Current Legal Issues Affecting Central Banks, Volume IV.
Chapter

Chapter 7 Banking Law Developments in the European Union: Deposit Insurance and Money-Laundering Initiatives

Author(s):
Robert Effros
Published Date:
April 1997
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Author(s)
PAOLO CLAROTTI

Introduction

The European Community (EC) banking legislation covers all credit institutions that receive deposits and similar repayable funds and that also grant credits, unless there is specific provision for an exemption. This fundamental principle was established in the Council’s First Banking Directive of 1977.1 The trend since that date has been to reduce the number of exempted institutions. The motivation, as put forward in the recitals to the First Banking Directive, was a mixture of prudential and competitive considerations:

… equivalent financial requirements for credit institutions will be necessary to ensure similar safeguards for savers and fair conditions of competition between comparable groups of credit institutions. . . .2

All types of credit institutions are, in principle, treated in the same way, and there is thus equality of competitive conditions in relation to prudential rules: the famous “level playing field.”

All member states have experienced, to varying degrees, the process of “despecialization,” in which some if not all providers of financial services have broadened their scope of activities and have begun to compete in new markets. Traditional areas of specialization and the demarcation of activities between groups of credit institutions have been eroded, largely as the result of market forces. The Second Banking Directive of December 19893 reflects this development by incorporating a full range of banking services in the scope of a single banking license. Such a development needs to be underpinned by the enforcement of common prudential standards for all banks. This principle is well demonstrated in the case of the Solvency Ratio Directive, under which the same risk weights and overall capital requirements apply without reference to the composition of business of the credit institution in question.4 For example, the same capital requirement applies to a mortgage credit extended by a specialized mortgage credit institution as to a mortgage credit granted by a truly universal bank or a bank that typically concentrates on trade finance.

During the course of the discussion leading up to the adoption of the Second Banking Directive, several requests were made for the development of two sets of final prudential standards, with one set applicable to those institutions operating across national boundaries, and another, unharmonized or partially harmonized set applicable to those confining their attention to purely domestic markets. It was decided that to take such a path would have been inconsistent with the basic freedom to supply services conferred by the Treaty of Rome—a freedom that is available to all—and with the aim of achieving equality of competition between institutions.5 Clearly, those credit institutions operating across the EC compete in the national markets of those engaging only in domestic business.

The EC’s banking legislation seeks to protect depositors and to safeguard the integrity of the European system. In other words, it pursues on a Community-wide scale what national supervisory authorities have been undertaking for decades. The Freedom of Capital Movements Directive6 and the Second Banking Directive are the foundations for the internal market in banking services. The framework laid down in the Second Banking Directive has been an enormous step forward for member states, which have had to change radically the process by which they have traditionally supervised such institutions. Under this framework, supervision of credit institutions has been undertaken since January 1, 1993 by the home member state; also, a bank, once established, can branch freely throughout the Community. Member states have to allow branches of banks registered in the EC to operate on their territories without any prior applications being made. To bring about such a change, it was necessary to ensure that supervisors knew that certain minimum standards were being applied by their fellow supervisors in other member states. Any credit institution established in any member state has therefore to comply with a number of conditions before it can be licensed to operate throughout the EC.

A necessary condition for achieving a single banking market was the elimination of the remaining capital controls in member states by the end of 1992. This necessary step to secure a fully integrated banking market was achieved in most countries by July 1990. However, a few countries were allowed to maintain certain restrictions until 1992, and Greece was allowed to maintain them until June 1994.

The supervisory rules are in the process of being redefined at a time of considerable change in the financial markets. Indeed, these rules are being redefined in order to prepare for major changes in the European market and to enable them to take place. For this reason, it seems especially important to draw up strong prudential guidelines. It would be wise to err on the side of caution rather than to set inadequate standards. The financial system survived the October 1987 stock market crash, but it would be wrong to be complacent. It seems equally important, at a time when the 15 national markets are about to fuse into one and money and capital markets have an international dimension stretching beyond the European time zone, that European banking legislation should be readily adaptable in the event of further changes in market structure and financial instruments.

The fact that the standards set in the EC legislation are minimum standards helps to make such adaptation easier. Member states are always free to apply tougher standards if they judge it necessary to do so. These minimum standards range from the minimum level of capital required to the fitness and suitability of directors. These standards not only comply with international standards but are also among the highest for credit institutions.

In this framework, cooperation among the respective supervisors becomes paramount. They will have a duty to consult with each other in the supervision of institutions operating across borders. More important, EC legislation has removed all barriers on banking secrecy that might prevent important information from being passed from a supervisor in one member state to a colleague in another.

Equally important, the European Commission has been working to ensure that its liberal trade philosophy, which allows financial services to be provided to the customer in a competitive environment with the greatest possible choice, is extended beyond the frontiers of the member states. This is witnessed, for example, by the Commission’s commitment to a strong financial services agreement emanating from the Uruguay Round negotiations in Geneva and by the discussions that it has had with its European Free Trade Association neighbors, which concluded with the signature of the treaty creating, from January 1, 1994, a single European Economic Area.7

The EC has succeeded in getting the 15 member states to agree on a system that is opening up markets, some of which had been relatively closed and underdeveloped, while giving adequate protection to the savers, investors, and other users or consumers of financial products. This chapter focuses on the contents of two directives approved according to the above framework: the Deposit-Guarantee Directive;8 and the Money-Laundering Directive.9

EC Directive on Deposit-Guarantee Schemes

Two essential reasons justify the setting up of deposit-guarantee schemes: first, the need to protect the depositors; and second, the need to ensure the stability of each bank and of the banking system in general. The schemes in question protect all those who are poorly informed about financial problems and, consequently, reduce the systemic risk resulting from depositors’ fears of not being able to recover their funds from a bank in crisis. These fears are the cause of runs on banks, which are extremely detrimental for all the banks that experience them. Systemic risk comes into play in this connection because, on the one hand, the interbank connections are today so close that a crisis affecting one bank is likely to involve others and, on the other hand, the well-known phenomenon of imitation can cause depositors with other banks to run to those banks even if they are not in crisis. Therefore, the guarantee schemes protect the banking system from the risk that depositors will withdraw their funds not only from banks in difficulty, but also from relatively healthy banks that could be the victim of unfounded rumors.

