the mistakes of the past (and rebuild capital) made mergers
difficult. The actions of European banks were even more circumscribed. In most countries even reducing
costs was almost impossible because of the social taboo on firing staff.
Today about the only choice a bank cannot make is to continue as it is. In most jurisdictions, commercial
banks can choose to get together with (or buy) an insurance business, an asset-management firm or
securities operation. Conversely, they can just as easily sell any of these operations if they decide they
don't like a business they are already in.

e. Global Financial Crisis Emerging scenario

In a more and more market driven world, financial institutions are under increasing and accelerated
pressure to strategically reposition themselves in a marketplace where the competitive landscape is being
redefined almost overnight. Banks will be forced to identify new ways to increase efficiency, enter into
emerging markets, provide new products, shed unprofitable operations and capitalize on new opportunities.
Promoting innovation by peering into the challenges ahead rather than the gloom of the past through the
rear-view mirror has become a top priority for the smartest banks. It is a continuous track race, which
contestants join, win a few laps/fall behind, recover or quit success will belong to those that produce a
"trajectory" of improvements and predicting a "corridor" of characteristics that users would demand.
"The market is an experimental discovery process" (Charles Coch).
The recent developments in the financial markets all over the world have proved that the "discovery
process" has become very painful. The global financial market during the past two years has been
tumultuously turbulent which has affected severely both the developed and developing countries. Never
has the common man on the street felt its effects so adversely and on such a wide scale, perhaps after
the Second World War. As a result of the failure of banks and financial institutions in the developed
markets to manage their risks, the cascading effects spread to the other parts of the global markets. It is
now well known how some of the leading international .banks were on the verge of collapse and had to
be rescued by their respective governments. As a result of the contraction of the real economies of these
countries, there has been a global melt down of the financial markets and the entire world is passing
through a period of deep economic recession. The leading international banks have drastically reduced
their balance sheets and curtailed global expansion plans and programmes. This has naturally affected
adversely international banking. With a substantial decline in international trade the prospects of growth
are not in sight immediately.
Risks in global financial stability has declined since the October 2010 Global Financial Stability Report,
helped in part by improving macroeconomic conditions. Many advanced economies are struggling
with the legacy of high debt and excessive leverage. High debt levels are evidence in many parts of the
global economy, in complete policy action and reform has left segments of the global banking system
vulnerable to further shocks. Elevated household leverage in the United States poses downside risks to
housing markets. More structural policies may be needed to reduce this debt burden. Capital inflows to
emerging markets have rebounded but volatile. Policymakers face three key challenges in putting the
recovery onto a durable path. They need to
• Address the legacy problems of high burdens and weakened balance sheets in advanced economies;
• Develop a stronger, more robust financial system that is subject to greater market discipline; and
• Guard against risks of overheating and the buildup of financial imbalances in emerging markets.
The implications of the recent financial crisis are far reaching. However for future growth in international
banking one would now need to look to some of the emerging economies of Asia, South America, Africa
and Russia. The real economies of these countries are showing signs of revival and along with them there
is a hope of revival of international banking also.

Let Us Sum Up
International banking has been dominated over the past four decades by a number of trends, the blurring
of distinctions between banks, securities houses and other financial institutions, the displacement of banks
as the main conduit for depositing and borrowing money (the process of"disintermediation" the erosion
of the distinction between debt and equity through the development oftradeable paper ("securitisation"),
the globalization of markets. All these trends are becoming as real in the domestic market place as they
are in international sphere. For centuries banking and finance have been pursued at a local level with
scant regard to changes or movements in the world scene, no longer.
The most immediate impact of this revolution is clearly on the industry itself, the players in the market.
For them this has so far been a story largely of competitive forces and opportunities for growth. Global
integration of financial markets is being driven by the worldwide search on the part of investors and
issuers for more favourable returns and lower cost of funds respectively. Meeting these objectives has
been facilitated by improved communications, the erosion of barriers to capital flows, the modernization
of key national financial systems and the gradual liberalisation of international trade in services. The
cutting edge of globalization has been the Euromarket those loosely organised, virtually unregulated,
over - the - counter global markets encompassing debt in a broad range of maturities and types of
securities. The effect of globalization is to give participants in financial markets a wide range of viable
alternatives. The market places strict demands on participating financial houses - staffing, facilities,
market intelligence and research and changing regulatory requirements all involve significant costs.
Foremost among the global trends in the world's financial industry are consolidation and convergence.
These deals encompass financially driven mergers within domestic markets designed to cut costs, more
strategic cross-border deals as bank with large shares in their own domestic markets seek to expand across
in other countries and a growing number of deals between banks and insurance companies.
Banks want to merge to gain economic scale or enter new geographic markets. The following factors
are spurring these mergers:
(a) Advances in technology- increases competition drives down prices, making the urge to merge a
financial imperative.
(b) Deregulation, in industries, permitting mergers that were once verboten (prohibited).
(c) The blurring of markets fuels new combinations.
(d) The need to compete on a regional or global basis prompts merger.
Financial institutions are under increasing pressure to strategically reposition themselves in a marketplace
where the competitive landscape has been redefined almost overnight. Banks will be forced to identify
new ways, to increase efficiency, enter into developing markets, provide new products, shed unprofitable
operations and capitalize on new opportunities.

