Current Legal Issues Affecting Central Banks

Volume 1

Edited by Robert C. Effros

International Monetary Fund

May 1992

© 1992 International Monetary Fund

Reprinted June 1994

Library of Congress Cataloging-in-Publication Data

Current legal issues affecting central banks / edited by Robert C. Effros.

p. cm.

Papers from a 1988 seminar for general counsels of central banks sponsored by the Legal Department of the IMF in conjunction with the IMF Institute.

Includes bibliographical references.

ISBN 1-55775-142-0 (v. 1)

1. Banks and banking, Central—Law and legislation—Congresses. 2. Banking Law—Congresses. I. Effros, Robert C. II. International Monetary Fund. Legal Dept. III. IMF Institute.

K1070.A55 1988

346’.08211—dc20

[342.68211] 92-16996

CIP

Price: $42.50

Address orders to:

External Relations Department, Publication Services

International Monetary Fund, Washington, D.C. 20431

Telephone: (202) 623-7430; Telefax: (202) 623-7201

Contents

• Introduction

• 1 The Fund Agreement in the Courts

  • François Gianviti

  • Comment

    • Pierre Francotte

• 2 Developing a Market for the Official SDR

  • Warren Coats

• 3 The Role of the BIS in International Monetary Cooperation and Its Tasks Relating to the ECU

  • Mario Giovanoli

  • Comment (on Chapters 2 and 3)

    • Rudolf R. Rhomberg

• 4 History of the Debt Crisis

  • C. M. Watson and K. P. Regling

  • Comment

    • G. Russell Kincaid

• 5 New Proposals for the Debt Crisis

  • Jerome I. Levinson

  • Comment

    • Edwin M. Truman

• 6 World Bank Cofinancing and Recent Developments with Respect to the Heavily Indebted Countries

  • Herbert V. Marais

• 7 Roundtable Discussion of the Debt Crisis

  • Country Debt Restructure, 1982–87: An Overview

    • Alfred Mudge

  • Coping with “Fatigue” in the Debt-Restructuring Process

    • Richard J. Davis

  • Creditor Concerns About the Debt-Restructuring Process

    • Francis D. Logan

• 8 Sovereign Immunity and Central Bank Immunity in the United States

  • Ernest Patrikis

  • Comment

    • Whitney Debevoise

• 9 The Settlement of Disputes Regarding Foreign Investments: The Role of the World Bank, with Particular Reference to ICSID and MIGA

  • Ibrahim F. I. Shihata

  • Comment

    • Russell L. Munk

• 10 Deposit Insurance: Current Problems and Proposals

  • John L. Douglas

  • Comment

    • John C. Murphy, Jr.

• 11 Commercial Bank Liability Under the Law of the United States for Deposits in Foreign Branches That Are Subject to Expropriation or Exchange Restrictions Imposed by Sovereign Governments

  • Ricki Rhodarmer Tigert

  • Comment

    • Eugene A. Ludwig

• 12 Banking Secrecy: Coping with Money Laundering in the International Arena

  • Gerald L. Hilsher

  • Comment

    • Michael Zeldin

• 13 Deregulation of Banking: A Worldwide Phenomenon

  • Michael Bradfield

  • Comment

    • Robert R. Bench

• 14 The Legal Barrier Between U.S. Investment and Commercial Banking: Its Origins, Application, and Prospects

  • Charles M. Horn

  • Comment

    • Steven Roberts

• 15 Stability of Financial Markets: Federal Reserve Responsibility?

  • Richard L. Fogel

  • Comment

    • Daniel L. Goelzer

• 16 The Basle Concordat: International Collaboration in Banking Supervision

  • C. J. Thompson

• 17 Risk-Based Assessment of the Capital Adequacy of Commercial Banks

  • Wiilliam Taylor

  • Comment (on Chapters 16 and 17)

    • William A. Ryback

• 18 The Legal Framework for Islamic Banking: Pakistan’s Experience

  • Sardad Khan Murvat

  • Addendum on Recent Developments

    • Akhtar Hamid

  • Comment

    • Zubair Iqbal and Abbas Mirakhor

• 19 Proposed Article 4A of the Uniform Commercial Code

  • Carl Felsenfeld

• 20 The Work of the United Nations Commission on International Trade Law in Electronic Funds Transfers

