VIII Financial Services and Capital Movements

International Monetary Fund
Published Date:
December 1990
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The Community’s efforts to create a European financial area59 are two-pronged: the removal of all barriers that inhibit cross-border trade in financial services and the establishment of EC firms in other markets within the EC; and the removal of all exchange and capital restrictions within the Community. Formal discussions between the EC and EFTA, which started with the Luxembourg process, are now being carried out in the working group on services and capital movements, which was created as part of the Oslo-Brussels process. The prospects for closer cooperation are generally good. However, certain policies—mainly related to the access of EC firms to EFTA markets—may still pose problems for some EFTA countries.

Implications of Financial Integration

The liberalization of trade in financial services and capital movements is a key component of the internal market program for several reasons. First, the financial sector accounts for a substantial share of output and employment in the Community. Second, trade in financial services is still subject to considerable protection, particularly in the retail sector. Third, financial services are used as inputs in other economic activities, implying important spillover effects throughout the economy. The gains from a unified financial market should be substantial.60 However, they may not accrue equally to all member states. The gains may be particularly large in the southern member states, which are relatively less integrated with world capital markets.

The economic effects of liberalizing trade in financial services are similar to those of liberalizing trade in other products. First, liberalization may help achieve a more efficient resource allocation within the financial services sector. Since trade in financial services is essentially of the intra-industry type, the main benefits should come from economies of scale and from increased competition. Second, liberalization may also help improve resource allocation across different sectors of the economy. Although the economic effects are similar to those in other sectors—since the provision of financial services usually requires a physical presence—there is likely to be more cross-border establishment than in nonservice industries.

The current variation in retail prices for financial services in Western Europe provides significant incentives for further cross-border expansion.61 In the retail sector, strong local networks in many countries suggest that the expansion will take place through mergers and acquisitions rather than through new establishments. Indeed, this process is already under way. The wholesale sector has long been more exposed to foreign competition and is less limited by the need for a physical presence. Cross-border trade may therefore play a more prominent role in the wholesale than in the retail sector.

The benefits of liberalizing capital movements are somewhat different from those of liberalizing trade (see Krugman, 1987). Free capital movements allow for an efficient allocation of savings and investment. In this respect, one-way capital movements are similar to inter-industry trade, that is, trade driven by comparative advantage. However, even without net resource transfers, important benefits can result. Two-way capital flows, often short-term, give rise to gains for much the same reasons as intra-industry trade. With free access to foreign financial markets, investors can diversify their portfolios and achieve a more efficient asset composition. Free capital movements will also help to increase competition in financial markets.

While the free movement of capital can generally be expected to be beneficial, this may not always be the case. If other distortions are present, liberalizing capital movements may actually reduce welfare. The most obvious example is the existence of different tax systems. Although free capital movements may equalize the real after-tax rates of return in different countries, real rates of return before taxes may still differ, implying an inefficient allocation of capital. However, it is generally better to remove the original distortions than to introduce additional ones. As Basevi (1988) argues, the internal market program turns the second-best argument around in that the removal of regulations and restrictions in the financial sector may make the underlying distortions more transparent. Particularly, in the area of taxation, there may be pressures for harmonization of the tax treatment of capital income (Bovenberg and Tanzi, 1990).

The effects on EFTA countries depend on several considerations.62 A complete integration—implying both the harmonization of rules and regulations and the elimination of all remaining capital controls—would enable the EFTA countries to share fully in the gains from financial integration in Western Europe.63 EFTA customers would benefit both from lower prices and access to other European markets. EFTA financial institutions would gain improved access to foreign markets, but they would also face more competition in their domestic markets. The effects of allowing more foreign competition may be different for different EFTA countries. Switzerland appears to have the strongest and most developed financial sector among the EFTA countries. Financial institutions in Norway, and in particular in Iceland, may face difficult challenges. Financial institutions in the EFTA countries are already preparing for the more competitive environment of the 1990s. In the Nordic countries, several banks and insurance companies have either merged or formed strategic alliances in order to build a stronger market position.

