Current Legal Issues Affecting Central Banks, Volume IV.

Chapter 6 The European Community’s Second Banking Directive

Robert Effros
Published Date:
April 1997
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Before addressing the Second Banking Directive, the major piece of legislation in the field of banking supervision of the European Community (EC), this chapter begins with some introductory statements on the EC and its legislative process. This introduction may help to put the Second Banking Directive into perspective.

Three European Communities

The European Union, as the major organization for European economic and political integration is now called, is the current “end result” of a process of “nation building” that started after the Second World War. At that time, German and French coal and steel production was placed under a common authority, the present-day European Commission. Its functioning, as well as that of the other institutions of the European Coal and Steel Community (ECSC), was laid down in the Treaty of Paris, which entered into force in 1951.1 A common regime for the market in the two products that had been at the center of the war industry was considered to bring to an end the internecine warfare that had plagued the continent for so long and had twice set afire the entire world. Italy as well the three Benelux states (Belgium, the Netherlands, and Luxembourg) joined France and Germany in the ECSC.

In 1957, the Treaty Establishing the European Economic Community (the EEC Treaty; after Maastricht, the EC Treaty) built upon that first construction for European unity.2 (The Treaty Establishing the European Atomic Energy Community (Euratom) became operative at the same time but has remained far less important.)3 The EEC Treaty provided for the establishment, within predefined time limits, of a customs union and a common market among “the Six,” as the members were called. They were joined by the United Kingdom, Ireland, and Denmark in 1973 to form “the Nine,” by Greece in 1981 (making ten members), while Spain and Portugal joined the EC (as the three Communities were then commonly named) in 1986. Currently, applications for membership are pending from Turkey, Malta, Cyprus, Hungary, and Poland. A request for accession from Switzerland is dormant; the Swiss voted down participation in the internal market through the European Economic Area, so full accession is not on the table. The accession of Finland, Austria, Sweden, and Norway was negotiated and ratified by the European Parliament; in Finland, Austria, and Sweden, the popular vote was affirmative, but the Norwegians voted against membership.

Customs Union and Common Market

The establishment of a customs union and a common market was meant to be brought about through decisions that the Council of Ministers (the body consisting of ministers from the member states) would take on proposals from the European Commission (the Community’s executive arm, consisting, at present, of 17 men and women who operate independently of government instructions and who are accountable to the European Parliament). The European Parliament was to give its opinion on draft legislation. A European Court of Justice was established in Luxembourg to ensure that the law was observed. Although many measures tearing down restrictions and abolishing discriminations between the member states were in effect taken, the major impetus toward integration came from the European Court of Justice. It held that citizens and companies could rely on the directly effective provisions of the EEC Treaty and of secondary law (that is, legislation adopted under the EEC Treaty). This ruling promoted the freedom of movement for economically active people, goods, services, and capital that the EEC Treaty meant to bring about.

1992 Internal Market Program

Nevertheless, the vision of an economically integrated Europe needed further positive action to be completed: too many national laws made the operation of business across state boundaries a difficult and expensive affair. Diverging labeling laws, local authorization requirements, a lack of recognition of diplomas and certificates, the incidence of tax laws, and the dispersal of supervisory authority among 12 jurisdictions made “Europe” nonexistent in many economic areas. To remedy this situation, an enormous legislative program was started, under which the Council was to adopt in cooperation with the European Parliament directives harmonizing many economic laws and eradicating the last obstacles to an integrated market. The Single European Act, adopted for this purpose, contained important amendments to the EEC Treaty.4 It provided that the internal market was to be completed before the end of 1992.

Maastricht Treaty: Political Union and Economic and Monetary Union

The vision of a politically integrated Europe that lay at the root of economic integration (which had been adopted once a direct road to a political and defense Community had been cut off in the early 1950s) gained momentum with the end of the cold war and the collapse of the Soviet Union. The time seemed ripe for a new leap toward common external policies beyond the field of international trade. Also, the commitment to abolish the internal Community borders necessitated further cooperation in the areas of justice and home affairs. Thus, a conference was called to draft the necessary provisions.

A parallel conference was to crown the internal market with the establishment of Economic and Monetary Union (EMU), that is, common economic policies and a single currency for Europe.

The end result of this bargaining process is the Maastricht Treaty on European Union.5 It establishes two pillars of intergovernmental cooperation (in external and defense matters, as well as for justice and home affairs) next to the Community pillar, whose legal foundations were expanded and modernized, with a specific timetable set for establishing EMU and delegating additional powers to the European Parliament. The ensemble was labeled the “European Union.” Although this name does not indicate a new international legal person, it gained acceptance once the difficult process of ratifying the Treaty on European Union had been completed. The Treaty on European Union encompasses amendments to the existing treaties, which it does not replace. The institutions of the Community (the European Commission, the Council of Ministers, the Court of Justice, and the European Parliament) are “borrowed” to perform functions in the two areas of intergovernmental cooperation based on the Treaty on European Union. The so-called European Council (the meeting of the heads of state or government of the 12 members and the President of the European Commission) is to give political impetus to the process and has been given some decision-making powers. The central position and political importance of the European Economic Community were underscored by the change of its name to the EC (hence, no longer only economic in character). The other two Communities (the ECSC and Euratom) are still alive but are certainly less active than the EC.

