A trend toward liberalization remained evident during 1987–88 in the major financial markets of the world. Aspects of the trend included further policy initiatives to eliminate controls on capital movements, to loosen restrictions on market access, and to lower barriers separating banking and securities markets. Continuing liberalization has, however, increasingly been accompanied by official scrutiny of its implications for the safety and stability of financial markets especially since the stock market break of October 1987. Policy reverberations specific to the October events are examined in detail in Chapter V. This chapter discusses a broader range of regulatory and supervisory developments during the period under review, both at the international and national levels. Its international focus is particularly on three significant developments—deepening geographic integration of financial markets, multilateral agreement on minimum capital adequacy standards for banks, and an acceleration of movement toward multilateral supervisory coordination on securities market issues

A trend toward liberalization remained evident during 1987–88 in the major financial markets of the world. Aspects of the trend included further policy initiatives to eliminate controls on capital movements, to loosen restrictions on market access, and to lower barriers separating banking and securities markets. Continuing liberalization has, however, increasingly been accompanied by official scrutiny of its implications for the safety and stability of financial markets especially since the stock market break of October 1987. Policy reverberations specific to the October events are examined in detail in Chapter V. This chapter discusses a broader range of regulatory and supervisory developments during the period under review, both at the international and national levels. Its international focus is particularly on three significant developments—deepening geographic integration of financial markets, multilateral agreement on minimum capital adequacy standards for banks, and an acceleration of movement toward multilateral supervisory coordination on securities market issues

Changing Regulatory and Supervisory Environments in Selected National Markets

The United Kingdom and France provide prominent examples of countries introducing major reforms of their financial regulatory and supervisory structures during the past two years. In the United Kingdom, the Financial Services Act of November 1986 provided a comprehensive statutory framework for the regulation of the securities and investment business. Power to authorize and regulate investment firms was given in May of 1987 to the newly created Securities and Investment Board (SIB), which could either regulate firms directly or delegate supervisory authority to one of several self-regulatory organizations (SROs). Complementing these measures, in July the SIB established a set of regulations for the retail market, and the Finance Houses Association issued codes of conduct governing the lending practices of its members (accounting for over 80 percent of installment credit extended by U.K. finance companies). Also in July 1987, the Bank of England established a new regulatory regime for the wholesale financial market, including the sterling, foreign exchange, and bullion markets. Moreover, in October 1987 a new Banking Act came into force, giving the Bank of England formal supervisory powers over commercial banks. This gave statutory authority to the Bank not only to protect depositors, but also to ensure systemic stability in the banking sector. In October 1988, the Government launched a new money market with the first issue of short-term treasury bills denominated in European currency units (ECU). Six-month ECU-bill offerings have been planned between October 1988 and March 1989 in order to build the market to as much as ECU 2 billion initially.

Additional new reforms in the United Kingdom were undertaken in 1987–88 to complement the “Big Bang” of October 1986. In particular, in January 1987 shares of new or small companies were able to start trading through the creation of the London Stock Exchange’s Third Market. In July 1987, the Bank of England allowed gilt-edged market makers and other financial institutions to write warrants on certain government stocks; also in July, London Clear Ltd. was created in order to provide a system of central depository, clearing, and settlement for the London money market. In addition, debt and equity issues denominated in sterling were freed from the requirement that they be lead-managed by a U.K. firm. At the end of 1987, building societies were permitted to sell unit trusts and offer credit cards, and in February 1988, they were allowed to take minority stakes in life and general insurance companies and to compete in sectors such as fund management, banking, and financial services.

In France, in June 1987 the Government proposed the creation of a stock exchange council in charge of market regulation and surveillance and a specialized financial institution in charge of administering the exchange’s common services. This proposal was implemented in January 1988 and the Council of Stock Exchanges was created. The main role of the Council is to set general regulations concerning the activities of stock companies, to approve entry of new securities houses as well as to take action against infractions of laws or regulations applicable to stock companies. The creation of the Council was part of a general stock exchange reform bill aiming to eliminate the monopoly of stockbrokers by 1992. In July 1987 the Banking Regulatory Commission tightened the rules governing risk exposures and reinforced surveillance of changes in banks’ stakes in other companies, and in January 1988 it obliged banks to make loss provisions on their bond portfolios. In September 1987 the Futures Market Council increased the sanction powers of its financial instruments committee.

In March 1987, the French Stock Exchange Commission abolished the requirement for firms based in the EC to seek approval from the French Government to obtain listings, and in September 1987, French subsidiaries of foreign banks were allowed to lead-manage French franc bond issues instead of having to co-lead with French banks. Moreover, to encourage investment abroad, French firms expanding their existing stake in a subsidiary in an EC country were granted in December 1987 a loss allowance for up to five years. As part of the stock exchange reform initiated at the beginning of 1988, domestic and foreign firms were allowed to take stakes of up to 30 percent in French stockbroking firms which, in turn, were also allowed to expand the scope of their financial activities. In order to ease the functioning of the futures market, the French Government proposed in May 1987 to adopt a tax structure similar to other countries and to allow savings institutions to grant loans to the non-personal sector, and in late 1987, brokers working only in the commodities futures market were allowed also to trade in financial instruments. Another group of important financial liberalization measures were oriented toward the privatization of several financial institutions. In particular, the control of the “Caisse Nationale de Credit Agricole” was returned from the state to regional member banks. Finally, in December 1988, the French Parliament passed legislation which, among other things, continues the process of domestic financial liberalization by allowing bank mortgage and other loans to be “securitized” through newly created mutual funds.

The 1987–88 period also witnessed important regulatory developments in other countries. In Japan, regulations discouraging the emergence of a domestic commercial paper market were abolished in March 1987. In particular, both banks and securities houses were allowed to underwrite and sell yen commercial paper and to treat commercial paper as commercial bills rather than as securities. In January 1988 the Government also allowed some nonresident companies to issue yen commercial paper, foreign firms were permitted to issue Euro-yen commercial paper, and domestic and foreign security houses were allowed to underwrite and trade in Euro-yen commercial paper. To improve access to trading of government bonds, the Government abolished in March 1987 a regulation limiting the number of foreign securities firms allowed to participate in auctions for medium-term bonds, and in May 1987 short-selling of Japanese Government bonds was permitted within a monthly ceiling of 30 percent of net assets for domestic brokers and 20 percent of own capital for banks with dealing rights. In October 1987 the government bond underwriting syndicate was opened to foreign banks. As a result of these liberalization measures, foreign financial houses were able to establish a gray market in new Japanese Government bonds in September 1988 when some foreign houses offered to sell bonds at a discount in advance of the actual issue. The discount was possible because foreign banks and brokers passed part of their commission on to their clients. In September 1988, a price-competitive bidding system was introduced in the ten-year government bond issuance market effective April 1989. In October 1988, the share of foreign financial institutions in the underwriting syndicate was raised from 2.5 percent to 8 percent. Finally, in June 1988, the Government allowed life insurance companies to raise foreign currency loans to hedge their overseas investments.