A decision not to participate in a European financial area is likely to imply some costs. The benefits of creating a common market for financial services in the EC would then accrue mainly to large customers—multi-national firms and institutional investors—which already have access to foreign markets. EFTA institutions may find it harder to compete both for foreign and large domestic customers. This would probably contribute to a greater expansion of EFTA subsidiaries abroad than otherwise. At the same time, smaller EFTA customers would not benefit from the lower prices and greater diversity associated with a unified European market.


The EC’s approach to liberalizing trade in financial services rests on three fundamental principles, which go back to the Cassis de Dijon judgment by the EC Court of Justice in 1979: home country control, mutual recognition, and harmonization of essential laws and practices. The first principle stipulates that supervision of a financial institution, including all of its branches, should be handled by the authorities in its home country, which implies that authorities in host countries must accept the judgments of the authorities in the home country.64 The second principle requires each member state to recognize the supervisory bodies of other Community members. If a financial institution is authorized by one member’s authorities, it should be permitted to operate in the other member states. The third principle calls on the EC Commission to establish certain minimum standards for prudential supervision of financial institutions with which all member states must comply. Since business is likely to flow to the least regulated areas, the EC hopes to stimulate regulatory convergence through competition among the regulatory frameworks of different member states. Community-wide minimum standards provide a floor to this process.

The centerpiece of the Community’s plans for an integrated banking market is the Second Banking Directive, which was adopted in December 1989 and will come into effect on January 1, 1993. This directive provides for a single banking license that will be the only authorization needed for a bank to operate in the Community. If a bank is authorized to operate in its home country, it will automatically be authorized to operate in other member states without prior permission from its host country authorities. However, host countries will continue to be responsible for the control of bank liquidity.

The single banking license is based on a universal banking model. It therefore allows banks to participate in a broad range of activities including leasing, portfolio management, and securities trading. Once a bank has been authorized by its home country authorities to undertake a certain activity, it is free to undertake that activity throughout the Community regardless of whether banks in other countries are authorized to do so. To safeguard the interests of depositors and investors—and the stability of the financial system—each member state must comply with certain basic standards with respect to capital requirements, the range of permissible nonbanking activities, and supervisory control of its main shareholders.

The Second Banking Directive is complemented by a number of directives on the harmonization of prudential standards and banking supervision. Common standards for the own funds of credit institutions were established with the adoption of a directive in April 1989. A solvency ratio directive adopted in December 1989 requires banks and credit institutions to limit their lending and financial exposure to a fixed multiple of their capital. These two directives constitute the harmonized prudential requirements necessary to implement the single banking license. Both follow closely the recommendations on capital standards by the Committee on Banking Regulation and Supervisory Practices of the Bank for International Settlements (known as the Cooke Committee or the Basle Committee).65 A number of other directives and recommendations deal with similar prudential issues and with accounting standards.66

According to the Second Banking Directive, subsidiaries of foreign banks will generally be able to operate under the same conditions as EC banks. They may engage in all of the activities authorized in the EC country in which they were first established and where they are supervised. While existing EC-based subsidiaries will be covered by a grandfather clause, newly established subsidiaries will be subject to a reciprocity requirement.67 Banks from non-EC countries may establish subsidiaries in any EC country if their home countries treat EC banks similarly to domestic banks. Branches of banks not headquartered in the EC may not have the right to provide services throughout the EC. The rules for establishing branches of non-EC-originating institutions have not been set on an EC-wide basis and are likely to remain subject to the discretion of each member state.

The original draft of the Second Banking Directive called for reciprocity based on equivalent treatment. This would have implied that non-EC countries would be required to grant EC banks the same treatment as that granted by the EC. Since Europe has a universal banking tradition, while the United States and Japan still impose a legal dividing line between banking and securities operations, this approach was heavily criticized both within and outside the Community. The directive was subsequently modified and the EC has indicated that it will apply the principle of national treatment. This implies that foreign banks will have access to the EC if their home countries do not discriminate between EC banks and domestic banks. However, the Commission will continue to use equivalent access as a bargaining tool. If the Commission finds that a non-EC country is not granting EC banks treatment comparable to that granted by the EC to non-EC banks, the Commission can initiate negotiations.68 Licenses can be denied in cases where non-EC countries do not grant national treatment to EC banks. Subsidiaries of non-EC banks established in the Community prior to the implementation of the directive are subject to grandfathering provisions and will be treated as Community banks.