European Economic Area

The European Union got off to a slow start on November 1, 1993. Two months later, another ambitious project finally became operative: the so-called European Economic Area.6 It links the states of the European Free Trade Association (EFTA)—a free trade zone, established in 1961 as an alternative to the European Economic Community, whose dwindling membership included only the Scandinavian and Alpine countries, owing to defections to the EC—with the common market. Legislation on the single market became effective in Austria, Sweden, Norway, Finland, and Iceland, and it will also apply in Liechtenstein as soon as this state has severed its economic union with Switzerland (the only EFTA member that chose not to join the European Economic Area).

Through the Agreement on the European Economic Area, the economic integration of the continent was brought one step forward: non-EC members have effectively joined the internal market without taking part in the other fields of EC activity or participating fully in the decision-making process in Brussels and Strasbourg.

Second Banking Directive’s Place in European Integration

The Second Banking Directive is the cornerstone of the internal banking market.7 It sets the tone for similar directives in the area of insurance and securities trading. The Second Banking Directive applies, by virtue of the Agreement on the European Economic Area, in 19 states, which are each required to adapt their own legislation to the directive’s contents. That is the nature of a directive; it is a binding decision that imposes upon member states the obligation to comply with its terms within a predetermined period left for national implementation.

Because it helps to realize an integrated banking market, the Second Banking Directive can be said to contribute to laying the groundwork for the single monetary policy that will be conducted with the establishment of EMU.8 This chapter shows that, although there is still some room to improve the Second Banking Directive to bring about a fully integrated banking market and a currency union, the groundwork has been laid.

Structure of the Second Banking Directive

First and Second Banking Directives

The Second Banking Directive is not the only piece of EC legislation on banking supervision. It builds upon, amends, and expands the First Banking Directive of 1977, which was a modest first step toward harmonizing supervisory rules in the common market.9 This chapter addresses the body of law consisting of the First and Second Banking Directives taken together.

Three Directives on Banking Supervision

The Second Banking Directive was adopted in 1989; it had to be implemented by the member states by December 31, 1992 at the latest.10 Two accompanying directives were also adopted in 1989; the three together were intended to harmonize banking regulation in such a way that the banking supervisory authorities of the member states could from January 1, 1993 onward rely on each other’s supervision.11 The internal market is based on this system of home state control and on the mutual recognition by the member states of the regulatory framework and its application to the banking system.

It was considered necessary and sufficient that the authorization requirements for banks were harmonized, as well as the main rules to which banks are subject once licensed to operate. These rules are contained in the Second Banking Directive itself, and in the Solvency Ratio and Own Funds Directives.12 The latter directives lay down the regime of solvency testing for credit risk. They implement in the EC the Group of Ten’s agreement on capital adequacy (the so-called Basle Capital Accord).13 It is interesting to note that a nonbinding understanding as to the capital ratios for internationally operating banks was thus given legal effect in the EC for all credit institutions authorized to operate in the internal market, whether locally or throughout the Community.

Home State Supervision: The Rule and Exceptions to the Rule

Regarding the solvency tests, there is a division of responsibilities in the context of the Second Banking Directive. It was agreed that the state licensing a bank (the home state) is responsible for supervising the bank’s compliance with all supervisory rules, especially the solvency ratio, while the state or states where the bank operates have only residual powers.

With respect to these residual powers, the lack of monetary integration in the EC (as yet) made it necessary to stipulate that the host states are responsible for monetary (as opposed to prudential) supervision and for overseeing a branch’s liquidity (which, after all, has to do with its funding capabilities in the local currency market). Finally, competences with respect to host state rules, which are indispensable and have not been the subject of harmonization, remain with the host state authorities. In this context, this “general good” exception to the main division of tasks among the supervisors derives from the European Court’s case law on the powers of host states to regulate business conducted on their territories by producers or providers of services from elsewhere in the internal market.14

Contents of the Second Banking Directive

The Second Banking Directive consists of a long preamble containing no fewer than 23 considerations and 25 articles, divided into six titles. After the first title, which provides the definition and scope of the directive, the conditions for harmonizing authorization requirements are given in the next title.15 Relations with third countries form the subject matter of the third—and, internationally, the most widely discussed—title, which is placed between the licensing criteria and the rules applying to a bank once admitted to the market.16 A separate title consists of specific provisions giving procedures for putting into effect the freedom of establishment and freedom to provide services in another member state given by the Treaty on European Union.17 Matters such as technical amendments and entry into force conclude the text of the Second Banking Directive,18 to which a list of banking activities subject to mutual recognition is annexed.19

Concept of a Credit Institution

The EC has taken an institutional approach to the supervision of banks: all companies and firms that conform to the definition of a credit institution are to apply for licenses before starting business. The definition from the First Banking Directive has been maintained, namely, that a “credit institution” is “an undertaking whose business is to receive deposits or other repayable funds from the public and to grant credits for its own account.”20 There are several striking features of this definition.

