Luxembourg: Selected Issues and Statistical Appendix

Luxembourg's impressive growth performance has been accompanied by regional specialization of production, high labor mobility, export-propelled growth, and the dominance of regional growth fluctuations. Luxembourg's public pension system faces the challenges of population aging and Luxembourg's small, open, and highly specialized economy. Luxembourg's labor market performance holds a seeming paradox, favorable labor market outcomes are coupled with rigid labor market institutions. The supervision of cross-border financial activities raises the difficult challenge of obtaining a complete, consolidated view of the operations of international banking institutions.


Luxembourg's impressive growth performance has been accompanied by regional specialization of production, high labor mobility, export-propelled growth, and the dominance of regional growth fluctuations. Luxembourg's public pension system faces the challenges of population aging and Luxembourg's small, open, and highly specialized economy. Luxembourg's labor market performance holds a seeming paradox, favorable labor market outcomes are coupled with rigid labor market institutions. The supervision of cross-border financial activities raises the difficult challenge of obtaining a complete, consolidated view of the operations of international banking institutions.

IV. Supervising a Largely Foreign-Owned Financial Sector: A Sketch of Luxembourg’s Approach and Alternative Arrangements31

A. Introduction

52. Luxembourg’s financial sector is large relative to the size of the economy—it accounts for more than 20 percent of GDP and 10 percent of employment—and is the undisputed growth engine of the economy, with important backward and forward linkages to other service sectors. Moreover, the financial sector is largely foreign owned—of the 211 banks established in 1999, only some 10 percent had owners located in Luxembourg or Belgium; the remaining banks’ owners were located in 23 different countries, with a majority from Germany, Italy, and France (Figure IV-1).

Figure IV-1.
Figure IV-1.

Luxembourg: Number and Origin of Banks

Citation: IMF Staff Country Reports 2000, 067; 10.5089/9781451824308.002.A004

Source: Financial Sector Surveillance Commission

53. With the advent of Stage 3 of EMU at the beginning of 1999, supervision of Luxembourg’s financial sector (excluding insurance) was separated from the central bank and consolidated within the Financial Sector Surveillance Commission (FSSC). Ensuring a stable and sound environment for financial activities has long been a prime concern of Luxembourg’s public policy—reflecting not only the financial sector’s importance for the Luxembourg economy but also the possible cross-border externalities arising from the international nature of its ownership and operations.

54. This chapter reviews selected issues pertaining to the supervision of a largely foreign-owned banking system. The first section reviews briefly the evolution of cross-border supervision practices and standards since the 1970s; it highlights the interplay of widely publicized instances of cross-border supervision failures and the adoption of new rules for cross-border supervision. The next section describes how practices and standards are applied in Luxembourg’s particular case. The following section discusses two alternative supervision arrangements for banking systems with extensive cross-border ownership structures: delegation of supervision to a supranational supervisory agency (“pan-European approach”) and a shift toward market-based supervision (“New Zealand approach”).

B. The Accident-Prone History of Cross-Border Supervision32

55. Following the large cross-border spillovers from the closure of Bank Herstatt33 in 1974, the Group of Ten established the Basle Committee34 to define broad principles for international coordination of supervision. The Basle Committee agreed on a Concordat in 1975, with the broad objective of ensuring that no banking establishment escaped adequate supervision. While recognizing the joint responsibility of both home and host country supervisors, the Concordat made the parent supervisory authority primarily responsible for solvency oversight (home country supervision principle). Moreover, in 1978, the Basle Committee recommended the adoption of consolidated supervision to improve the quality of information of international bank activities (consolidated supervision principle). However, it immediately became evident that consolidated cross-border supervision is subject to difficulties. First, supervision problems may arise when the parent owns only part of a foreign entity, or if the entity engages in additional, non-banking business. Second, differences in national accounting standards may impede meaningful consolidation. Third, claims on affiliated banks may not legally bind the parent company, and therefore the host supervisor should be concerned about the solvency of resident foreign banking entities. And fourth, local bankruptcy laws often discriminate in favor of local creditors, even if the entity in question is a foreign branch.