The EFTA countries all have a strong interest in participating in a Western European market for banking services. The prospects for further cooperation between the EC and EFTA are generally good. Initially, the talks between the EC and EFTA focused mainly on proposals regarding solvency and equity requirements, deposit insurance schemes, and accounting standards. All EFTA countries are currently revising their legislation and practices to conform more closely with internationally accepted standards, as well as with EC standards. However, if EFTA banks are to take full advantage of the EC’s liberalization efforts, EFTA countries must satisfy EC reciprocity requirements. This may call for changes in the legislation of some EFTA countries with respect to current limitations on foreign ownership and establishment.

In Austria, foreign banks may establish subsidiaries and acquire shares in Austrian banks. Subject to authorization, they may also establish branches. The Nordic countries all have restrictions on foreign ownership and establishment. However, all countries have recently taken important steps to liberalize these restrictions. Although the existing legislation in Finland limits foreign ownership to 20 percent of Finnish banks, foreigners can acquire up to 100 percent with special permission. Finland is considering allowing foreign banks to establish Finnish branches. In Iceland, while foreign participation in nonbank financial institutions is already permitted, banks may have only representative offices. However, Iceland recently declared its interest in opening its banking industry to limited foreign competition, and new legislation has been prepared to allow foreign ownership of up to 25 percent of shares in Icelandic banks. Norwegian banking legislation generally limits foreign ownership in Norwegian institutions. However, the limit was recently raised to 33 1/3 percent and foreign banks can now establish branches. Beginning July 1, 1990, Sweden lifted the special ban on foreign ownership of Swedish banks, securities firms, and consumer-oriented finance companies, although the general provisions limiting foreign participation in Swedish companies still apply to banks. Foreign banks will also be able to establish branches. All countries are considering further liberalization measures. EC reactions to these moves have been positive. Provided that certain key provisions are adopted, the EC seems to be willing to include the EFTA countries in the internal market for banking services.


The insurance industry in the Community already enjoys freedom of establishment. The EC has long had a body of legislation that coordinates national laws both on the establishment and the operation of insurance companies. Community laws cover the setting up of new companies, the opening of new branches, and supervision. However, reflecting considerable differences in national regulations, a number of obstacles remain that limit the freedom of an insurance company in one member state to cover risks in others.

The basic initiatives covering non-life insurance are included in the Second Non-Life Insurance Directive, adopted in June 1988. Any insurance company based in the EC will be able to cover large risks throughout the EC without having to establish itself in other than its home country. The directive is the follow-up to a 1986 decision by the European Court of Justice, which found that the freedom to provide insurance services already existed on the basis of the Treaty of Rome. However, the Court also declared that, in some areas, certain restrictions against insurers from other member states were compatible with the Treaty. The Court saw a particular need to protect small clients. As a consequence, the ruling distinguishes between large risks, which relate to larger commercial and industrial clients, and mass risks, which relate to small businesses and individuals. For large risks, only simple notification is required for providing services in other member states. The access procedure for mass risk insurance is more complicated. Since national supervision and control is considered more important in this area, some retention of host country control has been deemed necessary. Therefore, in order to realize a common market for mass risk insurance, the EC may have to take further action to harmonize national regulations. A proposal for a directive on these matters was tabled by the Commission in July 1990.

In contrast to the Second Banking Directive, the Second Non-Life Insurance Directive deals only with cross-border provision of services and does not provide for Community-wide branching of insurance companies under home country control. Therefore, the EC is considering a framework directive for non-life insurance that will introduce a single license and home country control for all insurance risks. A similar directive is to be proposed on life insurance policies. This directive also will deal with technical reserves, the choice and content of laws applicable to insurance contracts, and administrative procedures regulating the activities of insurance companies outside their home state.

The EC took a further step toward a unified market in life insurance policies by adopting the Second Life Insurance Directive in December 1989. This directive essentially frees Community citizens to take out life insurance policies in any member state. However, it distinguishes between the case where an individual wishes to take out a policy in a country other than his resident country—in which case he would have to accept the degree of protection in the country of the insurer—and the case where an insurance company wishes to conclude an agreement outside its resident country—which requires the insurance company to accept the provisions of the country in which the risk is located. This is an exception to the principle of home country control. Further harmonization efforts are being considered to achieve a common market for life insurance policies.