• Only a firm that is in the business of banking is considered a credit institution. Occasional banking-like activities do not bring a firm within the purview of the EC directives.

• Decisive for qualifying as a “bank” (shorthand for “credit institution”) is the solicitation of repayable funds. Approaching the public for investments makes a firm an investment company, subject to the securities directives.

• A firm that limits its banking activities to nonpublic activities is not a credit institution. In the Netherlands, banking activities for institutional investors only are considered not for the public. Of course, the interpretation of the elements of the definition is ultimately up to the European Court.

• A credit institution is in the business of accepting funds to grant credit for its own account. A firm that acts only as an intermediary, bringing depositor and debtor together without committing its own name, will not count as a credit institution.

When these elements are combined, a credit institution is said to exist. EC law requires credit institutions to be authorized and supervised. It follows from the nature of EC legislation that member states may encompass more entities under their banking laws, including companies engaged in other activities under their own definition of a bank. These definitions must, as a minimum, have the scope of the EC’s definition. Any discrepancies remaining among state banking laws are lessened by the common list of activities in which a bank may engage once authorized in a single state (provided that its home state license does not restrict its scope of business). This list, which is annexed to the Second Banking Directive, will lead to harmonization in practice as the interpenetration of banks on each others’ territories will bring about market forces conducive to an alignment of regimes: out-of-state competitors that are allowed to engage in more activities than local banks are a powerful inducement to adapt banking regulations.21

Harmonized Conditions for Obtaining (and Keeping) a Banking Authorization

Reading the First and Second Banking Directives together makes it clear that six authorization requirements apply. First, a credit institution must have own funds.22 This condition obliges bankers to incorporate. It seeks to ensure that the funds of the banker are legally separate from those of the depositors.

Second, a credit institution must have initial capital of at least ECU 5 million.23 Sufficient own funds are required to start a banking business, in order to restrict entry to the banking market to serious applicants who can muster a minimum amount of own funds. Of course, the actual business that banks undertake may lead to higher capital requirements under the Solvency Ratio and Own Funds Directives. The solvency requirement is separate from the initial capital requirement. The minimum is to be maintained throughout the life span of the banking business.

The level of ECU 5 million was arrived at through a compromise. The amount is “peanuts” for an internationally operating bank, but it also applies to local credit unions, which are allowed to do business throughout the internal market (through a procedure to be discussed below). A lower threshold of ECU 1 million may be set by the state authorities for specific classes of banks; such a move is subject to European Commission scrutiny.24

Third, a credit institution should be managed by at least two persons.25 The requirement that a minimum of two persons “effectively direct the business of the credit institution” means that its day-to-day management must be subject to the “four-eyes principle.” Effective checks and balances must be present, with a view to “avoiding risky solo operations.”26

Fourth, the managers of a credit institution are to be experienced and of good repute.27 Sufficient banking experience will shield a credit institution from incompetence. It should always be borne in mind that a bank solicits funds from the public and is expected to administer and invest them better than the individual depositor would or could. The requirement as to the good repute of bank managers means that only trustworthy people may be at the helm of an institution that is in the fiduciary business.

The high standards to be applied in connection with this fourth requirement have not been specified further in Community legislation, or in that of several member states, where it is considered a matter for the discretion of the central bank or other supervisory authority granting the banking license. Elsewhere, a list of previous acts considered incompatible with the office of bank manager has been drawn up: bankruptcy, conviction for fraud, and similar events are considered to make one unsuitable for running a credit institution.28 Any decisions on the acceptability of bankers are subject to judicial review. The principle of court review of supervisory decisions underlies Article 13 of the First Banking Directive and also follows from Article 6 of the European Convention on Human Rights (which covers each of the member states and is also applied by the European Court to Community decisions).29

Fifth, a credit institution must have suitable shareholders.30 In addition to the requirement of experienced and suitable management, the suitability of members or shareholders of a bank must also be tested in advance.31 Once a license has been granted, the continued suitability of shareholders is to be screened by the supervisory authorities under Article 11 of the Second Banking Directive.32 The sound and prudent management of the bank is the criterion by which to judge the shareholders, and to detect and counter any influence to the detriment of the depositors.33 Article 11 provides for a continuous notification of changes in membership to the authorities, who must try to neutralize any detrimental shareholders’ influence.34 In some states, this is done by requiring that any exercise of voting rights in a banking corporation that has not been authorized in the most recent scrutiny is null and void or can be declared so on supervisory application by the courts. Thus, harmful influences can be effectively thwarted.