Terminal Question
1. How do you see the prospects of international banking as a result of global financial crisis?
 UN IT
CORRESPONDENT BANKING AND
4 INTER-BANK BANKING

STRUCTURE
4.0 Objectives
4.1 Introduction
4.2 What is "Correspondent Banking"?
4.3 Attractions of "Correspondent Banking"
4.4 Factors in the Growth of Correspondent Banking
4.5 Changes in the Field of Correspondent Banking since the early 1980s
4.6 Clearing House Functions
4.7 Payments and Collections
4.8 Letters of Credit and Bankers' Acceptances
4.9 Trade Development and Referrals
4.10 Credit Services - Loans and Placements, etc.
4.11 Foreign Exchange Services
4.12 Travel Services
4.13 Other Facilities
4.14 Competitive Environment
4.15 The Euro's Challenge to Correspondent Banking

Let Us Sum Up
Key Terms
Terminal Questions
4.0 OBJECTIVES
After reading this Unit, you will know the nature of correspondent banking, the recent trends, reasons
for its growth, its various functions, the present competitive environment and the importance of pricing
activities correctly and the euro's challenge to correspondent banks.

4.1 INTRODUCTION
For a long time correspondent banking was considered as a relatively unimportant back-office business
offered by banks and given scant attention by Senior Management. Bank to bank relationships have been
redefined and as a result passive approach to managing reciprocal business has been supplanted by a
marketing drive and identified as an independent profit centre.

4.2 WHAT IS "CORRESPONDENT BANKING"?

A correspondent bank is a financial institution that provides services on behalf of another, equal or unequal,
financial institution. It can facilitate wire transfers, conduct business transactions, accept deposits and
gather documents on behalf of another financial institution. Correspondent banks are most likely to be
used by domestic banks to service transactions that either originate or are completed in foreign countries,
acting as a domestic bank's agent abroad.
In the strictest sense Correspondent Banking is the relation between banks which have mutual accounts
or at least one has an account with the other and such transactions between these banks are called Inter-
Bank transactions. However, more often it is used in a more general sense means relations with banks.
Correspondent Banking is the practice whereby a bank establishes a presence in an overcostly or otherwise
inaccessible market by means of a relationship with a local bank. It is one of the vehicles available for
the transaction of international business, other being agencies, branches, consortium banks, local bank
acquisitions, joint ventures and merchant banks. Typically, correspondent banking is the most appropriate
vehicle in the low-volume, early stage of business. The decision to use a correspondent relationship is
influenced also by the high costs associated with operating global branch systems. With access to national
banking in foreign countries, through correspondent relationships, a bank can easily obtain national
access for certain services. Generally correspondent banking is reciprocal between the two banks who
have established correspondent banking relationship.

4.3 ATTRACTIONS OF "CORRESPONDENT BANKING"

A particular attraction of an international correspondent relationship is that it allows the bank to take
advantage of the business opportunities abroad while minimizing its operating cost. Many banks have
found that the expansion of correspondent networks can develop a greater customer base that can
simultaneously be used as a basis for strategic marketing decisions.
Correspondent banking consists of banking services that are provided by banks to other banks. Typically
the banks buying and selling correspondent banking services are located in another city, state or country.
Due to logistical difficulties a given bank can only have a limited number of correspondent relationships
at a time. When a direct depository relationship does not, exist a third bank - the so-called reimbursement
bank - is chosen to settle transactions.

