What We Can Learn From the Last Year’s Offshore Banking Disasters

/in /by

In the last year three well known offshore banks were hit with travesty. While none were large they were well known in offshore banking circles. At the time of this writing it remains to be seen exactly how much   depositor money will be lost but in the meantime, we can reflect on what can be learned so as not to repeat past errors.

The three banks in question were:

  • FBME – a Cyprus and Tanzania bank cited by the US as a primary money laundering concern with threat of being cut off from the US financial system. This resulted in the bank being taken over by the central bank of Cyprus. Depositor funds were mostly frozen for months crippling many businesses
  • Banca Privada (BPA) – an Andorran bank likewise cited for money laundering concerns
  • Caledonian – a Cayman bank brought up by the SEC on a stock scam resulting in their accounts being frozen triggering a run on the bank and ultimately insolvency

There are a few interesting points to note:

  1. All three banks were in separate completely unrelated jurisdictions
  2. All three banks had very different compliance protocols – BPA required in person visits to even discuss accounts while FBME and Caledonian allowed remote opening
  3. All three banks received differing responses from the local regulators/authorities
  4. All three banks did a significant volume of their business with non-residents
  5. All three banks were solvent
  6. All three banks were effectively taken down by the US

In cases like this it’s useful to notice what the real risks are to depositors in order to predict and help select banks in the future.

While Cyprus following the 2008/2009 financial crisis along with Iceland and Greece up to the present saw risks associated with the jurisdiction this was not the case in any of these particular   issues.

While certain banks have failed due to issues of insolvency related to offering poor loans or loans that became poor when an economic bubble popped all the banks in this example were solvent at the time of their failure.

It’s actually interesting to note that even though banks definitely run losses in many cases a bank failure particularly a failure resulting in a loss of depositor funds due to a lack of profitability on behalf of a bank is fairly rare. This probably stems from the relatively well understood operational nature of banking, significant financial regulation, and a banking system where generally unprofitable banks are purchased by profitable ones at the point of failure.

These were not issues predictable through reading financial statements even if such financial statements were publicly available (which they were not). How then could the issues be predicted?

 

Risk Assessment

The most important point to note here is in my opinion two similarities in all cases. First, all three banks were taken down by the US for issues related to crime.

The nature of crime is you want to hide it so it would be unlikely to see any disclosure signs in fact if such signs did exist the inference should be the authorities would see them as well and take the action that resulted in the freezes to begin with. In other words, it hardly seems reasonable to detect criminal activity when performing due diligence on a bank.

On the other hand, one could argue there are symptoms, which would predict a higher risk of such activity. In other words, criminals (money launderers since two of the three banks in question were frozen out of the US financial system because of money laundering) will be attracted to places where it is easy to carry out their business. FBME certainly seems to fit this criteria. Cyprus is known as a hub for Russians and FBME had relatively poor compliance. But what of BPA? It certainly isn’t known for its close connection to Russia or other similar jurisdictions in the same manner (in 2012 there had been a freeze of certain funds in supposed connection with Venezuelan money laundering at the bank but as an outsider there’s very little reason to suspect a connection to any particular connection to a particular risky jurisdiction). BPA also along with all Andorran banks has a relatively strict compliance protocol. Account opening requires an in person visit and compliance can be fairly extensive. The language barriers (Andorra is primarily Spanish) also create a less attractive environment to bank in for those who don’t speak the language. On the surface FBME and BPA would seem quite different.

This isn’t entirely true though. While they were quite different they both had separate but attractive qualities to criminals. While FBME had lax compliance BPA’s compliance was only strict on the surface. When accompanied by an in person visit compliance wasn’t especially challenging. But this overlooks a more important fact. Andorra was and is one of the most well-known jurisdictions on the planet for bank secrecy. While Cyprus lacks this secrecy, it gives each jurisdiction a distinct but nevertheless useful   appeal.

In other words, if you were wanting to launder money what better places to choose? One that has proximity and makes opening accounts extremely easy. Another with slightly less proximity but where you can be assured of the secrecy of your banking. If you wanted these factors are there other options? Certainly, in theory any bank in Andorra or any bank in Cyprus might do and there were other options though there are reasons they might not have been as appealing (though similar options might help us predict where not to bank).

If we apply this standard, then we should be wary of jurisdictions where it’s easy for non-residents to open accounts (probably especially for zero tax companies) where the bank secrecy is tight or the opening requirements are simple. Applying this standard makes much of eastern Europe potentially risky along with much of the Caribbean but in particular the likes of Belize, St. Vincent, & St.  Lucia.

