Fallout, Bailout and the Cayman Islands

The fallout in the US financial markets as well as the bailout plan will not only impact US markets and other onshore economies. It has potential ramifications offshore as well and certainly in the Cayman Islands.

To be certain most economists see the bailout plan as essential to preventing an outright crash in the US financial markets. Others, while viewing the rescue plan as a necessary evil strongly believe that the US economy, irrespective of the bailout plan, is set for a rough ride in several respects. But if that is the consensus, as it seems to be, then there are also clear potential risks faced by a jurisdiction such as the Cayman Islands.  

The Cayman Islands are potentially affected in three ways; first via the financial market crisis which has a wider economic impact within the US far beyond Wall Street and therefore the Cayman Islands, secondly via the bailout plan itself which includes amendments to US legislation aimed at improving revenue measures for the US Treasury, and finally as a result of a possible post-crisis push for additional regulations aimed at preventing a future crisis.

In its most simplistic form, the wider economic fallout within the US clearly poses a threat to the Cayman Islands economy generally due to the heavy reliance on North America in the areas of tourism and trade generally. As wealthy (and ordinary) American citizens experience serious erosion in their wealth, the Cayman Islands should expect to see a reduction in US based travel to, and spending and investment (for example via real estate) in, the Cayman Islands economy. If you subscribe to the view that the US economy has not yet seen the very bottom, at least this much should be expected in the Cayman Islands over the short to medium term.

A more intricate impact of the fallout is also expected within the Cayman Islands offshore financial services sector as well. In fact, anecdotal evidence suggests that some service providers are already seeing both positive and negative changes as a result of the fallout.

Generally speaking, the crisis is unlikely to have any major impact on the local capital markets in the Cayman Islands, which is relatively small anyway and almost entirely dominated by banks as the main channel of financial intermediation. This is because the majority of activity in the Cayman Islands financial sector relates to provision of services to various financial services entities, rather than a direct involvement in the onshore financial markets. The major impact will therefore depend on a) whether the various entities are reduced significantly as a result of the crisis or b) in the case of entities which generate fees (and indirectly employment) on the basis of market values such as in the case of fund or trust administration, whether there is serious erosion in value of assets under administration. This is particularly an issue as fund managers may start to switch to cash partially in preparation for a possible increase in redemptions in the fourth quarter as well as partially due to their decision to hold cash as a safety net against negative market movements in their current investments, thereby creating a vicious downward cycle on the financial markets.

In the case of the funds sector, anecdotal evidence indicates that we are already losing some funds as a result of the crisis. But new funds will also be created as investment managers onshore pounce on opportunities in the current state of the financial markets, especially with the key assumption that the US bailout plan will go ahead in some form or another.

Most experts believe that the insurance markets in the US will see hardened market and pricing as a result ofthe crisis and following the US government takeover of its largest national insurer AIG. As a leading jurisdiction for creation and management of captive insurance companies, on the one hand we might expect that the hard market conditions would be ideal for some new captive formations. But this also has to be offset by the general conditions in the US regarding access to capital as well as the potential difficulty gaining access to reinsurance. In the case of our captive industry, we may well not see much of a change at all in the short term.

There are potential opportunities in the area of liquidations as vehicles are wound up whether by force or on a voluntary basis, so out of the crisis there may be some additional revenues for firms in the Cayman Islands providing these types of services.

How might the US ‘rescue plan’ affect the Cayman Islands? Ironically, while it does reduce the wider economic risks for the Cayman Islands, the US bailout plan itself could also introduce a new threat to the Cayman Islands.

US Senators have taken every opportunity to use the bailout plan to introduce other measures as part of the negotiations on whether the Bill receives full support or not. Among these are provisions within the draft bill that are targeted at changing the tax treatment of deferred compensation paid through accounts in jurisdictions like the Cayman Islands.

These provisions are contained within Title 8 of the draft bill entitled ‘Spending reductions and appropriate revenue raisers for new tax relief policy’ which spans its final pages from page 442 onwards. The provisions within this section have yet to be analysed in detail, but should be examined further as tax deferment remains at the heart of the business rationale of many offshore strategies. The Cayman Islands would do well to look at these provisions very carefully as they clearly could have very wide economic ramifications for the jurisdiction in the absence of a counter strategy.

To the extent that additional regulation follows the bailout plan, we should also expect to see a corresponding ‘global’ push for some changes to the way some financial institutions are regulated which will inevitably be pushed on regulators in many countries, including the Cayman Islands. Just how much additional regulation and in what areas is yet to be determined as US Treasury Secretary Henry Paulson has for the most part, so far rejected a straight knee-jerk reaction to the regulatory actions stemming from the crisis.

The Title 8 provisions aside, there is no question as to whether the financial crisis will impact the Cayman Islands. It already is. The key thing to be prepared for is the wider short to medium term economic impact which is expected to be negative, while monitoring developments in the US to ensure that the negative impact of the fallout, bailout and any additional regulation on the local industry is minimised.  

Paul Byles is a local economist and consultant with Focus Corporate Services & Consulting