One of the fundamental principles involved in setting up a deposit-guarantee scheme is that the costs of such an operation, or the possible distortions caused by the existence of these systems, are more sustainable than the costs that a massive withdrawal of banking deposits would cause for the whole economy.

The 1986 Recommendation

In December 1986, the European Commission published a recommendation, almost ten years after the First Banking Directive, aiming to establish deposit-guarantee schemes. At that time, only six member states (Germany, Belgium, France, the United Kingdom, the Netherlands, and Spain) had one or more deposit-guarantee schemes.10 The 1986 recommendation invited the six member states that did not have deposit-guarantee schemes to introduce them by January 1, 1990.11 The six member states where deposit-guarantee schemes already existed were invited to check that such systems

  • guaranteed compensation for depositors who did not possess the means of properly assessing the financial policies of the institutions to which they entrusted their deposits;
  • covered the depositors of all authorized credit institutions, including the depositors of branches of credit institutions that had their head offices in other member states;
  • distinguished sufficiently clearly between intervention prior to winding-up and compensation after winding-up; and
  • clearly set out the criteria for compensation and the formalities to be completed in order to receive compensation.12

In the preamble to the recommendation, the Commission reminded the member states of the proposal for a directive concerning the coordination of the provisions on reorganizing and liquidating of credit institutions that it had forwarded to the Council earlier in 1986.13 This proposal contained “a transitional provision stipulating that, pending the entry into force [of the above recommendation] in each member state, the guarantee schemes in which credit institutions take part [have to] extend cover to deposits received by branches set up in host countries which have no guarantee scheme.”14 It was a sign of the type of solution that would later be generally applied.

However, an amendment to the proposed directive stipulated that, as soon as that recommendation had been applied in all the countries, a branch of a bank with its head office in another member state should join one of the systems existing in the host country.15 This proposal for a directive expressed the approach favored at that time, whereby each bank had to form part of the deposit-guarantee scheme of the host country. This approach was, moreover, already in force in the six countries that by 1986 had adopted deposit-guarantee schemes. Germany, however, was an important exception because the guarantee scheme set up by its commercial banks’ association covered branches situated abroad.

What was the member states’ reaction to the recommendation? For the six member states that already had deposit-guarantee schemes, their only “obligation” (legally, it was not one) was to conform to the four criteria mentioned above. In practice, all the countries did so; however, there were some difficulties. In Belgium, foreign banks’ branches were not covered automatically by the local guarantee scheme; it was considered that the guarantee scheme (if there were one) of the country where the bank had its head office had to cover that branch. However, the entity managing the guarantee fund had the option to stipulate agreements with the corresponding bodies of foreign countries, in order to organize with their cooperation possible mutual assistance in the event that a crisis befell that branch. In addition, the public banks were not covered by the guarantee fund because they enjoyed a state-provided guarantee. In Spain, too, the public banks were not covered. Neither were establishments specializing in mortgage or consumer credit.

With regard to the six countries without deposit-guarantee schemes, the situation developed as follows. While Italy and Ireland had already studied the possible implementation of deposit-guarantee schemes, it was Denmark that introduced the first scheme with the passage of a law on October 28, 1987.16 Italy followed immediately with the approval on November 4, 1987 of the Articles of Association of the Interbank Guarantee Fund (a private fund).17 In Ireland, a law on the deposit guarantee was adopted on July 12, 1989,18 and, in Luxembourg, a private interbank fund was set up on October 2, 1989.19 Greece also has a deposit-guarantee law,20 as does Portugal.21 Given that the majority of the banking system is not in the hands of the state in either Greece or Portugal, it is more convenient and practical to set up deposit-guarantee schemes by legislation, rather than through interbank agreements, as these agreements are difficult to achieve between public and private banks. (As exceptions to this general rule, interbank agreements were in fact carried out in Italy and France; in the latter country, agreement was reached before the nationalization of the core of the banking system). In Italy, while foreign bank branches can join the Interbank Guarantee Fund, none have joined as yet; there is therefore an important gap in the coverage of deposits.

The 1992 Proposed Directive

Thus, despite the 1986 recommendation, two member states had by 1992 not yet established deposit-guarantee schemes, and others had applied them only partially. Moreover, only limited progress had been achieved in the harmonization of the prudential rules. As a result, the European Commission forwarded on June 4, 1992 to the Council of Ministers a proposal for a directive to give a binding framework to deposit guarantees in the member states.22 The provisions of this proposal for a directive responded therefore to a need and took account of the experience gained in implementing the 1986 recommendation, as well as of the crises befalling some institutions with branches in several member states. In the proposal, depositors’ protection was based on the principle that deposits had to be guaranteed by the scheme in force in the member state where the bank had its registered office (home member state), even if the deposits had been made with branches in another member state.

With the completion of the internal market, all the activities that a credit institution carries out in its branches throughout the EC will be subject to the same accounting and evaluation rules, the same layout of profit and loss accounts, and the same solvency rules. According to the opinion of the Banking Advisory Committee, ignoring the “country of origin” principle in a field as closely connected with banking supervision as that of deposit-guarantee schemes would have set “a dangerous precedent for the completion of the internal market of banking services.”23 The completion of this market will therefore involve the coexistence in the same territory of several deposit-guarantee schemes. However, the experience of the member states—in which, for a number of years, different categories of credit institutions have been carrying out their activities while being covered by different guarantee schemes—proves that such a solution can work well, especially if the minimum cover fixed by the directive ensures that depositors with small savings will be equally compensated in all the member states.