Further steps toward reduction of the division of activities between securities firms, banks, and other financial institutions were taken in Japan in August 1987 when the Government allowed banks to resell newly issued government bonds from the time of issue, instead of having to hold them for at least 40 days. In addition, city banks were permitted to issue yen-convertible bonds effective April 1988. Certain Tokyo Stock Exchange (TSE) regulations were also relaxed during 1987; in July, margin trading controls were relaxed, and in September, regulations concerning the distribution of commission income between domestic and overseas offices were modified in order to achieve equal treatment for both foreign and Japanese brokers. As an additional measure of financial liberalization, the minimum maturity for European bonds issued by nonresidents was reduced at the beginning of 1987 from five to four years, and the authorization was extended in June 1987 to include resident borrowers. Finally, to continue a program of decontrol of interest rates on deposits, in April 1988, the minimum size of large time deposits and certificates of deposits was cut from ¥ 100 million to ¥ 50 million and the minimum size of large time deposits was further cut to ¥ 30 million in November 1988. In April 1988, the maruyu system of tax-free savings accounts was eliminated, increasing the competitiveness of alternative sources of saving.

Access to German financial markets was broadened in May 1987, when trading in the new national secondary securities market began. Trading in this market was to be regulated by the individual stock exchanges and regional regulators. In June 1987, the Bundesbank allowed for the expanded private use of ECUs by permitting the holding of ECU accounts with credit institutions and by enabling new forms of borrowing in ECUs. Starting in August 1987, the notification period for the issuance of Euro-deutsche mark bonds was reduced from 15 days to 2 days. Moreover, in order to reduce special tax exemptions, in October 1987 the Government decided to introduce in 1989 a 10 percent withholding tax on interest payments on bonds issued by residents. Finally, in October 1988, nonresidents of the Federal Republic of Germany were given permission to buy German Federal Government bonds (Bundesobligationen). (Federal savings bonds and treasury financing notes still remain prohibited to nonresidents.)

In the United States, the most important measures concerning access to financial markets involved steps toward the liberalization of trading in foreign assets, elimination of certain controls limiting bank activities in the securities markets, and continued erosion of barriers to interstate banking. In March 1987, American exchanges were allowed to trade futures contracts in Canadian, Japanese, and U.K. Government securities, and foreign firms were permitted to trade futures involving foreign government securities. In July 1987 the Commodity Futures Trading Commission (CFTC) lifted a ban on the sales of foreign options and decided to apply U.S. regulatory requirements to foreign futures and options. Moreover, in June 1987 the SEC allowed U.S. institutional investors to purchase unregistered shares offered by foreign companies, with the provision that such shares not be sold in the United States. An additional measure aimed at increasing competition in the international capital markets was proposed by the SEC in June 1988, whereby barriers to the offering of Eurobonds directly to U.S. nationals abroad were to be eliminated and the ability of U.S. residents to establish companies abroad for the purpose of investing in foreign securities were to be increased.

With regard to the expansion of bank activities, the Federal Reserve Board in March 1987 allowed a bank to issue and trade commercial paper through an independent subsidiary, and in April 1987 three major New York money-center banks were permitted to underwrite and deal in mortgage-backed securities and municipal revenue bonds through wholly owned securities subsidiaries. In May, however, the New York Court of Appeals blocked the Board’s authorization of these activities. Although the Federal Reserve Board followed this up by authorizing several banks in June 1987 to underwrite and deal in consumer-related receivables, the implementation of these authorizations was later postponed by congressional moratorium. In February 1988, the New York Court of Appeals upheld the authorizations granted by the Federal Reserve Board, and the Supreme Court subsequently decided not to hear a case aimed at overturning the decision. The Board took further action in January 1989 when it agreed to allow five major banking firms to underwrite and deal in corporate debt, and, within a year, to buy and sell common stock. With regard to the geographic expansion of banks within the national market, the principal mechanisms for liberalization remained the passage of reciprocal banking legislation by state governments.

In Canada, the Federal Government submitted a plan at the beginning of 1987 to establish international banking centers in Montreal and Vancouver. Later in the year, a series of liberalization measures allowed domestic banks and foreign securities companies to provide a range of investment services. By the end of 1987, seven new foreign securities firms were permitted to establish operations in Ontario. Further federal and provincial reforms followed, including a phasing out of limits on the ownership of domestic securities firms by foreign financial institutions. As discussed below, a free trade agreement with the United States, implemented at the beginning of 1989, was expected to have had important regulatory implications.

Italy adopted a series of measures during 1987 and 1988 directed toward the scheduled integration of EC capital markets. In April 1987 the National Stock Exchange Supervisory Commission submitted a plan for a global stock exchange reform by the end of 1992, and in May 1987, territorial restrictions on the operation of foreign bank branches in Italy were eliminated. Additional measures liberalizing capital movements were also taken in mid-1987, including elimination of a 15 percent non-interest-bearing deposit requirement on capital investments abroad. Banks were also allowed to expand the range of their activities. In particular, in February 1987 they were permitted to set up subsidiaries dealing with corporate investment, underwriting and risk capital funding, and in May, credit controls on lira bank lending were abolished. In February 1988, the amount of liquid assets that Italian companies trading abroad may keep in foreign currency was increased, and in June, companies were allowed to open current accounts abroad. In October 1988, Italy’s new foreign exchange law came into effect. The new law, perhaps the most important step taken toward liberalization to that date, provided freedom for all foreign exchange transactions not expressly prohibited and guaranteed free repatriation of capital and factor income. While some controls on capital movements still remain, Italy has committed itself in the EC context to remove them by July 1, 1990.

Mainly as a result of the continuing process of financial liberalization and increasing competition between financial institutions, several new hedging instruments were created in various markets during 1987–88. In the United Kingdom, the London International Financial Futures Exchange (LIFFE) in September 1988 started trading German Federal Government bond futures, the only deutsche-mark-denominated futures contract on a fixed income bond then available. In 1987, the Bank of England allowed trading in a futures contract on Japanese Government bonds. In May 1988, bills to create financial futures and options were approved by the Japanese Diet. These bills granted both banks and securities firms permission to broker domestic and foreign public sector futures and options; the bills also granted securities firms exclusive rights to broker stock index futures and options. Trading in stock-index futures started in September 1988 in Tokyo and Osaka. In France, MATIF (the Paris financial futures market) started, at the beginning of 1988, its first interest-rate options contract based on a notional ten-year, 10 percent government bond futures contract. In the Netherlands, the European Options Exchange in May 1987 started trading a new stock-index option, and in New Zealand the Futures Exchange launched two new futures contracts, involving a 90-day bank bill and the Barclays stock index.

Shifting Territorial Boundaries for Financial Services

During 1987–88, developments in various regions contributed to the continuing geographic integration of national financial markets. Negotiation of the Free Trade Agreement between Canada and the United States and the movement toward the creation of a unified internal market within the European Community were most significant in this regard.