The EC’s policy with respect to insurance companies from nonmember countries is similar to that in the banking area. Subsidiaries of EFTA insurance companies operating in the EC will be subject to the same treatment as EC companies. Once a subsidiary is established in any member state, it is free to compete with EC companies on an equal footing. However, the Second Life Insurance Directive includes a reciprocity clause that follows the wording in the Second Banking Directive. Moreover, the 1973 First Non-Life Insurance Directive and the 1979 First Life Insurance Directive both seem to imply that branches of non-EC companies would be subject to certain provisions requiring them to deposit assets relative to their commitments in each member state. Most member states have also filed exceptions to the Organization for Economic Cooperation and Development (OECD) code on capital movements, which would allow them to apply reciprocity requirements on non-EC countries. Finally, as in banking, the freedom of non-EC insurers to provide services does not apply to branches or operations of companies headquartered outside the Community.

The possibility of concluding agreements between EC and non-EC countries on insurance was established both in the First Non-Life Insurance Directive and in the First Life Insurance Directive. Switzerland was the first country to do so. Under an agreement concluded in October 1989, which may serve as a model for similar agreements in the future, Swiss and EC insurers will have access to each other’s markets for non-life insurance on a reciprocal basis. Swiss companies will be able to operate in the EC through agencies or branches provided that Switzerland grants EC companies equal rights. The agreement introduces minimum standards based on the First Non-Life Insurance Directive. It is valid only as long as Switzerland keeps its legislation in line with that of the EC.

All of the EFTA countries want their insurance companies to have sufficient scope to operate abroad. The talks between the EC and EFTA have so far been rather general in nature. In the Nordic countries, the insurance industry has been highly regulated, with prohibitive restrictions on foreign establishment and ownership. In line with the general trend of financial deregulation in other countries, efforts to liberalize the insurance sector are now being considered. An EES agreement is expected to provide for an integration of the insurance markets between the EFTA countries and the EC; it will imply removal of existing restrictions on establishments from other EES countries.

Investment Services

The White Paper envisaged the creation of a unified European securities market system that would link the existing stock exchanges in the Community. A number of directives have been proposed or enacted, aimed at breaking down barriers between national markets. A major step was taken by the Council of Ministers in November 1985 with the adoption of a directive establishing the free marketing of units issued by investment funds.69 It was the first directive establishing the freedom to market a financial product throughout the Community on the basis of the principles of mutual recognition, home country control, and harmonization of essential standards. Several directives have focused mainly on harmonizing listing and information requirements.70 In the area of mergers and acquisitions, a proposal for a directive on public takeover bids was put forward in 1988, while a directive on insider dealing was adopted in the fall of 1989.

The Commission has also proposed a directive on investment services that would provide for a single authorization procedure for firms wishing to engage in investment advice, brokerage dealing, market making, and portfolio management in the Community. This directive gives securities houses the same freedoms as banks. It also contains reciprocity provisions similar to those in the Second Banking Directive.

Foreign investment houses have already been able to operate in most EFTA countries for several years. These companies have worked almost exclusively in the wholesale market. The talks between the EC and EFTA have dealt primarily with issues such as insider dealing, requirements for stock exchange registration, and the activities of investment funds.

Capital Movements

Since a complete integration of financial markets is impossible without free movement of capital, the EC has made rapid progress in this area. In June 1988, the Council of Ministers adopted a directive that called for a complete removal of all remaining capital controls in most EC countries by July 1, 1990. Several countries implemented the directive well in advance of the deadline. While France and Italy abolished remaining restrictions in January and May, respectively, Belgium and Luxembourg abolished their two-tier exchange market in March. However, Ireland and Spain have been authorized to maintain certain restrictions until the end of 1992 and through the end of 1995 in the cases of Greece and Portugal. The directive contains safeguard clauses that allow member states to reintroduce restrictions on short-term capital movements in the event of disturbances to monetary and exchange rate policies. Such restrictions must be authorized by the Council and may be maintained for a period not to exceed six months.

The 1988 directive recommends the application of the “erga omnes” principle. This implies that the liberalization of capital movements be accomplished unilaterally, on a worldwide basis. However, this does not prevent the application of any reciprocity requirements in other areas. In this connection, direct investment, the provision of financial services, and the admission of securities to capital markets are explicitly mentioned.