The 1986 recommendation did not fix a harmonized minimum cover. In 1992, however, it appeared essential from the point of view of completing the single market that depositors should benefit from basic protection, whether they had deposited their money with a credit institution having its head office in the member state where they resided or in a branch of a credit institution established in another member state. The European Commission considered that the minimum cover fixed for the EC should not be too high, in order to avoid what had occurred in the United States, where the risks incurred by the individual depositors had been reduced so much because of the high covers that the depositors had been completely indifferent to concerns about the soundness of their banks. Moreover, in that situation, the managers of the banks had been prompted to assemble high-risk portfolios without facing the discipline of the market (that is, without having to pay high premiums with their guarantee schemes), with the result that the risk of insolvency had increased. Thus, the profits had benefited the banks, while the losses had been charged to the guarantee schemes. Conversely, the minimum cover must not be too low or exclude too large a number of deposits from the minimum protection threshold.

Because direct statistics on the size and distribution of the deposit accounts in Europe were not available, it appeared reasonable to try to fix a minimum cover based on the current levels of the guarantee schemes in the member states (see Table 1). If one excludes the two member states (Germany and Italy) in which the protection level is extremely high and those members where there has been no protection (Greece and Portugal), the median level is approximately ECU 15,000—the figure that was used in the Commission proposal of 1992.24

Table 1.Levels of Depositor Protection in Member States Having Deposit-Guarantee Schemes1
CountryAmount in ECUAmount in National Currency
Spain10,000Ptas 1.5 billion
Belgium12,500BF 500,000
Luxembourg12,500Lux F 500,000
Ireland18,000IR£ 15,000
Netherlands15,500f. 40,000
United Kingdom25,000£20,000
Denmark33,000DKr 250,000
France60,000F 400,000
Italy525,000Lit 1 billion
GermanyIn practice,

unlimited2

Based on the most recent available data, these figures give only a summary indication of the existing protection levels because the characteristics of the various systems in the member states are not comparable. In some cases, the figures given in the table represent the actually refunded maximum amounts; in others cases (Ireland, the United Kingdom, and Italy), although the figures represent the maximum amount taken into consideration in the intervention of the guarantee fund, the actually refunded amount is only a percentage of that total.

In theory, there is a limit: 30 percent of the own funds of the bank in crisis by depositor. However, if the crisis involves a large bank, the cover is practically unlimited. In the case of banks of smaller size, the limit is purely theoretical, for no saver deposits substantial amounts in these banks.

Based on the most recent available data, these figures give only a summary indication of the existing protection levels because the characteristics of the various systems in the member states are not comparable. In some cases, the figures given in the table represent the actually refunded maximum amounts; in others cases (Ireland, the United Kingdom, and Italy), although the figures represent the maximum amount taken into consideration in the intervention of the guarantee fund, the actually refunded amount is only a percentage of that total.

In theory, there is a limit: 30 percent of the own funds of the bank in crisis by depositor. However, if the crisis involves a large bank, the cover is practically unlimited. In the case of banks of smaller size, the limit is purely theoretical, for no saver deposits substantial amounts in these banks.

At the time of the elaboration of the proposed directive, the question arose as to whether it would not be preferable to fix a refunding limit in percentage terms, which would have more of a leveling effect but be less protective of the small depositors. This solution was not adopted because it would have involved important modifications of certain solidarity systems aimed at rescuing failing establishments and, therefore, would have called into question the concept of integral compensation for its depositors. The compromise solution finally adopted makes it possible to limit the guarantee to a percentage of the deposit by requiring that at least 90 percent of the deposits be covered up to the limit of ECU 15,000.25 Beyond this limit, member states or the schemes are free to refund at lower percentages or even to refuse to make guarantees.

Most of the existing guarantee schemes envisage that depositors will be refunded relatively rapidly, but, until now, this refunding has often depended on the progress made in the liquidation procedures and the diligence of the liquidators named by the courts. This process, which involves deadlines, has caused understandable disarray among depositors. It also is a source of numerous disputes, which can slow down the refunding. The proposed directive envisaged a starting point for refunding that was unconnected with the insolvency procedures.26 It was considered that, if the deposit were unavailable for more than ten consecutive days, it should be possible to begin payment of the guarantee, which should be completed within three months, except in certain circumstances.27 The decision to set the deadline at three months resulted from the practical experience of the guarantee scheme managers. It was further envisaged that, if this three-month period could not be respected, the evaluation of the deposits under the guarantee scheme could follow the same legal procedure used for liquidations, which covered inheritance problems and necessarily took more time.

In this connection, as touched on previously in the chapter, it should be emphasized that depositors must be informed of the extent of the protection of their deposits. Complete information is also important to reduce the systemic risk; indeed, the more depositors are aware of a risk, the more attentively they will make inquiries about the sound management of the institutions to which they entrust their deposits and the less sensitive they will be to unjustified rumors.

Several points were not included in the proposed provisions. First, regarding the legal status of the guarantee schemes, in the EC, and even within the member states, private deposit protection systems coexist with systems regulated on a legislative basis. Most private systems fall under the responsibility of professional entities, and they are just as sound as the schemes managed by, or with the assistance of, the public authorities. Therefore, it was considered convenient not to modify this state of affairs by compelling the member states and the credit institutions to be subject to a guarantee scheme based on a harmonized statute. Second, there are also major differences with respect to the financing mechanism. If a guarantee fund exists, the credit institutions periodically pay contributions to the fund according to the value of their deposits or some other yardstick; these funds are managed by the guarantee schemes themselves. If no fund exists, the financing of the guarantee scheme is ensured by commitments to pay on the part of the member credit institutions, which are then paid to the scheme only if a bank defaults. Finally, some financing systems are mixed, that is, there are permanent funds to which may be added exceptional contributions in the event of a bank crisis. The Commission, having been convinced that the various financing mechanisms were sufficiently sound to compensate all the depositors covered, including those with branches located in other member states, considered that it was not useful to harmonize rules that were closely connected with the management of the schemes in question.