Finally, a credit institution should submit to the supervisory authorities a program of operations.35 A business plan makes it easier for the authorities to evaluate the request for a banking license. This condition makes it possible to look into the plans of the prospective entrant to the banking market and test the organization against prudential standards, such as the establishment of sound administrative and accounting procedures, and to see whether adequate internal control mechanisms will be put in place.36 This condition also makes it possible to evaluate the probability that the bank will conform with solvency requirements and report thereon to the supervisors.37

“Reciprocity” or Relations with Third Countries

The issue of reciprocity stirred up much debate during the preparations of the Second Banking Directive. The relevant provisions of the directive set out what the Community can do if it considers that the creation of its single banking market is being used by banks from third countries without EC banks being able to operate just as freely in those countries.38

Authorization to Operate Across the Common Market (European Passport)

The six conditions for an authorization to set up a bank just addressed apply to any new applicant from the Community, the other European Economic Area states, or third countries. Member states are free to impose other licensing conditions, provided that they are compatible with the directives. After all, the Second Banking Directive and its companion directives complete the minimum harmonization necessary and sufficient for mutual recognition by EC states of each other’s prudential systems. These directives do not purport to regulate banking supervision exhaustively.

Those who wish to establish a bank must go through this licensing process. However, contrary to the pre-1993 regime, setting up a branch or starting cross-border activities in another state is no longer subject to separate licensing by the host state: a credit institution authorized in one member state is granted a “European passport” and may operate throughout the internal market (subject to qualifications to be addressed later). Any legal entity lawfully established in the common market and authorized as a bank can avail itself of the single market procedures for Community-wide banking, irrespective of the nationality of its parent. Under Article 58 of the EC Treaty, any corporation of a profit-making nature established in one member state, whatever its parents, is considered a European legal entity and can avail itself of the freedom of establishment and the freedom to provide services.39

Market Access and National Treatment for EC Banks Elsewhere

In the case of applications for a banking license from outside the EC and from the other participants in the European Economic Area, an additional test may be applied. This test concerns the openness of the banking markets in the home country of the applicant.40 Establishing this condition was meant not as an entry restriction, but as a last resort to ensure that the liberalization of the EC banking market would serve as an example and lead to the tearing down of walls around other lucrative markets. Also, it proved necessary to replace any state reciprocity rules by a Community-wide provision, as otherwise a member state that made entry into its market contingent upon free access to a third market for its own banks would decide the issue for other states as well. Once inside the market, a bank will profit from its European passport and thus circumvent any reciprocity policy applied by another member state. The U.K. reciprocity policy was the most important in this respect, as the London market is the main prize for many outside banks.

Notification of Authorized Entry from Third Countries

Article 8 of the Second Banking Directive requires the supervisory authorities to notify the European Commission of banking licenses granted to third-country banks and of declarations that the supervisory authorities do not oppose a third-country shareholder in an EC bank for prudential reasons (the “suitability” test referred to previously). This reporting requirement gives the EC executive an insight into outside penetration of the single market.

Suspension of Applications from Third Countries

If banks encounter difficulties in establishing branches elsewhere, the European Commission may act. If it finds that “effective market access comparable to that granted by the Community to credit institutions” from third countries is absent, it may propose to the Council of Ministers that negotiations be opened with the country concerned.41 Should national treatment also be lacking, the European Commission may act on its own and temporarily limit or suspend the handling of applications from the third country concerned.42 Then, for a three-month period, banks from this country may not start operations in the EC or become shareholders in EC banks.43 These situations are regulated in Article 9 of the Second Banking Directive.

This power is, however, heavily circumscribed. Apart from the limited period in which it may be applied, the Commission is further subject to scrutiny by the member states in a “comitology procedure.” This strange “Eurospeak” stands for a committee of member state officials that must give its opinion on a proposed act of the European Commission.44 The executive may act only if this opinion is favorable or the member states do not react to its proposal.

Respecting International Obligations

Thus far, the European Commission has not yet had occasion to submit proposals for specific agreements or to order the suspension of the handling of applications from outside the EC, partly because the treatment of financial services providers was the subject of negotiations in the framework of the Uruguay Round of the General Agreement on Tariffs and Trade. Under the General Agreement on Trade in Services (GATS),45 an Annex on Financial Services was adopted, which would make it difficult, if not impossible, for the Community to apply its reciprocity regime (which was copied from the banking sector in the insurance and securities fields).46 It would appear that the agreed GATS texts, although almost inscrutable to an outsider, will, once ratified, end the reciprocity debate.