4.4 FACTORS IN THE GROWTH OF CORRESPONDENT BANKING

The growth of international correspondent banking is closely linked to the growth of international trade.
As the level of trade has grown, banks have increasingly had to service the needs of their clients in new
international markets or lose business. As the US Dollar is the principal transactions currency a large
proportion of world trade is denominated in Dollars and banks throughout the world have had access to
the US payments system. American banks have been able to earn significant income handling US Dollar
transactions and providing lines to credit to their foreign correspondents.

4.5 CHANGES IN THE FIELD OF CORRESPONDENT BANKING SINCE THE EARLY

1980s
Until the 1980s correspondent banking was traditionally viewed by US banks as a profitable activity, the
primary reason being that US banks were able to earn enough on the relatively large balances maintained
by correspondents overseas to more than pay for the cost of service provided and in addition to return
a good profit. In view of the significant profit generated there was little pressure on the US banks to
have a very accurate estimate of their costs. US banks in order to increase market share were able to
offer many free services without significantly denting their profits. In short, the business was effectively
"unmanaged" in terms of profitability.
All that began to change in the early 1980s due to deregulation and increased competition from investment
banks and heavy losses on domestic and international loans. All banks had to re-evaluate their main lines
of business to focus sharply on profitability and to improve their balance-sheet management. These drastic
changes were felt in the correspondent banking business as elsewhere.
Introduction of CHIPS (Clearing House Interbank Payment System) Same Day Settlement by the Federal
Reserve had a dramatic effect on the profitability of correspondent banking. Same day settlement required
US banks to provide almost instant reporting of transactions and balances to their correspondents. The
revolution in communications technology that was taking place at the same time, enabled US banks to
provide this instant reporting. No longer was it necessary for banks to wait till the end of a week or end
of the month to get details of their account-activity. This rapid information enabled banks to manage their
funds with greater precision and the possibility of fine - tuning their balance levels caused what appears
to be a secular decline in the level of balances they maintain. The high interest rate environment provided
a further incentive for better cash management as the cost of idle balances became only too transparent.
CHIPS differs from the Fedwire payment system in three key ways. First, it is privately owned, whereas
the Fed is part of a regulatory body. Second, it has 47 member participants (with some merged banks
constituting separate participants), compared with 9,289 banking institutions (as of March 19, 2009)
eligible to make and receive funds via Fedwire. Third, it is a netting engine (and hence, not real-time).
While revenues from correspondent banking were getting smaller (due primarily to a declining level of
balances) the costs were escalating rapidly due to inflation and the extremely high cost of technology
required, i.e., electronic money transfers and balance reporting systems.
Further deregulation in the US has blurred the distinction between the traditional business of banks and
non-banks. With the invasion of non-banks into the traditional banking turf specialisation in different
products and services is emerging, leading to "unbundling" that is to say, increasingly products and services
are being sold separately and priced separately and each product service will have to be profitable on its
own. This represents a major departure from the traditional way of measuring profitability on an overall
relationship rather than on a product by product or service by service basis.
All banks have re-organised and rationalised their correspondent banking activities, paying much greater
attention to costs on a product basis and increasing prices whenever possible. Fees have assumed a new
importance. But interest-free balances remain "the umbilical cord that ties a correspondent bank together".
Banks still pay for correspondent services with these balances which are ascribed a notional value, by
the upstream bank although they can opt to pay fees instead or some combination of the two. The client
bank receives a monthly bill for services rendered and is charged if the balance is too low.
4.6 CLEARING HOUSE FUNCTIONS
Correspondent banks typically handle the transactional requirements of other banks. These functions
are normally paid for by fees, balances or a combination of both. Due to the Dollar's importance as an
international unit of exchange worldwide it was necessary to develop a settlement system to deal with
payments, processing and clearing. This task has been primarily undertaken by the large New York banks
and it represents their main correspondent banking role.
This function involves arranging details of transactions execution including debit and credit advices
and account statements. The clearing function also involves the correspondent banks in bearing intra-
day risk. As payments are made in anticipation of later cover, these payments are often at risk for long
periods of the day.
There are two main categories of risk that are borne by banks that perform the clearing house functions:
1. Credit risk in making payments before the funds have been covered.

ii. Systemic risk due to the possibility of technical or operational failure in the system in which case
the banks could face significant interest costs.
In the interbank arena, local banks provide local check-clearing facilities as well as clearing facilities for
foreign exchange contracts denominated in the local currencies or in Eurocurrencies.