Financial Aspects of the Free Trade Agreement Between Canada and the United States

In October 1987, agreement in principle was reached on the elements of a free trade agreement between Canada and the United States. The legal text was finalized in December and signed by the President of the United States and the Prime Minister of Canada on January 2, 1988. Following ratification by the U.S. Senate in September 1988, a national election in Canada in November, and the subsequent passage of enabling legislation, the Agreement became effective on January 1, 1989. One of the most comprehensive bilateral trade agreements ever negotiated it commits the United States and Canada—the world’s largest bilateral trading partners—to eliminate or reduce barriers to trade and investment and to “level the playing field” for bilateral economic relations. It includes, inter alia, a phasing out of all tariffs over a ten-year period, a reduction in certain nontariff barriers, a significant liberalization of investment flows, and the establishment of mechanisms for the resolution of trade disputes. It breaks new ground, particularly in respect of services, investment, and technology transfer.22

The agreement on financial services (Chapter 17 of the Free Trade Agreement) covers commercial banking, investment banking, and trust and loan companies. The exemptions from restrictions on ownership of Canadian-controlled firms provided for under the Agreement also apply to insurance companies; however, insurance activity is mainly covered by separate chapters of the Agreement. Commitments in the financial services chapter appear to be based implicitly on the principle of “national treatment,” as opposed to “reciprocal treatment,” with regard to the regulation of the other party’s financial institutions. Chapter 17, however, does not contain an explicit, general undertaking by the parties to abide by this principle. In effect, and especially on the U.S. side, the negotiations were geared to create conditions approximating what the U.S. Treasury has traditionally termed equality of competitive opportunity between the two countries. Financial institutions, other than insurance, are not subject to the dispute settlement arrangements applicable to the rest of the Agreement. Instead, both countries have agreed to a special consultative mechanism between the U. S. Department of the Treasury and the Canadian Department of Finance. The mechanism is not only intended to resolve disputes arising from the implementation of Chapter 17, but also to oversee the effects of further financial liberalization in both countries as the Agreement takes effect. Unlike the chapter on services, Chapter 17 does not cover regulatory policies at the state or provincial levels.

The financial services agreement was negotiated against a background of increasing cross border activity in financial services between Canada and the United States. Operations of U.S. commercial bank subsidiaries in Canada have grown markedly, especially since the 1980 revisions to the Canadian Bank Act which, inter alia, authorized the entry of wholly owned subsidiaries of foreign banks (as “Schedule B” banks). As of the end of April 1988, there were 15 U.S. commercial bank subsidiaries operating in Canada with assets totaling Can$11.7 billion. Canadian banks, for their part, have been active in the United States for a longer time. Furthermore, the U.S. International Banking Act of 1978 grandfathered the Canadian banks’ ability to maintain retail and other banking operations in more than one state. At the end of 1987, there were 32 Canadian bank branches and agencies in the United States, with total assets of $27 billion, and 12 U.S. chartered banks, with total assets of $9.7 billion, were wholly owned by Canadians. Also, there were 48 U.S. chartered banks partially owned by Canadians—with Canadian participation of at least 50 percent in 10 of them. In addition, 12 Canadian firms or subsidiaries were members of the New York Stock Exchange, while 50 U.S. security dealers were registered with the Ontario Securities Commission. These numbers, however, understate the degree of the financial linkages between Canada and the United States, because both countries have continued to increase their dealings with one another indirectly through offshore securities and capital markets.

Chapter 17 of the Free Trade Agreement not only reflects but is likely to provide a further impetus to continuing processes of financial liberalization in both countries. In effect, both countries declare that the provisions in Chapter 17 will not be construed as representing the mutual satisfaction of the Parties concerning the treatment of their respective financial institutions. They also commit themselves to consult with one another as they liberalize further the rules governing their markets and to extend any resulting benefits to one another’s financial institutions. Under the agreement on financial services, Canada will essentially remove for U.S. financial institutions restrictions on ownership, asset growth, market share, and capital expansion placed on foreign financial institutions operating in Canada. U.S. commercial bank subsidiaries will also be exempted from the formal 16 percent ceiling set by the Canadian Bank Act on the aggregate foreign bank share of all domestic banking assets. (As of the end of August 1988, foreign-chartered banks accounted for only 11.5 percent of all domestic banking assets.)

In the area of ownership, Article 1703 of the Agreement exempts U.S. firms and investors from aspects of the “10/25 rule.” According to the Bank Act, the acquisition of ownership shares in a federally regulated, Canadian-controlled institution is restricted to 10 percent for any individual nonresident firm or investor, and to 25 percent for all nonresidents collectively. Article 1703 essentially exempts U.S. investors from the 25 percent restriction; the 10 percent limitation—which embodies an ownership policy requiring that large Canadian financial institutions be widely held—continues to apply to all investors, resident and nonresident. Thus, majority ownership stakes in the larger banks (“Schedule A” banks) will remain off limits for U.S. companies. They will, however, receive the same rights as Canadians to diversify in the financial sector by building or buying federally regulated insurance companies, trust and loan companies, or Schedule B banks, and, as mentioned earlier, as of June 1988 there are no regulatory impediments on foreign ownership of security firms.

Despite the absence at the provincial level of formal impediments to foreign ownership of security dealers, applications for entry by U.S. securities firms, in fact, tended to be held up in the investment review process at the federal level, partly reflecting Canadian concerns about reciprocity. The provisions of Chapter 17 aim at removing uncertainty in this area. Canada is explicitly committed to not using its review powers concerning the entry of security firms or other U.S. financial institutions in a manner inconsistent with the objectives of the agreement. As for commitments on the part of the United States, as noted earlier, the 1978 International Banking Act grandfathered the existing multistate operations of Canadian banks in the United States. This Act, however, is subject to review after ten years. Under the Free Trade Agreement, the right of Canadian banks to retain their multistate branches will be grandfathered indefinitely (Article 1702). Under the Agreement, Canadian banks operating in the United States will be permitted to underwrite and deal in securities issued or guaranteed by the Canadian Government or its political subdivisions. In keeping with the traditional separation of commercial and investment banking, such operations in the United States had been permitted only to securities companies unaffiliated with banks. Article 1702 of the Agreement also ensures that Canadian financial institutions will be treated in the same way as their U.S. counterparts in respect of any future amendment to the Glass-Steagall Act or related laws.

Since a substantial degree of freedom already exists in cross-border activity in financial services between Canada and the United States, it is difficult to gauge the ultimate impact of Chapter 17 of the Agreement. While restrictions will be lifted on U.S. commercial bank subsidiaries in Canada with respect to asset growth and market share, these limitations have not, in practice, been binding. Given current Canadian policies on ownership of large (Schedule A) banks, the exemption of U.S. companies from some aspects of the 10/25 rule appears to have the most relevance for insurance and trust companies. Much uncertainty over the regulatory framework for these companies remains, however, as corresponding reforms proposed in late 1986 have not yet been implemented, largely because of strong concerns in the Canadian Parliament regarding commercial-financial linkages, the attendant risk of self-dealing, and difficulties associated with coordination of federal and provincial regulatory regimes.