The European Commission, however, considered it advisable to harmonize at least partially the scope of the directive with regard to the deposits benefiting from the guarantee and the credit institutions covered by it. In the first area, some deposits were excluded from the guarantee—interbank deposits, for instance. This exclusion is justified by the assumption that banks are supposed to recognize better than other entities the symptoms of a troubled bank. Subordinated debts were also excluded by contract from the guarantee so as not to have priority over any other creditor of an ailing institution. Moreover, member states can permit certain depositors or certain categories of deposits mentioned in an annex to the directive to be excluded from the guarantee.28 These exclusions concern mainly the deposits of other financial institutions, insurance companies, the government, and the local authorities. However, the number of institutions and persons involved is large, and the assessment of the necessity of their exclusion can vary from one member state to another, making it impossible to achieve a more complete harmonization in this area. The situation of these institutions and depositors largely depends on the amount of the guarantee granted by the system and on national traditions. Thus, several systems cover bearer deposits under certain conditions because most of the smaller savers have recourse to them, whereas some other countries prefer to exclude them. The list appearing in the annex to the directive is restrictive, and the member states will not be able to exclude from the guarantee institutions and persons not mentioned there, as any further exclusion would be against the directive.

Concerning the credit institutions covered, two fundamental principles were expressed in the proposed directive. The first principle is that membership of all the authorized credit institutions in a deposit-guarantee scheme should be mandatory.29 The introduction of at least one deposit-guarantee scheme in each European member state had already been recommended by the European Commission in 1986. The 1992 directive not only renewed this requirement (which had not been satisfied in two member states) but made compulsory the membership of any authorized bank. The second principle is that die home country of an institution is responsible for the guarantee scheme for branches established in other countries.30 This principle was supplemented by a provision intended to allow the depositors of branches located in other countries to benefit from the advantages of the host country’s guarantee scheme by giving them the option of joining that scheme.31 This is not, strictly speaking, an exemption from the principle of the responsibility of the home country system, which must guarantee the depositors of the branches up to the amount offered to the depositors of the institution’s head office, but it is to some extent a complementary guarantee, which can be obtained whenever the managers of the branches deem it useful—from a competitiveness viewpoint—to make their customers beneficiaries of the host country scheme.

In conclusion, the directive was intended to ensure a minimum protection of depositors, based on the principle of “home country control.” However, it did not forbid member states from envisaging a broader coverage than the minimum provided. Moreover, the proposed directive allowed branches abroad to join the deposit-guarantee scheme of the host country if it were more favorable to the depositor than the scheme of the home country.

Adoption of the Proposed Directive

The three competent bodies—the Economic and Social Committee, the European Parliament, and the Council of Ministers—examined the proposed directive on deposit-guarantee schemes. The Economic and Social Committee delivered its opinion on October 22, 1992. The European Parliament delivered its opinion at its session of March 10, 1993. Following these opinions, the European Commission forwarded to the Council of Ministers on June 7, 1993 an amended proposal containing two important modifications of the original proposal. First, it was proposed that the minimum cover level should be raised to ECU 20,000, to take account of the reduction in the value of the ECU following the crisis in the exchange rates of the Community currencies.32 Second, it was proposed that the solidarity systems existing in certain member states, in particular with regard to the credit cooperatives and the savings banks, should be treated as deposit-guarantee schemes.33 Therefore, there would no longer be an obligation to create deposit-guarantee schemes for an institution whose depositors were already indirectly protected by solidarity systems.

Following the amended proposal, the discussions within the Council accelerated; on October 25, 1993, agreement on a common position was reached. In this common position, the two modifications mentioned above were adopted. The initial text of the Commission was also amended on other important points. One point relates to the verification of the unavailability of the deposit (the starting date of the compensation procedure) through a court order or an act of the supervisory authority. In addition, the three-month period within which the guarantee has to be paid was modified. Additional such periods could be permitted, as dictated by exceptional circumstances.34

The Council of Ministers also introduced, for a transition period through the end of the century, a clause of “nonexport,” which suspends the application of the rule whereby the depositors of branches in states other than that of the head office are compensated up to the amount planned for the depositors in the state of the head office when the latter amount is higher than that paid by the guarantee scheme of the host country.35 During the transition period, the depositor will receive the amount of the guarantee in force in the host country.36 This provision aims to avoid distortions affecting competition in the host country due to the difference between the two amounts. The decision to set a transition period is intended to allow banks with their head offices in other countries to explain to their customers the reasons for this difference and to reassure them on the probabilities of a bank failure. In the long run, any competitive aspect related to the different amounts of the guarantee granted by the respective systems should be removed; nevertheless, whatever the reasons that led the Council to amend the text proposed by the Commission, it is difficult to conclude other than that the solutions selected worsened the situation of depositors in the short term.

The European Parliament’s second reading took place on March 9, 1994. Amendments restoring depositors’ rights and certain other criticisms were considered. In view of the entry into force of the codecision procedure provided for in the Treaty on European Union, a conciliation procedure was set in motion.37 The conciliation committee met on April 12, 1994, and complete agreement was reached between the Parliament and the Council. Among the amendments of the Parliament that the Council accepted were the obligation for the supervisory (or legal) authorities to check the unavailability of the deposits within 21 days, the obligation for the guarantee scheme to compensate depositors at the latest a year after the verification in question, the obligation for the Commission to review the minimum amount of the guarantee every five years, and the addition of a right of recourse to the guarantee scheme for the depositors. The Deposit-Guarantee Directive was adopted on May 30, 1994.38

EC Directive on Money Laundering

Background

The process of financial globalization will benefit individuals’ undertakings and enhance legitimate business, but it will also open enormous opportunities for criminals to place and move the proceeds of their criminal activities, to disguise the source of the money, and to invest it profitably. This is the phenomenon of “money laundering.” The international nature of money laundering can be considered as having three different aspects: first, the proceeds to be laundered mainly come from internationally organized crime, such as drug trafficking; second, the laundering procedure usually involves the transit of money across international borders; and third, the practice is difficult to combat exclusively at the national level.