4.7 PAYMENTS AND COLLECTIONS

At the heart of any financial service is a payment. Most, payments are accomplished through interbank
account debiting and crediting. In recent years electronic instructions have replaced telexed instructions
as the means of effecting transfer. Two networks collectively owned by the banks that use them dominate
international payments. The Society for Worldwide International Funds Transfer (SWIFT) provides the
international lines used for such interbank advice, while the Clearing House Interbank Payment System
(CHIPS) is the system in operation in New York. They are connected by a system called "Gateway".
The British equivalent of CHIPS is CHAPS, named in a very British way. CHAPS (the Clearing House
Automated Payments System) was originally called apparently the Financial Institutional Settlement
House (FISH) designed to go with the American CHIPS.
Correspondent banks, can through the agency function act on behalf of clients to prepare and present
negotiable instruments. Collections of this nature cover:
1. The settlement of terms of contracts.
ii. Sales and purchases of merchandise or securities.
111. Security receipt and delivery services.

1v. Dividend receipts and coupon collections and

v. Provisions of safekeeping services for assorted assets.
At the international level, organisations such as Euroclear (Brussels) and Cedel (Luxembourg) provide
many of these services, including securities lending and credit advances to participating firms in the
Euro bond market. A network of custodial banks in each case permit a wide range of transactions without
bonds physically leaving the custody of banks.

4.8 LETTERS OF CREDIT AND BANKERS' ACCEPTANCES

The letters of credit business is an important part of both international trade financing and the correspondent
banking business. Another area of trade financing that provides attractive business for the correspondent
banks involve bankers' acceptances. The L/C business involves advising, confirming and negotiation of
L/Cs issued on reciprocal basis.
4.9 TRADE DEVELOPMENTS AND REFERRALS
Correspondent banking relationships can provide an attractive means to serve clients with prospects
for development of collateral business. As foreign investment levels increase business referrals and
introduction by correspondent banks can lead to new accounts in the local market and can generate the
potential for international remittances and related fee-generating business.

4.10 CREDIT SERVICES- LOANS, PLACEMENTS, ETC.

A large amount of the international lending activities of commercial banks comprises bank-to-bank
lending and a significant portion of the international assets of a typical bank comprises interbank credit
in one form or another.
The major categories of the interbank lending are the following:
1. Lines of credit to permit financing of trade transactions.

11. Clean loans or advances to finance specific imports or exports.

iii. Open facilities to borrow for general purposes.
iv. Medium - term loans or guarantees to finance imports.
v. Inter-bank placements of funds for periods upto one year and
v1. Facilitating capital market access for correspondent banks.
vii. Issue of Guarantees, bid bonds, etc.
Extension of credit between banks in different countries is not significantly different from credit extended
between banks within the country. In either case a credit risk must be assumed, although it is always
more difficult to analyse offshore credits because of differences in governments and accounting as well
as other foreign practices.

4.11 FOREIGN EXCHANGE SERVICES

Foreign exchange services have traditionally been an important component of correspondent banking
services. With the increase in trade and international expansion of corporations, the demand for foreign
exchange dealings has increased. These are Treasury operations requiring interbank dealing forex lines
and money market lines.
Since foreign exchange lines and interbank deposits are unsecured, periodic financial analysis of banks
that are counterparties in money and foreign exchange dealings is critical-that is analysis of their capital
structure, size, credit ratings, managerial competence and other factors already mentioned above. Based
on this analysis, a bank will normally set dealing limits for redeposits, foreign exchange lines, swaps
and other transactions.

4.12 TRAVEL SERVICES

Travel services include foreign currency notes and coins, travelers cheques, drafts, travelers letters of
credit, local drawings and cheque encashment facilities, local borrowing supported by bank guarantees.