The EFTA countries have gone through a similar liberalization process. Switzerland was the first EFTA country to free capital movements, followed by Austria. However, until recently, all the Nordic countries maintained tight capital and exchange controls. Sweden removed all remaining restrictions in July 1989. Norway removed most of its existing restrictions on the corporate and institutional sectors in December 1989. Effective July 1, 1990, Norway abolished nearly all remaining restrictions, including those affecting individuals. Finland has taken similar steps. Iceland still retains a rather comprehensive system of restrictions, but the Government intends to implement extensive liberalization measures by 1993.

The freedom of capital movement raises a number of fiscal issues with respect to the scope for tax harmonization and its realization (Bovenberg and Tanzi, 1990). The EC Commission has so far considered three options: increased cooperation and exchange of information among national tax authorities; stepped-up reporting requirements; and a minimum withholding tax imposed on dividends and interest income imposed at the source on all EC residents. Initially, the Commission opted for the third approach as it proposed a minimum withholding tax of 15 percent on interest income in February 1989. After much opposition from some member countries, the Commission shifted the emphasis in the direction of enhancing the exchange of information to assist member governments in enforcing taxation of their respective residents. The final solution remains unclear. Taxation is outside the scope of the Oslo-Brussels process. However, as in the EC, the EFTA countries will have to reconsider their tax systems in the process of liberalizing capital movements.71


The EC Commission’s original proposals are in its 1985 White Paper. In the course of implementing the internal market program, certain proposals have been withdrawn and others have been added. For a recent overview of the legislation covering financial services and capital movements, see European Documentation (1989).


The EC Commission (1988b) has estimated that the creation of a common market in financial services may raise GDP in the Community by 1.5 percent as compared with a cumulative gain of 4.5 percent for the internal market program as a whole.


Data on price differences for financial services within the EC are presented in the EC Commission (1988b).


The effects on EFT A countries are discussed in EFTA (1989) and Gardener and Teppett (1990).


Estimates by Pintado and others (1988), based on the same assumptions as those employed by the EC Commission (1988b), suggest that the EFTA countries would have more to gain than the EC.


However, supervision of a subsidiary is the responsibility of the authorities in the country in which it is chartered.


Committee on Banking Regulation and Supervisory Practices, “International Convergence of Capital Measurement and Capital Standards,” July 1988. Among the signatories were Belgium, Canada, France, the Federal Republic of Germany, Italy, Japan, Luxembourg, the Netherlands, Sweden, Switzerland, the United Kingdom, and the United States.


At the end of 1985, the EC Commission proposed a directive on the liquidation and reorganization of credit institutions. In December 1986, the EC Commission issued two recommendations on the supervision of large exposures to single customers and groups of customers and deposit guarantee schemes. A proposal for a directive on mortgage credit was issued in 1987. A 1986 directive and a 1989 directive seek to harmonize accounting standards.


Key (1989) discusses different reciprocity concepts and their implications for third countries.


It remains unclear whether the EC could insist on equivalent treatment given legal commitments by several member states. The Organization for Economic Cooperation and Development code on capital movements generally prohibits discriminatory measures between OECD countries. The only exceptions relate to countries forming a customs or monetary union or to countries that have made an explicit reservation for reciprocity. However, some EC countries have not lodged such a reservation.


The directive refers to unit trusts or “undertakings for collective investment in transferable securities,” which are legally similar but not identical to mutual funds.


Early initiatives included a 1979 directive coordinating the conditions for the admission of securities to official stock-exchange listing and a 1980 directive coordinating the requirements on listing particulars to be published for the admission of securities to official stock-exchange listing. These were followed up by a 1982 directive on the regular publication of information on listed companies. The Council took a further step in 1988, when it adopted a directive on the information to be published when major changes in the ownership of a listed company take place. In 1989, the Council adopted a directive coordinating requirements on the prospectus to be published when transferable securities are offered to the public.


Finland, Norway, and Sweden are currently carrying out major tax reforms. Reform efforts in all three countries have been guided by the need to conform with international trends. However, it is premature to predict the extent to which further adjustments will be needed.

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