Whether U.S. financial institutions in Canada or Canadian institutions in the United States will, as a direct result of the financial services part of the Agreement, gain enduring competitive advantages visa-vis other foreign financial institutions remains an open question. In the securities area, for example, Canadians have already essentially granted national treatment to all foreign security dealers. As the Agreement takes effect, other countries can be expected to intensify efforts to obtain, for their own financial institutions in areas other than securities, treatment comparable with that accorded the United States under Chapter 17. And there is nothing in Chapter 17 that prevents Canadian authorities from acceding to such requests. On the U.S. side, owing to the principle of national treatment underlying current banking law, U.S. commitments under the Agreement do not accord Canadian financial institutions any particularly significant concession that is not also granted to other foreign financial institutions. For example, while the indefinite grandfathering of the Canadian banks’ right to retain their multistate branches may help to reduce uncertainty, it promises no significant advantage not already available to banks from other countries. And while Canadian banks may in fact act as preferred brokers of Canadian Government securities in the United States, Article 1702 explicitly acknowledges the right of all banks, including bank holding companies and their affiliates, to underwrite and deal in such securities.

The implementation of the agreement on financial services may make more obvious remaining differences in the financial regulatory structures of Canada and the United States and may, therefore, heighten pressures for regulatory harmonization and coordination. Complexities may prove to be particularly acute with respect to the contrast between the remaining geographic and functional restrictions on banking activities in the United States, on the one hand, and the increasingly universal (in both geographic and functional terms) nature of banking activities in Canada, on the other.

Financial Aspects of European Single Market Plans

The EC has set 1992 as a deadline for creating a barrier-free, single internal market in goods, services, labor, and capital. This effort began in 1958 when the Treaty of Rome espoused the objective of creating a European common market through the elimination of customs duties and other obstacles to the free movement of goods, services, and capital. Significant progress toward this goal has been made in the goods market. Internal tariffs have been abolished; however, a number of nontariff barriers remain in place. Such nontariff barriers are particularly pronounced in the area of financial services, where conflicting rules and regulations effectively impede cross-border movements of financial institutions and transactions. Despite strenuous efforts by the Commission to break down these barriers, little progress was made in the 1970s. Growing concern among EC countries about how to proceed with the creation of the internal market mandated by the Treaty of Rome, combined with increasing external pressure owing to the internationalization of financial markets, stimulated increased cooperation among EC governments in the 1980s. This was reflected in the commitment made by the member states at the 1985 Brussels summit to achieve a single internal market by 1992. Subsequently, the Commission was asked to prepare a detailed program and timetable of measures to accomplish such a goal. Accordingly, in May 1985, the Commission proposed a White Paper containing plans for 300 directives. The White Paper was endorsed at the Milan summit in June 1985 and the process of turning the 300 proposed measures into binding legislation was facilitated by the adoption of the Single European Act in 1987. In particular, Article 13 of the Act introduced the December 31, 1992 deadline for completion of the single market into the Treaty.

Moreover, Article 18 of the Single European Act introduced voting by qualified majority into many decisions taken by the Council with regard to the creation of an internal market. In part, this represented a reversal of the so-called Luxembourg compromise of 1966 that had established the veto right of each individual member country. Unanimity is still required, however, on such issues as the harmonization of tax policies. The other element that greatly facilitated the adoption of the Commission’s proposals was the introduction of the principle of mutual recognition. This principle empowers the Council to determine that, after a minimal level of cross-country regulatory harmonization has been achieved in a certain field, regulations of member countries are to be recognized as effectively equivalent.

The integration of European financial markets is to be brought about by the removal of capital controls and the liberalization of restrictions on financial activities. The Treaty of Rome mandated that EC members liberalize capital movements to “the extent necessary to ensure proper functions of the Common Market.” Members could, however, maintain or reintroduce capital controls—on a temporary basis—in case of financial markets disturbances or balance of payments difficulties. But significant differences in the treatment of capital flows remained in the 1960s, with many EC countries reintroducing capital restrictions during 1968–73. In 1983, the Commission informed the Council that it regarded the full liberalization of capital movements and the integration of financial services as preconditions for the achievement of the single internal market. In November 1987, the Commission presented to the Council a comprehensive proposal to liberalize capital movements, which then served as the basis for the directive on liberalization of capital movements adopted on June 24, 1988.

Under that directive all restrictions on the movement of capital between persons resident in member states were to be abolished. The most extensive liberalization applied to monetary or quasi-monetary operations, that is, operations in current and deposit accounts and in securities and other instruments normally dealt on the money market. The directive is to be implemented by July 1, 1990 by most member states. Spain, Greece, Ireland, and Portugal are authorized to maintain certain restrictions until the end of 1992, and Belgium and Luxembourg will be able to maintain their dual-exchange markets until 1992. The directive contains specific safeguard clauses that allow member states to reintroduce, for a period not exceeding six months, restrictions on short-term capital movements in the event of disturbances to monetary and exchange rate policies. Such measures, however, must be authorized by the Commission. The directive also allows for EC concerted action in response to external monetary or fiscal shocks, after consultations within the monetary committee and the committee of central bank governors on the initiative of the Commission or of any member state. Coordination of monetary and exchange rate policy are the main measures envisaged here, but regulation of short-term capital movements to and from third countries is explicitly allowed. The directive also provides a timetable for provisions to counter the risk of tax avoidance or evasion that might be brought on by the full liberalization of capital movements in the face of continuing diversity of national tax systems. The Commission was scheduled to present proposals to the Council in this area by the end of 1988 and the Council was expected to respond by the end of June 1989.

The Commission’s White Paper detailing the measures necessary to complete the internal market for financial services follow the two principles of mutual recognition and minimum harmonization. In the absence of a basic degree of harmonization, mutual recognition could result in business flowing disproportionately toward the least regulated environment. The principle of mutual recognition also implies that the supervision of financial institutions is carried out for the most part by the home country and not by the host country. Moreover, while Council directives carry the force of law, most directives allow for a time period deemed sufficient for member countries to revise their national legislation and implement necessary administrative changes. Thus far, efforts to liberalize financial activity have concentrated on banking, securities, and insurance.

The main vehicle for liberalizing banking activities has been the draft Second Banking Coordination Directive, expected to be adopted by the Council by June 30, 1989. This directive allows banks to conduct business anywhere in the EC, once they have been authorized to do so in their home country (the “single banking license”). They would operate abroad under home country rules even if these rules differed from host country rules. For example, an Italian bank would be able to branch into London without having to request permission or meet all regulatory requirements of the United Kingdom. It is expected, however, that capital adequacy and other essential regulations will be included in the rules and regulations that are to be harmonized. In fact, the capital standards recommendations of the Commission are parallel to those adopted in 1988 by the Basle Committee of Bank Supervisors. In addition to traditional banking activities, the Second Banking Directive would also authorize banks to undertake securities underwriting and other securities operations either as principal or as agent. The Second Banking Directive is to be supplemented by directives or recommendations aimed at promoting common standards for accounting, deposit insurance, reorganization and liquidation of failing institutions, mortgage lending, and large exposures to single customers or groups of customers. The Commission will also propose common rules for limiting large exposures of banks to 15 percent of their own funds, restricting banks’ holdings of individual industrial companies’ equity to 10 percent of their own funds and 50 percent in total, abolishing barriers to the free provision of mortgage credit throughout the Community, and harmonizing deposit insurance practices.