4.13 OTHER FACILITIES

Other facilities include: cash management facilities, automated balance reporting and nostro account
investment schemes, securities facilities including purchase and sale, custodial, clearing, registrar paying
and fiscal agency, underwriting, futures and options, new issue management and advisory service,
insurance trust, advisory services on mergers and acquisitions.
The size and nature of the banking institutions' business will give rise to variations on the above theme
and other preferences, although the services indicated above are considered profitable and reciprocal
business is generally sought on the basis of facilities offered.

4.14 COMPETITIVE ENVIRONMENT

The competitive environment for correspondent banking has traditionally been stable. Correspondent
banking depended very much on the idea of reciprocity and most of the players were relatively price-
inelastic. Correspondent banking was heavily dependent upon the quality of the personal relationship and
banks tended to collaborate using one another's services and sharing business risks and information. Due
to the changes in the competitive environment, many have taken a cold, hard look at their correspondent
relationship. For these banks that are continuing, correspondent banking is typically treated as a profit
centre.

4.15 THE EURO'S CHALLENGE TO CORRESPONDENT BANKING

The launch of the euro - the Europe's New Currency - on pt January 1999 had a dramatic impact on
correspondent banking. Earlier correspondent banks from outside the EMU need to have individual
accounts in each member states in order to clear their funds. After pt January 1999 banks are able to
offer a service whereby non-European banks can open a single account in Europe to clear all their trade
denominated in the euro.
Banks will, therefore, need to have fewer correspondent counterparties and they will choose only those
which are selling the best products - the cheapest, the quickest and the most efficient.

Let Us Sum Up
Correspondent banking in a general sense means relations with another bank. It is a practice whereby a
bank establishes a presence by means of a relationships with a local bank. In a foreign country it allows
a bank to take advantage of the business opportunities abroad while minimizing its operating cost.
Significant changes have taken place in the field of correspondent banking since the early 1980s. Unit
the 1980s the major banks' main earnings in these areas came from the current account balances of their
correspondents. With the rise in interest rates in the late 1970s and early 1980s many minor banks started
to economise on their holdings of non-earning assets, resulting in a consequent decline in the level of
nostro balances held. Correspondent banking increasingly came to depend on other financial services as a
source of income and many major banks began to offer a wide range of new credit and consulting services
to their correspondents. Consequently, there has been a shift from balance income to fee income. Each
service now carries a price tag-either by way of fees or by means of peg balances or combination of both.
Correspondent banking services include:
1. Clearing house functions
ii. Payments and collections
iii. Letters of credit and banker's acceptances, Guarantees, bid bonds, etc.
iv. Trade developments and referrals
v. Credit services - loans and placements
vi. Foreign exchange services
VIL Travel services
v111. Cash management facilities
IX. Automated balance reporting
 CORRESPONDENT BANKING AND INTER-BA

x. Nostro account investment schemes

x1. Securities facilities
xn. Futures and options
xiii. New issue management and advisory services
xiv. Insurance trust
xv. Advisory services on mergers and acquisitions
Correspondent banks are not only customers but in the main are an essential cornerstone in the provision
of international banking services for all other customers of the bank. It is essential therefore to maintain
an efficient and cordial working relationship.
The advent of the euro had a dramatic effect on correspondent banking as after 1st January 1999. Banks
will be able to offer a service whereby non-European banks can open a single account in Europe to clear
all their transactions denominated in the euro. Banks will have fewer counterparts and they will choose
only the best.

Key Terms/Glossary
Correspondent Bank: A bank with which a second bank in another area has an account relationship and
that helps the second bank to conduct business at a place where it does not have a physical presence.
CHIPS: Acronym for New York's Clearing House Interbank Payment System an automated large item
payments system.
CHAPS: Acronym for UK's Clearing House Automated Payments System - British equivalent of CHIPS.
SWIFT: Acronym for Society for Worldwide Interbank Financial Telecommunication a co-operative for
a standardised automated international funds transfer information system between banks.
Strategic Pricing: Pricing on the basis of relationship.
Tactical Pricing: Pricing each product separately.

Terminal Questions
1. Define correspondent banking. What are its advantages and the reasons for its growth?
2. State the changes in the field of correspondent banking since the early 198Qs.
3. State the principal functions of correspondent banking.
4. Write short notes on:
1. The importance of pricing correspondent activities.
ii. The competitive environment of correspondent banking.
m. The Euro's challenge to correspondent banking.