Meanwhile, the Community is bound to apply its provisions on entry from third countries while respecting its international obligations. This obligation follows from Community law principles and is confirmed expresses verbis in Article 9(6) of the Second Banking Directive. This clause was inserted, inter alia, to put to rest the concerns of the Organization for Economic Cooperation and Development (OECD), as national treatment requirements under the OECD codes on liberalizing capital movements and current invisible transactions would make it difficult to apply Articles 8 and 9 of the Second Banking Directive in respect of the non-EC countries among the 25 OECD members.47

Unilateral Liberalization of Capital Movements with Third Countries

Since the adoption of the reciprocity clauses, the Community has taken another big step toward liberalizing international financial trade: it included an erga omnes obligation to free current and capital transfers in the Maastricht Treaty on European Union.48 The newly inserted Article 73b of the EC Treaty, which took effect with the start of the second stage of EMU on January 1, 1994, requires complete freedom of financial transactions between the member states inter se and between the Community and third countries.49 Article 73c specifies some exceptions, inter alia, for the reciprocity provisions in directives adopted prior to 1994.50 Any variations on the current regime may be decided on by a so-called qualified majority in the Council, but any retrograde step on the road to liberalizing capital transactions with the outside world can only be agreed unanimously. Thus, the thrust of the new law is clear: Europe is the only jurisdiction to liberalize financial transfers unilaterally in a constitutional text.

The inclusion of reciprocity provisions in the Second Banking Directive has served a dual purpose: first, it has helped put financial services liberalization firmly on the agenda of international trade politics; and second, it may help the Community gain access to markets elsewhere on a level similar to what it offers to non-European banks and financial institutions through the creation of the internal market.

Harmonized Supervisory Rules

The Second Banking Directive not only regulates entry into the banking market but also lays down rules for the conduct of banking business. Again, other directives play a role here. The Solvency Ratio and Own Funds Directives are particularly important.51 Directives on the consolidated supervision of banks and banking groups, the annual accounts of banks, their large exposures, and the capital adequacy rules in respect of market risk are directly relevant from a prudential point of view.52

The Second Banking Directive itself establishes the following banking rules:

  • continued observance of the initial capital requirement;53
  • screening of shareholders’ influence to ensure sound and prudent management of the bank concerned;54
  • limits on the qualified holdings of credit institutions in other (non-financial) companies;55 and
  • establishment of sound administrative and accounting procedures and adequate internal control mechanisms.56

A brief word on each of these prudential rules is called for.

Minimum Capital of ECU 5 Million

The capital requirement was explained previously in the section on authorization conditions. It should not be confused with the solvency requirement for credit risk resulting from the combining of the requirements for market risk under the so-called Capital Adequacy Directive with the requirements of the Solvency Ratio Directive.57

Suitable Shareholders

The screening of shareholders is an initial requirement that must also be continually applied. It represents a major innovation in EC banking law. Previously, certain member states attached great importance to the vetting of bank owners and used various techniques to do so, ranging from the reaching of an understanding between majority owners and supervisors in Belgium to the placing of legal constraints on the exercise of voting rights in credit institutions in the United Kingdom and the Netherlands.58 The new rules leave room for national discretion in applying sanctions, but they ensure that a uniform minimum regime will test shareholders’ suitability in the internal market. Any shareholder wishing to have a 10 percent participation in a credit institution must have been found suitable.59

Limiting Banks’ Involvement in Commercial Companies

Also new for some states are the limits placed on a bank’s participations in nonfinancial companies. The Second Banking Directive is only concerned with participations of a certain size (so-called qualifying holdings, defined as a 10 percent interest in another company’s capital or similar voting rights).60 It prescribes that such participation should remain below 15 percent of a bank’s own funds.61 Thus, a double computation is required for applying this norm: if the amount of shares or voting rights that the bank holds in a company exceeds the threshold of 10 percent, its stake is limited to 15 percent of the bank’s capital. The sum total of these participations may not exceed 60 percent of the bank’s own funds.62 There are qualifications to allow for participations in other credit or financial institutions and (at the option of the member states) insurance companies, as well as for temporary holdings for underwriting purposes or in the context of a financial rescue operation.63 Because in some banking markets large interests in commercial companies were the rule rather than the exception (Germany and France are cases in point), a ten-year transition period has been established, after which the rules will apply with full rigor.64

Adequate Administration and Internal Control

A company receiving money from the public should, as a matter of course, follow adequate administrative procedures. Article 13(2) of the Second Banking Directive does not add much, materially speaking, to what supervisors (in their oversight of banks) and auditors (in preparing their reports on annual accounts) would require. Including such obvious precepts in supervisory regulation gives the regulators the power to prescribe specifics and test compliance—and, if necessary, act upon noncompliance. Article 13(2) is wide enough in its wording to encompass rules on separating securities and credit departments (“Chinese walls”) and on restraining insider trading. A separate directive65 deals with this matter, but it concerns only stock exchange trading, and prudence and self-restraint are called for in any transaction involving a bank in a dual position, whether in managing its own and its clients’ accounts at the same time or in acting as both lender to, and owner of, a company.66 This provision of the Second Banking Directive creates supervisory competences where they may have been lacking and also makes possible interstate cooperation in enforcing such rules in respect of credit institutions.67

Establishment of Branches and Provision of Services

The purpose of harmonizing regulatory and supervisory practices was to create an integrated banking market. As already noted, banks are licensed by the state of their incorporation when they meet certain conditions. They then receive European passports, which authorize, in principle, their operations throughout the Community. It is this qualification—“in principle”—that is to be examined in order to see how the system of mutual recognition functions.