Aside from increasing competition among firms within the EC, the principle of mutual recognition and home country control could also increase competition among different national regulatory systems. National regulatory systems are expected to converge, since regulations that restrict a country’s own banks in the line of products they can offer would place those banks at a disadvantage. Home country control and mutual recognition would not, however, deprive national regulators of all discretion. It is anticipated that host countries would continue to oversee risk-taking in the securities markets, set standards for the control of banking liquidity, and regulate the execution of monetary policy. In addition, cross-border services would have to be provided in compliance with host country conduct-of-business rules.23

The Second Banking Directive contains an important clause, the so-called reciprocity clause, which allows the Commission to deny entry to banks from a non-EC country that fails to grant comparable treatment to banks from any of the 12 EC member states. The Council underscored that this clause would not be applied to financial institutions already established within the EC. A distinction is made, however, within these institutions, whereas bank subsidiaries would operate under the “single license scheme,” bank branches would remain under the jurisdiction of the authorities in each EC country where they operate. The Council has also indicated that the reciprocity clause would still apply to the sale of financial institutions already established in the EC to non-EC banks. Even with its narrower application, this clause could have wide-ranging implications if it worked to restrict the number of non-European banks operating in Europe. As its supporters argue, however, it could help accelerate liberalization in national financial markets outside the EC. The precise interpretation of the clause remains to be worked out.

EC countries with international financial centers or foreign banks, such as the United Kingdom, the Federal Republic of Germany, the Netherlands, and Luxembourg, have expressed reservations concerning the reciprocity clause, while other member states, for example, France, Belgium, and some southern European states, support stricter reciprocity requirements. The United States and Japan have publicly protested the proposed rule. In addition, some questions have been raised about the consistency of a reciprocity requirement with the obligations of EC member states under the General Agreement on Trade and Tariffs.

In the area of securities markets, growing competition from abroad has prompted deregulation in the EC. The Commission is seeking to further open up cross-border movement of securities services within the Community, again on the basis of mutual recognition of national supervisory standards, combined with home-country control of financial institutions. In the White Paper, the Commission put forward as a goal the construction of a united European securities market system with different EC stock exchanges as components. This is to be achieved essentially by linking European exchanges and coordinating clearing and settlement systems. To this end, the Council has put forth a directive on the mutual recognition of listing information on stock exchanges to be implemented by the beginning of 1990 (by 1991 for Spain and by 1992 for Portugal). Thus, a company listing on the Paris Bourse would automatically qualify for listing on other EC exchanges. In addition, the Council has forwarded a directive on the marketing of collective investment instruments, such as mutual funds or unit trusts. According to this directive, which is to be implemented by October 1989 (by April 1992 for Greece and Portugal), mutual funds authorized by any member state could be marketed without additional authorization in other member states once these funds have complied with certain minimum information requirements.

The Commission has also published a draft directive establishing common requirements for prospectuses for the sale of securities to the public. The Commission initially had extended this requirement to include Eurosecurities, that is, securities issued in the Euromarkets, but has recently changed this requirement to exclude issuers that raise funds denominated in currencies other than that of the country of its head office, thus excluding Eurosecurities from the directive. In addition, the Commission has issued a draft directive on transactions involving large stakes in listed companies and has proposed standardized rules on the regulation of insider trading. Finally, the Commission has sought to regulate the provision of investment-related services, such as portfolio management or brokerage.

In the area of insurance, the Commission’s White Paper proposed to allow insurance companies from one member state to insure large industrial or commercial risks within other member states. As regards mergers and acquisitions, the Commission has sought to establish rules for the regulation of takeover bids and transactions in large groups of shares. This could prove particularly significant given that, with the exception of the United Kingdom, France, and the Federal Republic of Germany, EC member states do not have well-defined antitrust rules to control mergers or acquisitions. The Commission intends to examine each merger and acquisition proposal above a certain size to see whether it violates EC competition law.

These proposed reductions in restrictions on the movement of financial services and capital within the EC are likely to have substantial structural effects. Significant gains could arise from increased competition and better allocative efficiency among EC countries when capital controls are eliminated. As already noted, the removal of capital controls is well advanced and scheduled to be completed before final implementation of the single internal market program. The proposed removal of restrictions on financial activity will likely lead to less segmented domestic financial markets because of increased competition and the introduction of new financial products. In particular, the boundary between banking and securities markets is likely to be further blurred through regulatory changes, securitization of bank assets, and increased participation of foreign banks in national capital markets. Cross-border expansion of financial services could be relatively greater in retail financial markets where price differences between national markets are larger. Potential economies of scale and scope in EC-wide expansion could provide additional benefits.

The expansion abroad could take several forms. The provision of financial services across borders without establishing new physical presences can be expected to play an important role in wholesale markets. Merger and acquisition activities in both wholesale and retail markets may intensify appreciably. However, the establishment of new retail branch networks is likely to be limited by the existing extensive branch banking systems in most EC countries. And expansion by way of acquisition may be dampened by the ownership structure of financial institutions in some countries, for example, Italy, France, and the Federal Republic of Germany, where many mid-sized banks are owned by federal or provincial governments. The increased presence of foreign institutions in domestic markets will contribute to the spread of financial innovation and increase the scope for currency substitution. Moreover, the presence of a foreign bank with access to the central bank clearing system in the bank’s home country will greatly facilitate clearance and settlement of transactions denominated in the home currency of the foreign bank. Finally, the recent pattern of more rapid expansion of activity in securities markets, as compared with banking markets, may be accentuated, since access to primary securities markets for many investors will be facilitated by increased cross-border competition among securities firms from countries with well-developed securities markets.

Multilateral Agreement on Capital Adequacy for Banks and Its Implementation

Since 1982 in particular, there has been a noteworthy trend across most industrial countries toward a strengthening of the capital bases of banks. Complementing efforts to bolster reserves against potential loan losses, banks in most OECD countries have moved to increase core capital. An indication of this trend is provided by a rough comparison of capital-to-asset ratios on a country-by-country basis (Table 9). With the exception of Japan, available data generally indicate an improvement in capital/asset ratios over a five-year period ended in 1987, particularly for the United Kingdom and the United States. This broad trend has emerged in response both to market pressures and to signals from supervisory authorities.

Table 9.

Capital/Asset Ratios of Banks in Selected Industrial Countries, 1979–871

(In percent)

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Sources: Data provided by official sources; and Fund staff estimates.

Aggregate figures such as the ones in this table must be interpreted with caution, owing to differences across national groups of banks and over time in the accounting of bank assets and capital. In particular, provisioning practices vary considerably across these countries as do the definitions of capital. Therefore, cross-country comparisons may be less appropriate than developments over time within a single country.

Ratio of equity plus accumulated appropriations for contingencies (before 1981, accumulated appropriations for losses) to total assets (Bank of Canada Review).

The changeover to consolidated reporting from November 1, 1981, had the statistical effect of increasing the aggregate capital/asset ratio by about 7 percent.