  • Eric Bergsten

• 21 The Proposed UNCITRAL Convention on International Bills of Exchange and International Promissory Notes

  • John A. Spanogle

• Appendices

• I. Revised Basle Concordat and Supplement

• II. Report of the Basle Committee on International Convergence of Capital Measurement and Capital Standards

• III. Article 4A of the Uniform Commercial Code

• IV. Draft UNCITRAL Model Law on International Credit Transfers

• V. United Nations Convention on International Bills of Exchange and International Promissory Notes

  • Notes

  • Biographical Sketches

Introduction

It was the ebbing of one century and the beginning of the next. An eminent mathematician was addressing a distinguished gathering of his colleagues. David Hilbert sought to evaluate the development of mathematical thought to date and to propose those problems the solution of which would propel the science into its future. In his famous address to the International Congress of Mathematicians in Paris in 1900, he singled out for study 23 important problems.¹ In the course of his remarks, Hilbert said:

History teaches the continuity of the development of science. We know that every age has its own problems, which the following age either solves or casts aside as profitless and replaces by new ones. If we would obtain an idea of the probable development of mathematical knowledge in the immediate future, we must let the unsettled questions pass before our minds and look over the problems which the science of today sets and whose solution we expect from the future. To such a review of problems the present day, lying at the meeting of the centuries, seems to me well adapted. For the close of a great epoch not only invites us to look back into the past but also directs our thoughts to the unknown future.

.... As long as a branch of science offers an abundance of problems, so long is it alive: a lack of problems foreshadows extinction or the cessation of independent development. Just as every human undertaking pursues certain objects, so also mathematical research requires its problems.... It is difficult and often impossible to judge the value of a problem correctly in advance; for the final award depends upon the gain which science obtains from the problem....²

Hilbert’s approach, the characterization of significant problems, is particularly applicable to a field in flux. Like mathematics, from which in other ways it is so dissimilar, banking is a field characterized by flux. There is a central concept which remains constant over the years. Nevertheless, the field is changing so rapidly that an observer who was a contemporary of Hilbert would be hard put to recognize some of the newer developments. While it would be presumptuous to attempt to duplicate Hilbert’s famous achievement in pinpointing the most pressing problems of banking, it is nevertheless possible to attempt to utilize his approach.

Since 1988, the International Monetary Fund has been organizing seminars for general counsels of central banks. In that year, the Fund’s Legal Department, in conjunction with the IMF Institute, invited 35 general counsels of central banks throughout the world to attend a seminar to discuss current legal issues affecting central banks. An agenda of important subjects was selected. The proceedings of this seminar are being published in the belief that the collected materials offer important and lasting insights into the subjects considered.

This volume contains the the collected views of many of the foremost thinkers and actors in the field of banking, having particular reference to the legal aspects of the matters discussed. Matters of both international and domestic significance are addressed. The contributors analyze topics ranging from central concepts of international monetary law to aspects of the debt crisis and the role of the international financial institutions and their units of account. In addition, the topics deal with banking secrecy, deposit insurance, deregulation of banking, the relationship between investment and commercial banking, the sovereign immunity of central banks, the responsibility of the central bank for the stability of financial markets, recommendations concerning the adequacy of bank capital, the responsibilities of national supervisors for banks operating across national boundaries, electronic funds transfers, international negotiable instruments, and Islamic banking.

Mr. Gianviti discusses the complex jurisprudence that has arisen concerning Article VIII, Section 2(b) of the Fund’s Articles of Agreement. This provision, which has been the subject of interpretation by the Fund’s Executive Board, is without doubt the most extensively litigated matter of the Articles of Agreement and the subject of much debate among legal scholars. A familiarity with the provision is central to an understanding of one of the basic principles of international monetary law. While one of the stated purposes of the Fund is to assist in the termination of restrictions in foreign exchange regulations which impair international trade, the Fund Agreement also recognizes that it may be necessary for some members to retain or impose exchange controls for a time after joining the Fund and even subsequently during intervals of stress. Accordingly, Article VIII, Section 2(b) deals with the effect of such exchange control regulations in the territories of other members by providing that:

Exchange contracts which involve the currency of any member and which are contrary to the exchange control regulations of that member maintained or imposed consistently with this Agreement shall be unenforceable in the territories of any member....