Treaty Rules on Establishment and Services

First, it should be recalled that, under the provisions of the EC Treaty, European legal entities have the right to establish themselves in other member states under the conditions applying locally.68 Furthermore, they are free to provide services in other member states without operating permanent establishments there.69

The European Court has developed case law on the abolition of restrictions on inward provision of services.70 According to the Court, host states cannot apply their own licensing rules to out-of-state providers of services unless four cumulative conditions are met.71 The host state rules should be

  • justified by the general good (that is, only standards for which a clear public interest can be demonstrated are acceptable);
  • nondiscriminatory in character (that is, they should also be applied without distinction to local operators);
  • nonduplicative (that is, a mere duplication of professional standards that already apply in the home state is unacceptable); and
  • necessary because a less restrictive method of meeting professional standards does not exist (that is, the application of host state rules is subject to a proportionality test in respect of the purposes that they seek to serve).

The application of a state rule on professional standards to an outside provider of services that fails these tests will amount to a prohibited restriction. This case law is in line with jurisprudence on the free movement of goods, known as the Cassis de Dijon precedent.72 The European Court’s decisions have paved the way for implementation of the system of mutual recognition in all areas of economic activity in the common market.73

Bank Operations in the Internal Market

Three different situations should be distinguished in the operation of a bank in the internal market. A bank may set up a subsidiary, open a branch, or begin to provide cross-border services.

Establishing a Subsidiary

A subsidiary, that is, a separate legal entity governed by the laws of the host state, still has to apply for a license in its state of incorporation. It is considered a creature of the law of the host state and may avail itself of the facilities of the Second Banking Directive for opening branches and providing cross-border services. A parent in state A may establish a subsidiary in state B and from the latter state may start operating throughout the Community. State B is then the home state for this bank’s branch network in the single market. Hence, in the case of subsidiaries, the EC Treaty system for establishment, which requires compliance with host state rules, remains fully in place.

Establishing a Branch

For a permanent establishment in another state without separate incorporation, the Second Banking Directive abolishes the rule of host state authorization.74 The First Banking Directive allowed branches to be licensed by the host state.75 The Second Banking Directive goes a major step further and makes the opening of a branch subject to a procedure in which only the home state authorities are competent to take any decision.76 A bank wishing to “branch out” is to notify its own authorities of its intention to do so. The home state supervisor then checks whether the bank’s administrative structure or financial situation give reason for doubt. If not, the home state supervisor passes the bank’s notification on to the relevant host state authorities. The host state supervisor is allotted two months to prepare for the supervision of the branch. The host state supervisor must indicate to the branch which host state rules the branch is bound to comply with in the interest of the general good.

The separate authorization of a branch, extra “branch capital,” and the screening of managers by the local regulator have all been abolished. Should the home state supervisor conclude that a bank is not sound enough or lacks the necessary administrative infrastructure to set up a branch in another state, it can refuse to send the bank’s notification on to the host state authorities, thus bringing the branch establishment procedure to a halt. Naturally, the bank concerned may apply to the courts for a revision of the supervisory judgment.77

Beginning the Provision of Cross-Border Services

A much simpler notification procedure applies when a bank, licensed in state A, intends to provide services in state B.78 The bank notifies its intentions only to its own authorities, who send the notification on to the host supervisory agency. The bank can then begin operations from its home base. This notification procedure does not imply that any decision is to be made by the home authorities on the soundness or administration of the bank, and there is no waiting period. Nevertheless, in view of the right created by the EC Treaty of free provision of services, the interposition of the notification would seem to be a step backward instead of forward. Arguably, the directive’s rules on the provision of services are incompatible not only with the objective of creating a single passport but also with primary EC law (notably, in the EC Treaty, Article 7a on the creation of the internal market and Article 59 on the freedom to provide services). The EC Treaty being of a higher order, the relevant clause of the Second Banking Directive may one day be declared null by the European Court.