Ratio of capital, reserves, and general provisions to total assets. Data exclude cooperative and mutual banks. This ratio is not the official one (ratio of risk coverage), which includes loan capital and subordinate loans in the numerator, while in the denominator, assets are assigned different weights depending on the quality of the assets. The official ratio provides the groundwork for the control of the banking activities by the Commission Bancaire (Commission de Contrôle des Banques, Rapport).

Ratio of capital including published reserves to total assets. From December 1985, the Bundesbank data incorporate credit cooperatives (Deutsche Bundesbank, Monthly Report).

Ratio of reserves for possible loan losses, specified reserves, share capital, legal reserves plus surplus and profits and losses for the term to total assets (Bank of Japan, Economic Statistics Monthly).

Ratio of capital resources (share capital, reserves excluding current-year profits, general provisions, and eligible subordinated loans) to total payables. Eligible subordinated loans are subject to prior authorization by the Institut Monétaire Luxembourgeois and may not exceed 50 percent of a bank’s share capital and reserves. Data in the table are compiled on a nonconsolidated basis and as a weighted average of all banks (excluding foreign bank branches). An arithmetic mean for 1987 would show a ratio of 12.6 percent. Inclusion of current-year profits in banks’ capital resources would result in a weighted average of 4.3 percent for 1987. Provisions for country risks, which are excluded from capital resources, have been moderately increased in the last year. The 1987 level of provision represents five times the level of 1982.

Ratio of capital, disclosed free reserves, and subordinated loans to total assets. Eligible liabilities of business members of the agricultural credit institutions are not included (De Nederlandsche Bank, N.V., Annual Report).

Ratio of capital plus published reserves, a part of hidden reserves, and certain subordinated loans to total assets (Swiss National Bank, Monthly Report).

Ratio of share capital and reserves, plus minority interests and loan capital, to total assets (Bank of England).

Ratio of capital and other funds (sterling and other currency liabilities) to total assets (Bank of England). Note that these figures include U.K. branches of foreign banks, which normally have little capital in the United Kingdom.

Ratio of total capital (including equity, subordinated debentures, and reserves for loan losses) to total assets.

Reporting banks are all banks that report their country exposure for publication in the Country Exposure Lending Survey of the Federal Financial Institutions Examination Council.

The increased ability of financial firms to assume credit, liquidity, interest rate, and other risks resulting from the liberalization of markets and the development of new products has, as discussed above, led major countries to strengthen their supervisory structures; it has also led them to seek to coordinate associated policies internationally. One of the earliest efforts in this direction took place in December 1975 with the formation of the Committee on Banking Regulation and Supervisory Practices of the Bank for International Settlements (known as the Cooke Committee or the Basle Committee), whose initial work aimed mainly to clarify the supervisory responsibilities of the home and host countries of international banks.24 The Committee thereafter began focusing on the issue of capital adequacy.

In 1986, the Basle Committee proposed an initial plan to link common minimum capital requirements for international banks to their credit risk exposures, including both on- and off-balance sheet exposures. The plan had two principal objectives: to strengthen the soundness of the international banking system and to diminish competition inequities among international banks arising from differences in national definitions and requirements regarding bank capital. In March 1987, the United Kingdom and the United States reached agreement on a common definition of capital adequacy, and in June 1987, Japan joined them. The consensus was subsequently broadened after extensive discussions among the Group of Ten countries. The central bank governors of the Group of Ten in July 1988 finally endorsed a compromise plan to harmonize capital standards for the major commercial banks under their jurisdictions.25 Since that time, national supervisors in the countries of the Group of Ten have been working on detailed guidelines for implementation of the proposals, which specify minimum levels for bank capital but leave room for national authorities to impose more stringent requirements and to extend those requirements to a broader range of institutions.

Since the financial structures of banks generally reflect unique national business customs, tax policies, accounting practices, and other country specific traditions, the impact of the new capital standards is expected to vary by country. The general requirement that banks maintain minimum capital bases of 8 percent of risk-weighted assets is being phased in over a five-year period that commenced at the end of 1987. Half of the required capital (4 percent) is to be in the form of core capital (generally, ordinary paid-in share capital plus disclosed reserves less goodwill), while the other half may be in the form of supplementary capital (various types of quasi-capital securities and nonspecific reserves, subject to certain ceilings and deductions). Earmarked and specific reserves for particular poor quality assets are not included in capital. By the end of 1990, banks will be expected to meet a standard of 7.25 percent, of which at least 3.625 percent should be core capital. Until the 8 percent level is fully achieved at the end of 1992, national supervisors retain a degree of discretion on such matters as the amount of subordinated debt and general loan loss reserves able to be counted as supplementary capital, the level of supplementary capital able temporarily to be considered as core capital, and the amount and timing of deductions of goodwill from core capital. By the end of 1992, the 8 percent target is to be achieved with no supplementary funds included in core capital, with general loan-loss reserves limited to 1.25 percent in supplementary capital (up to 2 percent on an exceptional and temporary basis), with allowable subordinated debt limited to 50 percent of core capital, and with goodwill entirely excluded from core capital.

Capital ratios are to be calculated on the basis of asset portfolios and off-balance sheet commitments weighted by credit risk categories. Once again, room has intentionally been left for some national discretion in the assignment of appropriate weightings. Risk weight assignments that have received most attention include cash equivalents (including claims on OECD governments or governments party to the General Arrangements to Borrow (GAB) of the Fund), with a risk weighting of zero percent;26 claims on multilateral institutions like the World Bank, either zero percent or 20 percent; claims on banks incorporated in OECD or GAB countries or interbank claims involving other countries and having original maturities of less than a year, 20 percent; claims on domestic public sector institutions, 0, 10, 20, or 50 percent; residential mortgage loans, 50 percent; and commercial loans or loans to non-OECD or GAB governments, 100 percent. Off-balance sheet items are first to be converted to on-balance sheet equivalents and then subjected to the standard risk weightings. General guarantees, for example, are to be converted at 100 percent and then treated as loans; note issuance facilities are to be converted at 50 percent; short-term, self-liquidating trade commitments at 20 percent.27

Implementation guidelines were expected to reflect differing circumstances prevailing in each of the countries of the Group of Ten. For many European countries, as mentioned above, those guidelines will be further complicated by the need to conform over time with EC efforts to create a single European banking market. Notwithstanding such complications, however, it appeared that most banks across the Group of Ten countries would be able to conform to the new standards within the time period allowed. Canadian and British authorities, for example, were able to issue early guidelines for implementation of the agreement. In certain cases, however, notably in the United States, France, Japan, Italy, and Belgium, important adjustments were expected. Some important differences were also expected to arise in the strategies employed by banks to meet the new standards and in the degree of flexibility provided by national supervisors.