How was the EC prepared to face this important challenge of money laundering before the first proposal for an EC Directive had been made? In 1990, the laundering of drug money did not constitute a crime in any member state other than the United Kingdom.39 Only in some cases could the first stage of the laundering process constitute a crime, namely, if the person receiving the proceeds had obtained an advantage from the crime similar to the offense of “handling stolen goods.” Money laundering was not even considered as an administrative infraction punishable under banking legislation. With the exception of the United Kingdom, financial institutions in the EC were allowed to close their eyes to money-laundering operations. If the law enforcement authorities required some information, owing, for instance, to a related investigation, the financial institutions might refuse to cooperate by invoking bank secrecy. These institutions were in no way obliged to report suspicious transactions to the competent authorities. The simple denunciation of a suspected transaction was even prohibited in many EC countries. In brief, the reality of money laundering was practically ignored by nearly all member states’ legislation.

In December 1988, two significant steps were taken at the international level to combat money laundering. First, the United Nations Convention Against Illicit Traffic in Narcotic Drugs and Psychotropic Substances (the Vienna Convention) required the criminalization of money laundering as an essential element in the strategy to fight drug trafficking.40 Second, the Basle Statement of Principles, which properly underlined how money laundering constitutes a clear violation of good banking practices, drew attention to the need to adopt appropriate measures to prevent the use of the financial system for these purposes.41

The European Commission was aware of the danger that money laundering represented to the soundness and stability of the European financial system. It had already started preparatory work by sending a questionnaire to the member states in June 1987. A working party was convened on this subject in October 1988. The Basle Statement of Principles in 1988 and the creation of the Financial Action Task Force (FATF) in the autumn of 1989 gave a decisive thrust to the international movement against money laundering.42 Following a first draft of measures prepared in October 1989, the European Commission presented to the Council of Ministers a proposal for a directive on money laundering in March 1990, which, after discussion by the European Parliament, was finally adopted in June 1991.43

Objectives and Specific Provisions of the Directive

This directive has three main objectives. The first objective is to prevent criminals from taking advantage of the single internal market to carry out laundering operations that could jeopardize the soundness, stability, and integrity of the EC financial system. The second objective is to prevent member states from adopting restrictive measures inconsistent with the single market for the purposes of fighting money laundering. The third objective is to contribute, within the limits of its competence, to opposing organized crime in general and drug trafficking in particular. In this context, the directive on money laundering constitutes a major element of the European plan to combat drugs adopted by the Community and the member states in December 1990.44

The directive is not a set of political guidelines but a binding legal instrument that obliges the member states to implement it in their national legislation before a specific deadline (in this case, January 1, 1993).45 No other international instrument affecting money laundering is immediately binding on the member states. Another important feature of the directive is its universal coverage of the financial system. Banks, saving institutions, building societies, life insurance companies, securities firms, leasing companies, credit card issuers, and money changers, among others, are covered. No financial operator falls outside the scope of the directive.46 Moreover, a specific provision obliges the directive to be applied to nonfinancial categories of professions and undertakings that could also be used for money laundering.47 As it was not considered appropriate to make an exhaustive list in the directive of these professions and undertakings, a contact committee was assigned to examine, inter alia, whether a specific category should be included in the scope of the directive when its use for money laundering had been established in one or more of the member states.48

In defining money laundering, the directive includes as mandated the laundering of proceeds from drug-related offenses, along the lines of the Vienna Convention of 1988. However, the directive underlines that the phenomenon of money laundering is not confined to the field of drugs, and it provides a legal framework so that member states may extend the scope of the directive to cover other serious crimes.49 As a matter of fact, most member states are implementing the directive so as to include the laundering not only of drug money but also of proceeds from other serious crimes. Legislation already existing in the United Kingdom, for example, covers drug offenses and terrorism. This line of not limiting money laundering to the field of drugs has also been followed by other international instruments, including the Basle Statement of Principles, the Council of Europe Convention on Laundering, Search, Seizure and Confiscation of the Proceeds from Crime (recently ratified by a majority of member states), and the FATF recommendations.50

The money launderers’ business will become difficult in the Community, as money laundering will be prohibited and duly punished in all the member states. Traces of financial transactions will be preserved. The practice of bank secrecy will be lifted to permit investigations in this field. Active cooperation between financial institutions and law enforcement authorities will be ensured by a system for reporting suspicious transactions.

The rule “know your customer” implies not only that anonymous accounts or passbooks or anonymous safe custody facilities will not be allowed in the EC but also that occasional customers carrying out single transactions amounting to ECU 15,000 or more must be identified.51 Identification of beneficial owners will be required whenever customers do not appear to be acting on their own behalf.52

The principle of “traces must remain” is also of great importance in facilitating money-laundering investigations. The directive provides that financial institutions must keep a copy or references of the customer’s identification document, as well as supporting evidence and records of all transactions.53 In this way, it will be possible to rebuild the transactions a posteriori and to retrace the path of criminal proceeds.

The principle of “due diligence” means that financial institutions will no longer be allowed to close their eyes when dealing with unusual transactions whose lawful purpose is unclear.54 As such transactions are likely to be used for money laundering, banks must be diligent and examine them with special attention to fulfill their other obligations under the directive. This provision is linked to the financial institutions’ obligation to set up appropriate internal control procedures.55 Moreover, one of the recitals of the directive recalls the need to apply this principle of due diligence in the particular case of transactions carried out with third countries that do not have equivalent standards in this field.56

Preventing the invocation of bank secrecy in money-laundering investigations is another essential rule.57 It is not that bank secrecy is questioned in itself; clearly, the relationship between banks and their customers is founded on confidence, and an unjustified disclosure of information to third parties constitutes a breach of the banks’ contractual obligations. However, when the essential values of the society are in jeopardy, as in cases of criminal law, the general good must prevail, and the veil of bank secrecy must be lifted. This principle is accepted in many countries throughout the world and is also included in the Vienna Convention. The criminalization of money laundering is a precondition for the proper application of this principle.58

Lifting the practice of bank secrecy when the penal authorities request information in the context of a legal proceeding—which is not contested in most countries and is usually considered sufficient to combat crime in general—is not enough to combat money laundering. First, judges and policemen are removed from day-to-day financial operations and often lack the necessary expertise. Indeed, if only the information requested by these authorities were supplied, most money-laundering operations would go unpunished. Second, the traditional legal means do not suffice in themselves to win the battle against this new kind of criminality, which is characterized by an extraordinary flood of criminal proceeds (mainly coming from drug trafficking) and the use of sophisticated international financial techniques to disguise the origin of the funds. A specific provision has thus been included in the directive, according to which financial institutions are obliged to report any suspicious transactions to the law enforcement authorities.59 As a matter of fact, ensuring the transmission of information to the competent authorities is the most effective way to maintain the integrity of the financial system, as well as to provide these authorities with the necessary material to succeed in the battle against money laundering.