Mr. Gianviti examines the background and content of the provision and considers general rules of conflict of laws concerning recognition by the forum of exchange control laws of other countries. He then considers the intent of the provision to unify the diverse approaches to this problem. In spite of this intent, Mr. Gianviti notes divergent interpretations that the courts of members have adopted. Finally, he analyzes the significant issues upon which the courts have divided. Mr. Francotte presents an outline of the research paper prepared by the Legal Department of the Fund on the interpretation of Article VIII, Section 2(b). After reviewing the different scholarly and judicial interpretations, he summarizes the conclusions reached by the Legal Department on the various aspects of Article VIII, Section 2(b).

Mr. Coats and Mr. Giovanoli discuss the development and use of two major units of account in use in today’s financial world: the special drawing right (SDR) and the European currency unit (ECU). Both of these units have their values defined in reference to baskets of currencies, and both units serve in an official capacity, the former created by the International Monetary Fund and the latter by the European Monetary System. While the SDR serves to supplement reserve assets and thereby add to total world reserves, the ECU is a means of marshaling gold and dollar reserves of members of the European Community. In addition to their official uses, both units have been used to denominate privately created financial instruments. The Bank for International Settlements acts as agent for the European Monetary Cooperation Fund in respect of the official ECU while the ECU Banking Association acts in respect of the private ECU clearing and settlement system set up by the Association.

Messrs. Watson and Regling explain the origins of the debt crisis which has affected a number of developing countries. They trace these origins to increases in world energy prices that occurred simultaneously with decreases in the prices of other primary commodities. These developments led to a deterioration of the terms of trade of many of those countries. The problem was intensified by a prolonged recession in industrial countries that adversely affected the demand for developing countries’ exports. To offset these adverse developments, many countries turned to expansionary fiscal policies that were financed by substantial external borrowing, setting the stage for the ensuing debt crisis. Mr. Levinson believes that the responsibility for the debt crisis is shared among debtor countries, creditor banks, and creditor countries. He recounts the extensive borrowing by developing countries during the period 1974–82, the concerns expressed by some observers, and then the advent of the debt crisis in 1982. He then describes the Baker initiative and the roles of the banks, the debtors, and the international financial institutions and multilateral development banks in finding solutions. Finally, he considers various proposals for dealing with the problem. Mr. Morais reports on the efforts of the World Bank to assist in meeting the financing needs of developing countries at a time when commercial banks were reducing their lending to them as a consequence of the debt crisis. The innovative mechanism that he describes is known as cofinancing. This refers to an arrangement in which the World Bank, together with other banks and lenders, agrees to finance a portion of a project or program or, alternatively, one in which the World Bank guarantees a portion of a loan made by those other creditors. The other creditors may include official bilateral lending agencies, multilateral financing institutions, export credit agencies, and commercial banks. Messrs. Mudge, Davis, and Logan, who have served as legal counsel to creditors and debtors in the debt crisis, share their experience and perceptions from a practical standpoint.

Mr. Patrikis surveys the sovereign immunity of central banks, a doctrine of particular interest in the perspective of the debt crisis. The (i) absolute doctrine of sovereign immunity has generally been in retreat before the more modern (ii) restrictive doctrine which distinguishes between governmental operations and commercial transactions, granting immunity to the sovereign and its agencies for the former but withholding it for the latter. Nevertheless, the position of the central bank is often accorded special protection, so that it may, in certain circumstances, enjoy a privilege beyond that of other sovereign agencies and instrumentalities in litigation conducted in foreign courts.

Mr. Shihata’s contribution considers the role that World Bank affiliates may play in the settlement of investment disputes. Both the World Bank and its President, in his personal capacity, have been willing to assist in the settlement of these disputes. In addition, the Bank was instrumental in the creation of two organizations active in the promotion of the amicable settlement of investment disputes. The International Center for Settlement of Investment Disputes (ICSID) provides private investors direct access to an international forum of arbitration. The Multilateral Investment Guarantee Agency (MIGA) was established to guarantee and reinsure eligible investments against losses resulting from non-commercial risks. In carrying out these responsibilities, MIGA not only contributes to the avoidance of conflict between capital exporting and capital importing countries but also facilitates the settlement of investment disputes.