In the United States, implementation guidelines proposed by the Federal Reserve Board in August 1988, and finalized with only slight amendment in December, applied to all banks under its authority, including bank-holding companies and state-chartered members of the Federal Reserve system. Consistent guidelines were expected from other regulatory agencies. Most smaller and regional banks were, even in 1988, generally in conformity with the 1992 standards, but a number of money-center institutions were expected to require adjustments in their asset portfolios or in the size and composition of their capital bases. Some analysts initially estimated, for instance, that major New York-based banks would need to bolster their capital by up to $15 billion before 1992 or else make substantial changes in their balance sheet structures. The Federal Reserve guidelines, however, attempted to ease the transition for those banks organized as holding companies by broadening the types of preferred share issues qualifying as core capital, by loosening requirements for the deduction of goodwill already carried on the books, and by exempting subsidiaries principally engaged in securities activities. American regulators have also shown flexibility with regard to the treatment of general loan-loss reserves and have opted for low-risk weightings for such assets as government bonds of all maturities. The extent to which undercapitalized U.S. banks or bank-holding companies will attempt to make up for any shortfall by deliberately shrinking the volume of their higher risk assets is still unclear. It should be noted, however, that the reduction in developing country exposures discussed above is consistent with such a strategy.

While the new capital standards were being negotiated, observers widely believed that any agreement would have the most serious impact on major Japanese banks, which have long been viewed as relatively undercapitalized. For fiscal year 1987, for example, Japan’s largest commercial banks possessed average levels of core capital in the 2 percent range. Although certain adjustments had therefore to be made, two factors appeared to make this less difficult than first supposed. The larger Japanese banks typically possess significant undisclosed reserves, mainly resulting from the practice of reporting such assets as long-term securities holdings and real estate at historic (and low) book values. Moreover, the structure of Japan’s capital markets may work to facilitate the raising of new core capital, especially if the authorities provide a wide range of options for the types of capital instruments deemed acceptable for purposes of meeting the new standards. Under the December 1988 implementation guidelines of the Ministry of Finance, a zero percent risk weighting was specified for Japanese Government bonds (as well as for obligations of multilateral institutions of which Japan is a member) and fully secured residential property loans were assigned a 50 percent weighting. By the end of 1988, major Japanese banks already appeared to be at or near the transitional target levels specified in the Basle agreement. Smaller banks in Japan may require more difficult adjustments to reach the same levels.

Within Europe, the new capital standards were expected to require varying degrees of adjustment. In 1987 the clearing banks of the United Kingdom were already in a position to meet the 1992 requirements. Most other banks in that country were expected to be in a position to meet them fully by the comparatively early deadline of June 30, 1989 set for them by U.K. authorities in November 1988. Similarly, the principal Swiss banks exceeded the standards even before the Basle agreement was concluded. German authorities, for their part, expected the large, internationally active banks under their purview to encounter few problems in meeting the new standards within the time frame contemplated. Bank capital has traditionally been viewed narrowly in the Federal Republic of Germany and the portfolio diversification characteristic of universal banking structures has long been seen as lessening the need for large, publicly disclosed capital bases. For the larger German banks, significant levels of undisclosed reserves were expected to ease the transition; as the standards are applied to smaller German banks, however, some significant balance sheet adjustments could be required. Adjustment may also be significant in France where the capital bases of a number of banks are relatively low and where nationalized banks have limited options for building core capital. The situation is somewhat similar in Belgium and Italy, although immediate challenges for internationally active banks appeared surmountable.

Outside the countries of the Group of Ten, reaction to the Basle agreement has been mixed. Nevertheless, a number of OECD countries that are not members of the Group of Ten and some major offshore banking centers announced their intention to adhere to the new standard. As discussed below, the Basle Committee has also begun to interact more closely with securities market regulators in light of a perceived need to address the competitive and prudential implications of differences in capital standards applied to banks and to securities houses. The members of the Committee, it should be noted, have specifically sought to broaden international support for the new capital standards and to encourage their adoption by other countries. In this connection, in October 1988 the agreement was formally presented to representatives from some eighty countries attending the Fifth International Conference of Banking Supervisors. Although generally viewed by conference participants as constructive, a number of developing countries objected strongly to the differential risk weighting of claims on sovereign borrowers on the basis of membership or nonmembership in the OECD or GAB. The fear was that this could unfairly disadvantage a number of countries when they approached international markets in the future. Also, in some other countries, particularly in the Middle East, concerns have been raised about the implication this classification of countries may have upon the cost of capital for their national banks. The Basle Committee is expected to keep this aspect of the new standards under review as implementation proceeds.

Incipient Regulatory Coordination in Securities Markets

During the past two decades the gradual integration of national banking markets has encouraged multilateral efforts to coordinate regulatory policies among the industrial nations. As discussed, on the issues of market access and prudential supervision of banks, significant progress has been achieved in recent years in such forums as the OECD and the Basle Committee. In the context of a progressive blurring of functional distinctions between banks and other types of financial intermediaries, analogous efforts to coordinate policies affecting other aspects of national and international financial markets have recently been stimulated, especially with regard to the securities sector.

Contact between national regulatory authorities is not an entirely new phenomenon in securities markets. Common problems have in the past spurred bilateral and multilateral discussions, but such interaction has usually taken place informally and on an ad hoc basis. With the rise of the Euromarkets, the coalescence of a distinct Eurobond market, and the overseas growth of intermediary institutions in the 1970s, the need for collaboration became more obvious. Indeed, one of the earliest assignments of the Committee on Financial Markets of the OECD resulted from problems associated with the marketing of mutual funds, both within and across the investment markets of member states.28 This led in 1972 to an initial agreement on common ground rules for the operation of mutual funds and similar investment vehicles. Other concerns related to the protection of investors led to further work by the Committee, in conjunction with the Commission of the EC, the Banking Federation of the EC, and the International Federation of Stock Exchanges. On the basis of this work, the Council of the OECD in 1976 adopted a recommendation to member states specifying minimum disclosure rules for all securities offered to the investing public.29

In the early 1970s, the OECD also began to focus on, and seek the removal of, obstacles to the development of the Eurobond market with the goal of promoting more efficient linkages with national bond markets. In a related move, the Commission of the EC in 1976 promulgated recommendations for a code of conduct for securities market professionals. Formal consultations among a broader group of official supervisory authorities commenced a year earlier, with the first annual conference of the International Organization of Securities Commissions (IOSCO).

During the 1980s, a range of economic, political, and technological developments made it clear that the efficient and safe operation of national and international securities markets could no longer be assured in the absence of more effective policy coordination between national authorities. Market access issues have been prominent in the ensuing dialogue. As in the banking sector, two of the institutional manifestations of a broadening trend toward international capital mobility have been the physical expansion of securities companies beyond their home markets and the direct marketing of securities services across borders. Not surprisingly, since such activities by their nature link market structures that for historical reasons remain idiosyncratic, problems of competitive equity and market efficiency have arisen. In this connection, on a multilateral basis the OECD is seeking to extend the scope of its Codes of Liberalization of Capital Movements and of Current Invisible Operations. It is also attempting to clarify and broaden the obligations of member states to ensure national treatment for foreign institutions operating in primary and secondary securities markets abroad or providing collective investment, portfolio management, and advisory services across national borders. This work is beginning to focus on operational experiences in specific subsectors of national markets where obstacles to freer competition can be subtle and differently perceived by regulatory authorities or market participants. Related work is being done under the auspices of the General Agreement on Tariffs and Trade in the Uruguay Round of trade negotiations.