Supervisory Cooperation

Consultation and Coordination

The foregoing has made clear that the creation of the internal market has made the supervision of banks operating throughout Europe a matter of cooperation. Not only are supervisors required to inform each other about the standing of a credit institution intending to establish a bank in another state, but they are also to consult with each other prior to granting a license to a bank with links to another member state.79 The obligations of mutual cooperation, which the First Banking Directive already contained, have been expanded: supervisors are to inform each other on the ownership, management, solvency, and liquidity of banks operating in more than one state, as well as on questions of, inter alia, administration and deposit guarantees.80 Home state authorities may send out inspectors to branches in other states, while a mandate from the home to the host state agency to check data or otherwise carry out inspections is also possible. The division of supervisory responsibilities, heavily tilted to the home state, makes such cooperation necessary.

Exchange of Cross-Border and Cross-Sector Information

As banks become more and more intertwined with other providers of financial services, cooperation with supervisors of insurance companies and investment firms has also become necessary. Thus, the confidentiality restraint that applies to all supervisory information has been lifted for such interagency cooperation.81 Of course, it has also become possible to exchange information among banking supervisors, especially on a cross-border basis.

Common Regime of Confidentiality

The secrecy regime itself has been further harmonized. The First Banking Directive, as amended by the Second, exhaustively lists the uses to which supervisory data may be put.82 The confidentiality clause has been copied in the other relevant directives and provides for strict secrecy.83 This European approach to supervision differs from the more open attitude of U.S. regulators. No publication of inspection reports is contemplated in the EC.

Memoranda of Understanding Between Supervisory Agencies

Confronted with the need to cooperate on a hitherto unknown scale, the supervisory agencies in the EC have concluded between themselves memoranda of understanding that set out the instances of mutual information, consultation, and coordination. To a certain extent, these memoranda are repetitive of the Second Banking Directive’s language. They also imply certain policy choices where the directive leaves room for interpretation. Regrettably, the agencies entrusted with banking supervision have concluded bilateral accords instead of one multilateral memorandum, if a detailed agreement was indeed necessary at all. Outsiders (credit institutions wishing to operate across the relevant borders, supervisors from member states other than the two concerned, and those interested from an academic or political point of view) do not know the contents of the memoranda, which, in the end, number so many that nobody has an overview of their provisions.

Cooperation in the Second and Third Stages of EMU

The conclusion of bilateral supervisory accords amounts to a carving up of the supervisory field, which seems harmful to effective regulation of the single market. It would not be surprising if this state authority reflex were in time superseded by the implementation of a more coordinated approach toward banking supervision. The existing coordination forums may provide opportunities for discussion and sometimes action, but they are framed too much like debating committees to operate effectively, especially in crisis situations. The forums are the Contact Group (of supervisors), the EC Banking Advisory Committee (consisting of regulators, treasury officials, and Commission staff), and the Banking Supervisory Subcommittee, which the European Monetary Institute (EMI) inherited from its predecessor, the European Community Committee of Central Bank Governors.

Although the EMU provisions of the EC Treaty do not designate a single authority for prudential supervision, they do provide for coordination among the national authorities, first through the EMI,84 and then in the third stage of EMU through the European Central Bank (ECB).85 This new organ, to be responsible for conducting monetary policy with the overriding objective of maintaining price stability, may further be given specific competences in banking supervision.

Amendments (The “Post-BCCI Directive”)

The Second Banking Directive was adopted as the cornerstone of the legislation bringing about a single banking market. With the First Banking Directive and the Solvency Ratio and Own Funds Directives,86 the EC’s legislative program seemed complete.

However, since 1989, the revision of the Consolidated Supervision Directive87 (the 1983 measure was replaced by a new 1992 text) and the adoption of the Large Exposures Directive88 and the Deposit Guarantee Directive89 have added to the EC’s banking regulations. The screening of market risk incurred by securities houses and banks alike is the subject of a new Capital Adequacy Directive,90 to be implemented by July 1, 1995; the national implementing legislation is to be applied as from January 1, 1996. These further pieces of legislation still do not conclude the EC’s activities in banking regulation. After the collapse of the Bank of Credit and Commerce International (BCCI), a tightening of supervisory rules seemed in order. Partly on the recommendations of the British committee91 set up to inquire into the affair, proposals were tabled to amend the Second Banking Directive, as well as other directives concerned with the supervision of banking, insurance, and securities firms. This “post-BCCI” directive went before the European Parliament for a second reading under newly gained “codecision” competences, in which the Council of Ministers and the European Parliament together adopt legislation.92

The directive contains a number of innovations. First, it provides that credit institutions will be subject to a further condition for authorization: transparency of group structure.93 Any credit institution that is the subsidiary of another undertaking or one in which the undertaking has an interest of 20 percent or more must make public its group structure. If the supervisory authorities are not satisfied that they can effectively supervise the bank, they may refuse the license.94 Thus, a seventh licensing requirement, in addition to those cited earlier in the chapter, is introduced.