Mr. Douglas considers proposals to modify a system of deposit insurance which has been under increasing scrutiny in the light of a wave of bank failures in the United States. He rejects a proposal for universal deposit insurance and cautions against lowering the limit of deposit insurance and raising the requirements of bank capital excessively. He similarly argues against indiscriminately shoring up failing banks by injecting government funds through purchases of preferred stock or long-term debt, preferring instead to countenance a role for bank failure in the discipline of the system.

Ms. Tigert analyzes a special kind of risk that may arise out of banking operations abroad. This is a liability for which some courts have held head offices of U.S. banks accountable. It covers losses suffered by depositors in foreign branches of the head office when the host governments have, by way of expropriation or exchange restriction, made it impossible for payment to be made from the related local assets at the branches.

Mr. Hilsher describes the growth of offshore banking centers whose banking laws are currently being tested through litigation by law-enforcement authorities who are striving to confront the money-laundering tactics of organized crime. He then examines relevant legislation and cases that have established ways of obtaining information needed in the campaign against international money laundering. He describes a balancing test which has been employed by the courts in determining whether the interests of (i) one country in obtaining information relative to criminal activities outweigh those of (ii) another country in protecting privacy by way of its banking-secrecy laws. He supports the effort to reach an accommodation of interests by way of international agreements.

Mr. Bradfield considers a worldwide trend toward banking deregulation. He attributes this trend to domestic pressures, the internationalization of financial markets, advances in technology and communication, and the growing interdependence of countries. He notes the elements of U.S. deregulation, including the removal of restrictions on interest rates that banks can offer on deposits, the growth of regional interstate banking, and efforts to repeal restrictions on the conduct of securities business by banks. These developments are described against a background of similar and related legal and policy changes adopted in the United Kingdom, Canada, Japan, Germany, France, and Italy.

Mr. Horn focuses on a central matter of the deregulatory process in the United States: the division between commercial and investment banking that was mandated by the Glass-Steagall Act. He traces the involvement of commercial banks in investment banking activities up to the economic collapse of the Great Depression and analyzes the legislative response of the Glass-Steagall Act. He then investigates the case law and regulatory interpretations under the Act and the arguments made in favor of changing its provisions.

Mr. Fogel reflects on the extent to which the responsibilities of a central bank may be considered to extend beyond the banking system. In particular, he considers the situation of a stock-market crash and the linkages between a securities market and a financial futures market. He proposes that governmental regulators and self-regulating bodies work together to develop an integrated contingency plan to deal with market crashes that might occur in the future so as to assure the continued functioning of these markets during such emergencies.

Mr. Thompson discusses the role of the Basle Committee on Banking Supervision in coordinating prudential supervision of international banking. The Committee provides a forum for the sharing of supervisory responsibilities among national authorities and the adoption of coordinated approaches to specific issues. In particular, he explains the Basle Concordat, which seeks to allocate responsibilities between parent and host bank supervisors in respect of the foreign branches, subsidiaries, and joint ventures of banks that do business across national boundaries. The Concordat seeks to ensure that no foreign banking establishment will escape supervision and that such supervision will be adequate. It covers matters of solvency, liquidity, and foreign exchange operations and positions.

Mr. Taylor explains the framework that was developed to test bank capital adequacy in relation to certain risks that are incident to an institution’s loans and investments. This framework, developed by the banking regulatory authorities represented on the Basle Committee on Banking Supervision, was endorsed by central bank governors from the Group of Ten countries and has been made the subject of a directive of the European Community. The framework adopted was, in part, a response to the decline in capital ratios that occurred, especially in some of the larger banks, in the 1970s and early 1980s. Since the regulatory authorities view capital as a prime determinant of the health of banks, they set about formulating an agreed framework to test capital adequacy. The framework relates an international definition of capital to risk assets and off-balance-sheet activities, setting rising targets for minimum ratios for 1990 and 1992. The framework not only addresses the composition of capital but also distinguishes between kinds of assets and off-balance-sheet items, assigning different risk weights to each.