This important bank secrecy provision of the directive has been inspired by British law. In other EC countries, the implementation of this clause requires not only adoption of new legislation but also modification of important traditional legal principles. However, all the member states have agreed that implementing a system of mandatory reporting is more efficient, less expensive, and less cumbersome than adopting the kind of routine reporting system used in certain third countries. Simply giving financial institutions the discretion to report could have been misinterpreted in some member states, in that the option of informing the authorities about a suspected transaction might be a matter of free election without legal sanction.

Nevertheless, cooperation between financial institutions and law enforcement authorities should be carried out without disregarding in any way the essential principles of law that safeguard the rights of customers and financial institutions. These principles have been fully respected in the directive. The general rules in the member states’ legislation on presumption of innocence and burden of proof are not affected; financial institutions and their employees are exempted from responsibility of any kind when they report in good faith suspicious transactions to competent authorities; the authorities receiving the information must be the competent authorities for combating money laundering;finally, the information received by the authorities should be used only for money-laundering investigations unless the member states’ national legislation provides otherwise.

Why does the directive not provide a definition of “suspicious transactions” in order to facilitate implementation? Any definition or list of suspicious transactions would necessarily be incomplete, as it is not possible to reflect in a directive or in a text of primary legislation the specific criteria covering the numerous modalities of money-laundering transactions that have currently been identified or that could be invented by criminals in the future. Member states shall establish, however, the guidelines needed for identifying patterns of money-laundering transactions in order to help the financial institutions carry out their reporting obligations. This step was taken by the Bank of England some years ago when it published guidance notes for banks and other financial institutions.60 However, these guidelines, which should be flexible and easily adaptable to changing reality, should remain confidential and unavailable to the financial institutions’ employees not directly responsible for reporting, as well as to customers and other third parties. In preparing these guidelines, the exchange of information on money-laundering methods and transactions patterns carried out in the framework of the FATF will be extremely useful. In the EC, the contact committee created by the directive will also be a helpful forum for coordinating criteria on this matter and other practical problems.61

In discussing the directive, two other important provisions are worth mentioning. First, financial institutions must establish adequate internal control procedures to detect and prevent money-laundering operations. Second, these institutions must ensure their relevant employees’ participation in special training programs on this matter.62 The specific way in which such control procedures and training programs should be organized is not detailed in the directive, but it is clear that the member states shall be obliged to take the measures needed to ensure the fulfillment of these obligations by financial institutions.

When duly implemented by the member states, the directive will constitute an effective mechanism to prevent money laundering in the EC financial system. The FATF’s core recommendations are contained in it.63 The directive will not produce integral harmonization of the member states’ legislation in this field; however, the purpose of the directive is not to create a uniform mechanism in Europe to prevent money laundering, but to ensure that the national standards in this field are appropriately high and converging at the appropriate rate. For instance, the kind of sanctions to be applied against infringements on the obligations provided for in the directive, as well as the authorities responsible for controlling the implementation of such obligations, will be decided by the member states according to the peculiarities of their legal systems. This diversity, which is inherent in the EC, should not affect the efficiency of the mechanism for preventing money laundering in Europe, provided that the directive is duly implemented in the member states and that the national systems work properly.

Nevertheless, much work needs to be done to ensure proper implementation of the directive. Most member states have already adopted the necessary legislation, and the European Commission must make every effort to confirm that such legislation is consistent with the directive.

The Money-Laundering Directive is based on a financial approach implemented according to the EC competence and does not include all the measures that could be used to combat money laundering. The machinery provided for in the directive fulfills its specific function either by preventing the carrying out of money-laundering operations or by making available to the competent authorities the information that they need to proceed with their investigations. The machinery needs to be complemented with other measures to ensure that criminal assets will be frozen, seized, and confiscated wherever they are located in the EC; that evidence may be used in the different jurisdictions; and that money launderers are duly punished regardless of where they are discovered. Achieving these goals requires improved systems of police and judicial cooperation, which cannot be accomplished by the directive, owing to its financial approach and the EC competence. For instance, the FATF recommendations on international cooperation, judicial assistance, and the freezing, seizure, and confiscation of criminal proceeds should also be followed by the member states.64 The ratification and implementation of the Vienna and the Council of Europe Conventions, as provided for in the member states’ statement annexed to the directive, are of paramount importance to this end.65

An aspect that should contribute to enhancing the effectiveness of the EC mechanism is the application of equivalent money-laundering standards in as many countries as possible in the world and the enhancement of international cooperation in this field. Otherwise, although criminal proceeds would be deflected from the EC in a first stage, they would ultimately enter into its financial system in a second stage, after being “prelaundered” outside.

As previously mentioned, six of the seven European Free Trade Association (EFTA) countries and the EC have signed the Agreement on the European Economic Area.66 This led to the creation of a “Great Market” of 18 countries on January 1, 1994. The Agreement involves the acceptance by these EFTA countries of a great part of EC legislation, including the directive on money laundering, which should be implemented into their national law. Therefore, the European Economic Area will be provided with high, harmonized standards to combat money laundering. From January 1, 1995, three of these countries (Austria, Finland, and Sweden) are members of the EC, now called the European Union.