Although the general trend across industrial countries during the 1980s has been toward more open securities markets, and toward more liberal conditions of competition generally, particularly difficult problems arise as a result of deepening institutional linkages between universal-type markets—where commercial and investment banking functions may be carried out under a single corporate charter—and segmented markets—where commercial banking and investment banking functions are legally separate. European banks, for instance, have faced legal obstacles in offering securities services in Japan, despite their long experience with such activities at home. As discussed above, similar problems have emerged in the currently changing markets of Canada and the United States.

If a pattern may be said to have emerged as a result of bilateral negotiations aimed at ameliorating such difficulties, it has generally been one of developing flexible accommodations that aim, over time, to approximate equivalent access across markets without necessarily forcing radical reforms of underlying regulatory structures. In recent years, for example, regulatory rules in Japan that forbid commercial bank ownership of securities operations (Article 65 of the Securities and Exchange Law) have been reinterpreted to permit the limited establishment of securities affiliates of certain international banks. Provisions of banking laws of the United States have worked to similar effect, especially the provision of the International Banking Act of 1978 that “grandfathered” the securities operations of foreign banks already established in the domestic market. Nevertheless, as international reactions to the reciprocity provision of the EC’s draft Second Banking Coordination Directive, discussed above, have made clear, market access problems remain capable of disrupting orderly linkages between changing national financial markets. Such problems continue to arise as foreign intermediaries deepen their involvement in the securities markets of other nations and continue to provide an important impetus for ongoing bilateral and multilateral consultations aimed at rendering distinctive regulatory policies and practices compatible.

Both within Europe and more broadly, official consultations have concentrated in recent years on issues of technical harmonization across diverse securities markets. In the context of plans for the single European market discussed above, mutual recognition of associated financial practices, if not complete harmonization of national standards, remains a goal of EC states. Work on a Pan-European data information system, which would more effectively link trading on various exchanges, complements those plans. In similar endeavors, separate working parties of IOSCO and of the OECD’s Committee of International Investment and Multinational Enterprise (CIME) are attempting to devise common standards for operations in nascent Euro-equity markets. Technical coordination on clearing systems and other matters is also the focus of ongoing work programs of the International Federation of Stock Exchanges, the International Society of Securities Administrators, and the private-sector consultative association known as the Group of Thirty. Technological and market innovations, such as screen-based trading and a widening use of futures and options as financial management tools, complicate such efforts, even as they underline the increasing importance of cross-national coordination.

As seen most clearly in the aftermath of the October 1987 events examined in the next chapter, the impulse toward cooperation is becoming especially clear on questions of prudential control over integrating securities markets. At the most basic level, investor protection has been a traditional rationale for official oversight of securities markets. With the gradual development of international securities markets and the deepening of operational linkages between existing national markets, the protection of investors from market manipulation has become more difficult. Just as countries differ in their supervisory coverage of markets, especially over-the-counter markets and futures and options markets, they differ in their approaches to dealing with such abuses as insider trading. Matters are further complicated by the fact that various countries have traditionally fragmented regulatory authority over securities markets along functional lines.

The necessity for agreement on fully harmonized regulatory practice in this area is debatable, but thus far securities and derivative product market regulators lag considerably behind their banking market counterparts in this respect. The precise division of authority between home and host country supervisors, as well as general standards and methods for investor protection, have yet to be agreed upon. Pressures are also gradually building for cross-national consensus on standards for short sales, margin requirements, clearing and settlement procedures, financial disclosure, and other aspects of modern securities markets. The direction for future official negotiation on such matters is being charted in various bilateral contexts. In 1986, for example, the British Department of Trade and Industry and the U.S. Securities and Exchange Commission, together with the Commodity Futures Trading Commission, signed an initial agreement to cooperate in uncovering insider trading and other types of securities fraud. American and British futures regulators followed this up in September 1988 with a memorandum of understanding that broadened the scope for information sharing and took a first step toward clarifying the supervisory responsibilities of home and host country authorities. U.S. authorities have negotiated analogous arrangements with Canada, Switzerland, and Japan. Efforts by various regulatory authorities to reach similar understandings involving other countries are known to be under way.

Although bilateral agreements have been helpful in dealing with current problems and safeguarding immediate supervisory interests, questions have been raised concerning the ultimate efficacy of such mechanisms for overseeing an industry rapidly becoming international in scope. As markets become more extensively linked, structural idiosyncracies potentially create regulatory gaps that can penalize unwary investors and undermine market efficiency. The danger remains that cross-national policy differences can open up opportunities for “regulatory arbitrage” (that is, participants undertaking activities in one market to escape restrictions imposed in another). Without a coordinated multilateral approach to securities supervision, at least among countries possessing the largest securities markets, such destabilizing activity could be encouraged. Various public interests in stable and efficient markets could thereby suffer. Many observers see a further rationale for a multilateral approach to international securities regulation in the need to avoid competitive inequities among differently structured intermediaries, like banks and securities companies, providing increasingly substitutable services.

At a broader level, another set of prudential challenges confront regulatory and supervisory authorities as national securities markets become more interdependent and as the functional connections between them and traditional banking markets become more intricate. Although integration is still at an early stage, the risk that extreme instability in one national market or submarket could develop into a systemic crisis appears likely to increase. On a global basis, the securities industry itself is undergoing consolidation. Intermediaries now commonly deal in a wide range of financial instruments and markets. In the face of both technological innovation and market liberalization, a trend toward fewer, better capitalized intermediaries could become clearer. The failure of important intermediaries in such an environment could potentially pose a global threat to financial stability. Moreover, with increasing linkages between various financial submarkets and a blurring of functional distinctions between intermediaries, the task of shielding national and international payments systems has become much more complex. Protecting those systems constitutes a conventional rationale for providing certain banks, for example, with explicit or implicit official safety nets, along with an attendant set of supervisory controls to offset the temptation of imprudent management. Extending such approaches to a wider group of intermediaries could mitigate the risk of systemic instability, but only at potentially significant cost. The trend toward global, liberalized capital markets, at least among industrial countries, has generally been welcomed because of perceptions of the positive benefits associated with increasing efficiency and diversification. New regulatory actions entailing the deliberate or implicit extension of official safety nets could work in the opposite direction by distorting the flow of capital through those markets. They could even increase macroprudential concerns by encouraging excessive risk taking by intermediaries that perceived themselves to be protected from failure. On the other hand, maintaining uncoordinated approaches to systemic risk management can potentially undermine the market efficiency that liberalization and integration are intended to encourage. Obvious difficulties are created, for example, when for prudential reasons competing intermediaries are expected to meet different standards of capital adequacy.

The systemic dilemmas posed by integrating securities markets provide a further incentive for coordination among national securities supervisors. Work programs and information exchanges on the interrelated issues involved have been developing within IOSCO, the OECD, and an informal forum for securities supervisors from a number of countries known as the Wilton Park Group. At the same time, the immediate questions posed by the implementation of international supervisory and capital adequacy standards for banks have encouraged initial contacts between banking and securities regulators in various multilateral forums. Much remains to be done, and the underlying issues appear likely to become more prominent in the future.30