I actually don’t believe those are the primary determinants though, after all banking has taken place in those areas for years with minimal issues (though the US also hasn’t taken the same stance so that’s worth considering).

 

Let’s look at Caledonian.

This wasn’t a case of money laundering. In fact, in spite of the fact that Caledonian had relatively weak compliance and security they weren’t shut down for a reason that had anything particularly to do with the depositors. Caledonian suffered for an even more challenging issue, allegedly assisting in a   scam.

How do you predict someone involved in a bank might assist in some sort of scam?

It’s almost impossible to tell. Well placed sourced in the SEC might have provided a warning to move funds out of the bank and the Cayman Islands Monetary Authority (CIMA) was allegedly working with them investigating meaning a source within CIMA might have provided some warning as well. But these are challenging relationships to build and hardly a secure warning system.

Instead I believe it’s the second similarity between the banks that we need to examine.

 

Protection Against the Risk

All three shared an important factor (two factors really, but at least one). They were small.

I don’t believe it is reasonable to predict issues of fraud, money laundering, etc. Criminal activity by its nature will hide. While we could use, the indicators listed above to reduce some risk and it might be very wise to do   so the fact is account opening standards are much weaker in many very mainstream parts of the world than they are in most offshore jurisdictions. It can be substantially easier to open a bank account in the US than it   is to open one in Latvia or Singapore or Cayman. In reality probably a lot more criminal money passes through accounts in the US, UK, etc. than through any offshore financial center.

But there are two key differences:

  1. The size of the institutions
  2. The people they affect

The collective banks of Andorra hold approximately $17 billion in a country of 80 000 people. Caledonian had less than $1 billion in assets, in fact most similar banks do (the largest bank in Belize is reported to have $1 billion in assets).

 

What does this mean?

Two things. They can’t afford to weather the storm and it won’t be particularly disruptive to take them   offline.

In the case of Caledonian what occurred was to quote the US District Court judge “an incredible government overreach”, combined with what amounted to negligence on behalf of Caledonian’s lawyers. Again, quoting the judge, “how could you conceivably agree to an asset freeze of $76 million when you knew that your clients’ net equity was $25 million?”

What happened is a freeze order was requested and issued for $76 million by the SEC when the bank only had equity of $25 million (meaning everything over this level were depositor funds). This amount was later lowered to $7 million but by this point it was too late as the process had already triggered a run on the   bank.

Consider if it were a much larger institution. The institution could have afforded the funds freeze without it resulting in issues for depositors. Furthermore, the legal team probably would have been better equipped, more skilled, in a stronger negotiating position, etc. The consequences of hurting the bank also would have been seen as much more severe given the number of people involved, the amount of money involved, and who those people were. Just imagine if major politicians, their friends and families had their accounts   frozen? The contrast is stark.

Compare this situation to the trouble HSBC found themselves in over the last year related to HUGE money laundering issues in Mexico. Here we are talking about the bank being complicit in criminal activity at a scale likely far greater than all three of these banks combined. Yet, did HSBC get frozen? Have their depositors ended up struggling as funds sit idle for months and their businesses unable to operate as they can neither send nor receive money?

No, none of the above. The bank has been fined $2 billion but otherwise it’s business as usual.

There are some who protest the consequences should be much direr for the bank or the bank employees after all we shouldn’t be letting organizations get away with money laundering simply because they are big. But then we get to see the other side of attempting to penalize banks and imagine the consequences to literally millions or tens of millions of depositors and understand it simply isn’t possible at least not to go after the bank in the same way as these three banks were hit.

 

The Lessons

From this we can extract three key lessons about protecting ourselves in our banking activities:

  • Avoid risky banks and jurisdictions – these would be cases where secrecy via fake IDs, secret corporations especially from tax havens, etc. are easy
  • Avoid jurisdictions and banks with a high % non-resident banking – local banking isn’t necessarily protection but it adds a certain level of insulation, if you look at Iceland there was much more protection for local interests than foreign
  • MOST IMPORTANT – when possible BANK AT LARGE INSTITUTIONS where the consequence of crime or scandal to the bank are minimal and where the consequences to the system of taking the bank down are significant resulting in a “too big to fail” scenario

These are of course in addition to our regular due diligence on jurisdictions, profitability/solvency of banks, etc.