Mr. Murvat examines the legal framework that underlies the concept of Islamic banking. He notes that Islam provides a comprehensive system that relates to all forms of human activity. He then draws attention to relevant constitutional provisions and traces the efforts in Pakistan to examine existing laws with a view to bringing them into conformity with the tenets of Islam. As a part of these efforts, the issue of interest-free banking is addressed. The role of the State Bank of Pakistan in furthering the introduction of Islamic banking is explained, as are the amendments that were viewed as necessary to the various statutes. Among the latter, the law and concept of modaraba are considered. Alternatives to interest are examined, including (i) returns based on a markup in price, hire-purchase, and leasing, as well as (ii) participation in profits. Financing on the basis of musharika—that is, the sharing of profit and loss—is explained. He examines the role of banking tribunals designed to furnish an expedited procedure for the recovery by banks of financing provided in non-interest-based banking. Finally, Mr. Murvat considers the jurisprudence that has arisen to deal with these issues. An addendum to these matters is furnished by Mr. Hamid.

Professor Felsenfeld and Professor Bergsten address legal issues encountered in the burgeoning field of electronic funds transfers. Professor Felsenfeld concentrates his attention on a project to govern electronic funds transfers under the domestic law of the United States. In particular, he examines the concepts that have been embodied in a new article of the Uniform Commercial Code which is designated as Article 4A. That article was drafted to deal with wholesale electronic funds transfers. He describes the two elements of a funds transfer: the order to pay and the resulting payment. He notes that consumer transactions are excluded from the project, as are debit transfers. He then proceeds to describe the solutions that have been adopted in respect of unauthorized transfers, the acceptance and rejection of orders, the obligations of the various parties to the transfer, and their rights and liabilities.

Professor Bergsten considers the efforts of the United Nations Commission on International Trade Law to formulate model rules to govern international electronic funds transfers. He notes the traditional division of countries into those where transfers occurred primarily by check and those where they occurred primarily by giro, and the differing outlooks that are reflected by such a division. He traces the history of the project to develop model rules that would cover the transfer of funds from an originator through banking intermediaries to the beneficiary. He then examines particular legal issues that must be addressed by a system of model rules.

Professor Spanogle describes the project of the United Nations Commission on International Trade Law that culminated in a convention on international bills of exchange and promissory notes. He notes the division of the world into civil-law and common-law systems and its further fragmentation into local variations. He analyzes the chief differences that these systems have adopted in respect of a number of key issues of negotiable-instruments law. He then traces the history of the effort to harmonize and unify this law. He describes the solutions that have been incorporated into the new convention, the compromises that these reflect, and the novel approaches offered by the convention. Among the compromises are those concerning protected holders, forged endorsements, warranties, avals, and guaranties. Among the novel approaches are those concerning floating-rate bills and notes, as well as the use of units of accounts such as SDRs and ECUs.

Following the main papers of the proceedings are the remarks of a number of distinguished commentators. Each of these commentators offers a distinct perspective on a given subject. The views expressed in the various papers and commentaries are those of the authors and should not be interpreted as reflecting the views of the International Monetary Fund or any other institution.

I would like to express my gratitude to Mr. Paul Gleason of the Fund’s External Relations Department for his expert editorial assistance and to three researchers who lent their efforts to the publication of this volume: Mr. Arjun Goswami, Ms. Fola Makinde, and Mr. David Trieloff. Thanks also to Mrs. Sue Khandagle, my assistant, who contributed so much to both the seminar and the publication of its proceedings. Three members of the Fund’s Graphics Section also made important contributions: Mr. Philip Torsani designed the cover; Mrs. Betty Maguire designed the book’s interior; and Mrs. Maguire and Mrs. Gloria Buckley did the typesetting. Manuscripts were prepared for typesetting by Ms. Alicia Etchebarne-Bourdin and Ms. Audrey Gross of the Fund’s External Relations Department. Finally, I am indebted to Mr. Francois Gianviti, General Counsel of the International Monetary Fund, as well as to Mr. Ian McDonald of the Fund’s External Relations Department and members of the IMF Institute, who, through their guidance and support, made this project possible.

Robert C. Effros

May 1992