A change in group structure that leads to a lack of transparency may lead to revocation of the authorization. Pursuant to Article 8(1)(c) of the First Banking Directive, a license may be withdrawn if the credit institution no longer fulfills the conditions under which authorization was granted.95

It was envisaged that the post-BCCI directive would be applied as of January 1, 1996.96 At that time, another condition for authorization would also apply: a bank’s registered office may not be in a state other than that where its head office is situated.97 This condition, already to be found in the preamble to the Second Banking Directive,98 will make it possible to deny authorization if it becomes clear that a bank incorporates in another member state in order to evade the supervision of the state(s) in which its main business is located. The BCCI had its registered office and was licensed in tiny Luxembourg while its activities spanned the common market, focusing on the United Kingdom in particular. The European Court’s case law on the freedom to provide services and on capital movements always makes an exception where so-called U-turns are concerned, namely, where a firm is established in another state with the objective of evading the rules adopted for the general good by the state on which the economic activities are “targeted.”99

The scope for exchanging supervisory information will increase: the post-BCCI directive will provide that liquidators, auditors, and central bank departments responsible for the oversight of payment systems will be included among the categories of persons and bodies with whom supervisory data can be shared.100

Finally, the auditors of a bank will have to report to the supervisors any circumstances that may lead to a qualification or refusal of the certificate of audit or that endanger the existence of the bank or imperil its depositors. The auditors will also have to inform the supervisors when principles of sound management are flouted.101 This kind of cooperation between supervisors and auditors, who may become aware of malpractice at an early stage and whose alertness may greatly facilitate supervision, is not new to some member states. However, the exhaustiveness of the regulation and the scope of this exception to the rules of confidentiality binding auditors and their banking clients are a novelty.


The Second Banking Directive can be said to be a major piece of banking legislation that will determine the shape of European banking supervision for years to come. In line with the European tradition, it provides for universal banking and makes the beginning of operations in the various states of the single market less cumbersome. The directive lays the responsibility for supervision squarely on state authorities and is therefore far removed from any centralizing tendency in banking supervision. “Common rules and separate enforcement” would be an appropriate qualification of the “1992” EC approach.

Although its adoption and implementation may be heralded as an important step both in the creation of a single market and in banking regulation as such, the Second Banking Directive has its flaws.

First, it does not facilitate the establishment of subsidiaries in other states. This lacuna means that banking groups seeking to do business through subsidiaries still have to deal with authorizations in several jurisdictions and separate capital requirements. The option in the Solvency Ratio Directive to mandate a parent bank’s authorities to oversee the solvency of its subsidiary may perhaps set an example to be followed in other areas of supervision as well.102

Second, the procedures that the Second Banking Directive prescribes for opening a branch and for starting cross-border services in the internal market would seem to contradict the very idea of a single European passport and of nondiscrimination among the depositors in the single market and may conflict with the relevant EC Treaty provisions. The measures adopted for implementing the Second Banking Directive form a net of diverging rules, in which banks wishing to operate in different states while engaging in different activities on the list annexed to the Second Banking Directive may easily become entangled. What should have been a facilitating measure may then provide another bureaucratic stumbling block to doing business in the Old World.

Third, the approach of state entities overseeing the operations of banks in an integrated market may in the end prove difficult to maintain if large banks develop with equal footholds in two or more states. This system of attribution of responsibilities is likely to be put to the test in crisis situations, as the BCCI case has shown. It may very well be that a European banking supervisory agency may be necessary. At the very least, a central “focus of authority” on the single banking market may have to emerge. In the absence of any other relevant institution with authority across Europe, it may be that the ECB will have to provide this authority. Despite the meager competences given to it in this sphere, the ECB can be said to have the powers to coordinate banking supervision among the national agencies and to provide lender-of-last-resort facilities, if necessary. In the second stage of EMU, the EMI may have to provide the necessary coordination, as a body with a large membership and an advisory—rather than executive—mandate such as the Banking Advisory Committee is not the best suited to provide authority in banking markets.

Fourth and finally, the First and Second Banking Directives and the other EC measures in the area of prudential supervision will have to keep pace with new market developments. In particular, cooperation with authorities in other fields of activity (insurance and securities) and the authorities that oversee the payments systems will need to be reinforced, now that Allfinanz groups are becoming the rule rather than the exception and the systemic risks involved in large-value payments systems are the object of justified scrutiny by central banks.

All this does not detract from the importance of the legal text of the Second Banking Directive. It remains a central and innovative banking law, albeit one that may not last unaltered for very long into the next century. Nevertheless, by then it may have contributed significantly to a reinforcement of supervisory cooperation among authorities who, ten years ago, saw their colleagues only at conferences. The Second Banking Directive may have helped the banking laws of many nations converge, not only in the West, but also in Eastern Europe, the Baltic countries, Russia, and the other countries of the former Soviet Union, and perhaps even in other continents. There is a keen interest in the European banking laws in other countries and in international organizations. Finally, the Second Banking Directive’s main contribution may be the realization, however slow and despite unwarranted red tape, of an integrated banking market in Europe.

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