With respect to the neighboring countries in Central and Eastern Europe, even if money laundering is only now emerging there, adoption of preventive measures in this field would impede organized crime from taking root and extending its influence in their territories. Six countries that have signed Association Agreements with the Community—Hungary, Poland, the Czech Republic, the Slovak Republic, Romania, and Bulgaria—have agreed to include specific clauses under which the parties will make every effort to cooperate in order to prevent money laundering and to establish standards equivalent to those contained in the Money-Laundering Directive and in the FATF recommendations. A pilot cooperation program on drugs, including money laundering, has been set up with these six countries. Furthermore, the European Commission has started negotiating “partnership and cooperation agreements” with the Baltic countries, Russia, and the other countries of the former Soviet Union, which would also cover the field of money laundering. All these provisions will constitute an appropriate framework for cooperation and assistance in this field over the next several years. The FATF will play an important role in coordinating and avoiding overlapping with other countries and international organizations involved in cooperation in this region.67

COMMENT

SYDNEY J. KEY

The European Community’s Approach of Mutual Recognition and Home Country Control and the Deposit-Guarantee Directive

In creating the internal market in the banking sector, the challenge facing the European Community (EC) was to establish a regulatory and supervisory framework that would promote a competitive and efficient Community-wide market for banking services and also would satisfy other public policy concerns, such as ensuring the safety and soundness of banks and the stability of the financial system and providing adequate protection for consumers of banking services. To establish such a framework, the Community had to choose rules to govern trade in banking services among the member states.

The principle of national treatment, which involves application of host country rules without discriminating between domestic and foreign banks, might have seemed the obvious choice.1 National treatment is a generally accepted principle for trade in financial services and is used in the General Agreement on Trade in Services (GATS) and in commitments made in the Organization for Economic Cooperation and Development (OECD).2 If the EC had used national treatment to govern trade in financial services among its member states, foreign and domestic banks would have received equivalent treatment within each member state. However, barriers created by nondiscriminatory differences in national rules would have remained-for example, differences in permissible activities for banks or differences in the types of products that may be offered.

To remove such nondiscriminatory barriers, it was necessary for the Community to go beyond the principle of national treatment. One possible approach, the complete harmonization of national rules, was eliminated because the Community had a history of unsuccessful attempts at complete harmonization in the product sector. Another possibility was to use home country rules. However, without any harmonization, this approach would not have been acceptable to host countries. The Community turned instead to the approach of “mutual recognition.”3

Mutual recognition involves two elements: first, harmonization of essential rules; and second, where harmonization has not occurred or has occurred only in very general terms, acceptance by host countries of home country rules. Thus, under the Second Banking Directive, a bank established in any member state may, subject to the minimum requirements set forth in EC legislation, provide services across borders or operate branches throughout the Community under home country rules and supervision.4

The Second Banking Directive sets forth a list of permissible activities (which includes all forms of securities activities but not insurance activities), and a host country is required to permit a branch of a bank from any other member state to engage in any activity on the list that is permitted by the home country.5 For example, an Athens branch of a German bank is governed by German rules for permissible activities, subject to the EC list, rather than by the Greek rules, even if the Greek rules would have been more restrictive.

Within the Community, such reverse discrimination favoring banks from other member states is essentially a strategy to produce additional harmonization and is predicated on political agreement on goals for convergence of national regulatory systems. Such agreement involves a crucial element: a consensus on where to draw the line between liberalization and laxity-that is, a distinction between national rules that have primarily the effect of imposing barriers to trade in services and national rules that are necessary for prudential purposes or for consumer protection.

Once the rules that will be used for trade in banking services have been agreed to, a separate but related question is, Who administers the rules-the home country, the host country, or a supranational entity?6 This is an important question because the harmonization of capital standards, for example, does not guarantee the quality of supervision. The Community is using home country control, which means that the home country supervisors are responsible for administering the rules.7

The shift to home country supervision and regulation of branches of banks within the Community is quite dramatic, especially in comparison with developments outside the Community. For example, in the United States, the Foreign Bank Supervision Enhancement Act strengthened the host country statutory framework that federal regulators must apply in dealing with the entry and operation of branches of foreign banks.8 Similarly, the Basle guidelines on minimum supervisory standards for international banking emphasize the responsibility of host country authorities, as well as those of the home country.9 For example, the consent of a host country is required to open a branch of a nonindigenous bank.10

The European Community has been able to rely on home country rules and supervision because its harmonizing measures are different from what has been achieved beyond the Community in two significant respects. First, the measures are legally binding as part of the body of supranational EC law, as opposed to informal agreements among, for example, bank supervisors of the major industrial countries. Second, the harmonization within the Community is much broader than the harmonization that has been achieved beyond its borders, where the major negotiated harmonization of rules involves the Basle Accord on risk-based capital standards, now expanded to include market risk.11 Besides capital standards, EC banking legislation also deals with matters such as bank ownership of nonfinancial institutions, bank accounting standards, major shareholders and changes in share ownership, large exposures, consolidated supervision, deposit insurance, and, in future perhaps, bankruptcy rules. (A long-standing European Commission proposal with regard to bankruptcy rules for financial institutions has recently been reactivated.) Moveover, harmonizing measures in other areas, such as competition policy and company law, also affect the banking sector.

The Deposit-Guarantee Directive is particularly interesting because it is a hybrid of the home country and host country approaches.12 It is structured as a home country directive: depositors at branches of a bank from another member state must be covered by the home country deposit protection scheme.13 Under a complete home country approach, this provision would imply that the home country scheme would determine the level and scope of coverage within the bounds set by Community-wide harmonization. It would also imply that the home country scheme would assume financial responsibility for any payout.

However, the member states were unable to agree on sufficient harmonization of coverage for the complete home country approach to be acceptable. They were able to agree on only a relatively low Community-wide minimum level of coverage, together with a limitation on risk sharing by depositors at low levels of coverage.14 The member states could not agree on a maximum level of coverage or a requirement for risk sharing by depositors at high levels of coverage.

As a result, the Deposit-Guarantee Directive provides a significant role for the host country with respect to both coverage and financing. In effect, host country rules determine the minimum coverage and also-until the end of a transitional period-the maximum coverage that may be offered to depositors at branches of banks from other member states. The host country scheme also assumes financial responsibility to the extent that host country coverage is higher than home country coverage. As a result of Germany’s objections to these provisions (and also to mandatory membership in a deposit protection scheme), the Council’s common position on the Deposit-Guarantee Directive was adopted by a qualified majority, without German support.

The exception to the home country approach that deals with minimum coverage and financing is known as the “topping-up” provision. Under this provision, a host country scheme must offer each branch of a bank from a member state where coverage is lower the option of topping up its coverage to the host country level.15 For example, the German scheme, which has the highest level of coverage in the Community, must offer German branches of banks from other member states the option of topping up coverage to the German level. A branch would, however, not be required to accept.

The main benefit of topping up is that it contributes to greater uniformity of coverage within a host member state. However, because topping up occurs at the option of the branch, it appears to be designed to reduce competitive distortions rather than to increase consumer protection. Moreover, topping up removes only one source of pressure to increase coverage, namely, competition between low-coverage branches and high-coverage domestic banks. Pressures to increase coverage could still arise because low-coverage domestic banks would be competing with high-coverage branches within a host country.

Topping up reintroduces some of the disadvantages of host country deposit insurance for branches, although in a milder form. Member states preferred a home country approach to deposit insurance primarily because of the shift to home country regulation and supervision of EC branches mandated by the Second Banking Directive. Several member states were particularly concerned about the financial exposure of a host country deposit protection scheme to the risk of inadequate home country regulation and supervision. To the extent that it exposes the host country scheme to this risk, topping up poses a similar problem.

Moreover, topping up could be complicated to administer and confusing for depositors. The directive provides for the establishment of objective, generally applied conditions relating to the membership of low-coverage branches in host country schemes, and an annex sets forth guiding principles for the home country and host country schemes.16 However, there are likely to be significant practical problems. Issues that could be particularly complicated involve deposits at multiple offices, coinsurance and the scope of coverage, netting deposits and loans, and the implementation of payouts involving more than one scheme.

The exception to the home country approach that deals with maximum coverage during a transitional period is known as the “no export” principle. Under this provision, coverage for depositors at a host country branch of a bank from another member state is limited to the maximum coverage available under the host country scheme until the end of 1999.17 Thus, during the transitional period, high-coverage home countries must apply host country rules to determine maximum coverage for EC branches of home country banks. The primary motivation for this provision appears to have been concern by low-coverage banks about their ability to compete with high-coverage branches located in the same market in the absence of a Community-wide limitation on coverage.

In August 1994, the German Government filed a complaint with the Court of Justice of the European Communities, contending that the no export provision violates the EC Treaty.18 This dispute emphasizes the need for an EC directive to establish the maximum level and scope of coverage. However, a Community-wide limitation on coverage was considered politically impossible, primarily because of Germany’s strong opposition.

The German complaint also challenges the topping-up provision.19 Some experts who had previously questioned the no export principle nonetheless suggested that topping up did not present the same legal difficulties because topping up occurs at the discretion of each branch. However, if the branch exercises the topping-up option, the host country is required to provide insurance coverage, even though the home country has responsibility for regulating and supervising the branch. This situation highlights the importance, as well as the difficulty, of achieving sufficient Community-wide harmonization of coverage to make the use of home country rules acceptable to the member states.

The approach of mutual recognition was used in other EC directives to achieve convergence of national regulatory systems. As previously discussed, although the Community did not require member states to allow banks to engage in activities listed in the Second Banking Directive, it created a situation in which market forces would be likely to lead to regulatory convergence with regard to the listed activities. For deposit insurance, however, it does not seem desirable to use the market behavior of bank customers to pressure national governments for the convergence of rules that have not been completely harmonized. There was a consensus within the Community regarding the activities on the list of the Second Banking Directive. In effect, the list was an explicitly agreed-upon goal for convergence. However, no such consensus exists for raising the levels of deposit insurance above the relatively low minimum level imposed by the Deposit-Guarantee Directive or that doing so would be worth introducing more distortions into the marketplace.

Limiting coverage by setting a Community-wide maximum level of coverage or by requiring depositor coinsurance above the Community-wide minimum level of coverage would reduce moral hazard and the magnitude of potential competitive distortions. These steps would not, however, address the underlying issues of pricing and subsidization in deposit protection schemes, which the Community did not attempt to deal with through the directive.

It remains to be seen how the Deposit-Guarantee Directive will work in practice. Any deposit protection scheme must address the problem of balancing conflicting policy goals. The goals of protecting depositors and reducing systemic risk argue for relatively comprehensive levels of coverage. The problem is that, in furthering these goals, deposit protection schemes may encourage banks to take excessive risks-the problem of moral hazard-and thereby tend, perversely, to undermine the safety and soundness of banks. Subsidies in deposit protection schemes may also introduce distortions into financial markets. Thus, the goals of reducing moral hazard and avoiding competitive distortions argue for a minimalist approach to deposit insurance.

Striking a balance between competing public policy concerns was particularly difficult for the EC because doing so involved trying to reach agreement among member states with deposit protection schemes that differed significantly. The Community had little choice but to adopt a home country deposit protection directive because, in light of the shift of authorization and supervision of EC branches from the host to the home country, the previous arrangements for deposit insurance were no longer acceptable to the member states. However, because of the absence of political agreement on sufficient harmonization for a complete home country approach, the Deposit-Guarantee Directive ended up as a hybrid. Experience will show whether adopting the topping-up provision and imposing a transitional host country limitation on coverage are adequate substitutes for the more extensive harmonization that would have been required to have a complete home country approach.

Finally, it is important to keep in mind that deposit insurance is only one element of the safety net. As a result, even if there were much greater harmonization of deposit protection schemes among the member states, differences in the overall protection that countries offer depositors would still exist. The reason is variations in other features of the safety net: “too-big-to-fail” policies; government ownership of banks, with its implicit guarantee; and potential government support for publicly or privately administered deposit protection schemes in times of crisis. In practice, differences in these other elements of the safety net could be more important than differences in deposit protection schemes per se. Of course, for all banks, the first line of defense in protecting consumers and reducing systemic risk is prudential supervision and regulation, including strong capital standards. Deposit protection and other elements of the safety net come into play only after measures designed to deal with safety and soundness have failed.

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