56. Another banking failure, the collapse of Banco Ambrosiano35 in 1982, led to a revision of the 1975 Concordat. The revision reaffirmed the principle of consolidated supervision and adopted several new principles: (i) if the host authority does not classify the entity as a bank, then the home country supervisor should either supervise it or demand that it be closed; (ii) if the host supervisory authority considers that the home country’s supervision is inadequate, the host supervisor should either prohibit or restrict the local entity operations; (iii) if the parent is a holding company, supervisors of the separate subsidiaries should cooperate to supervise it; and (iv) if the holding company is a subsidiary, the home country supervisor should supervise it.

57. A further spectacular bank failure, the collapse of Bank of Credit and Commerce International (BCCI)36 in 1991, revealed remaining loopholes in cross-border supervisory arrangements. The response of the international community to the BCCI case was the Basle Committee’s Minimum Standards for the supervision of international banking groups and cross-border activities in 1992. The new feature of these minimum standards was the host country’s authority to impose restrictive measures lest it be uncomfortable with the home country’s supervision of the local banking establishment. Such measures include: (i) setting a deadline for the bank and its home supervisory authority to meet acceptable standards; (ii) obliging the banking establishment to restructure as a separately capitalized subsidiary; or (iii) closing the banking establishment. To implement these standards, countries conclude bilateral agreements and sign memoranda of understanding (MOU) describing their cooperation arrangements.

58. The recent global financial crisis in 1997-98 highlighted new areas where coordination and information exchanges among supervisory authorities could be improved. The G-7 established the Financial Stability Forum, which encompasses both national authorities and international institutions, to promote international financial stability.37 At this point, three working groups have issued recommendations to address concerns relative to highly leveraged institutions, capital flows, and offshore financial centers. In addition, a compendium of international standards for the strengthening of financial systems will become the reference point for best practices, seeking to ensure sound and stable financial systems.

C. Luxembourg’s Present Supervisory Arrangements

59. Luxembourg’s present supervisory structure is based on the EU’s Second Banking Directive, which builds on the principles of mutual recognition and home country control. Under these principles, domestic banks, subsidiaries of foreign banks, and branches of non-EU banks are supervised by the domestic authorities, whereas branches of EU banks are supervised by the home country authorities.

60. In light of the difficulties inherent in the supervision of an international financial center, the current supervisory model raises four closely related issues:

  • First, the effectiveness of the home country principle requires a clear definition of the lead supervisor of each financial institution. This is especially relevant in the case of foreign branches, where supervision is delegated to the home supervisor. Furthermore, the law requires any bank registered in Luxembourg to have a transparent shareholding structure and to clearly indicate who the bank’s ultimate supervisory authority is. Banks whose home supervisor does not apply the Basle Core Principles for Effective Supervision38 may not be granted a license.

  • Second, the supervision of subsidiaries encounters the problem of achieving a consolidated view of the group to which the subsidiary belongs. This raises the need to exchange information with home country supervisors. The practice in Luxembourg varies depending on whether banks are from inside or outside the EU. Inside the EU, memoranda of understanding have been signed with all supervisory authorities, and exchanges of information take place at annual bilateral meetings; in addition, the Groupe de Contact39 provides a forum for institutionalized cooperation and exchange of information. Partial on-site inspection of subsidiaries in Luxembourg is allowed to home supervisors for their consolidated assessments. With countries outside the EU, bilateral memoranda of understanding are signed that describe in detail the specific supervisory arrangements.

  • Third, the supervision of nonbank holding companies must carefully determine who is the ultimate authority responsible for the solvency of their affiliated banks. The basic principle is that if a holding company owns banks elsewhere, the Luxembourg authority will expect the host country to carry on adequate supervision, and will not itself supervise the holding company. The Luxembourg authority would involve itself in the supervision of holding companies owning banks in Luxembourg, but only on a consolidated basis.

  • The final issue is which type of indicators is best suited to evaluate the soundness and vulnerabilities of a largely foreign-owned banking sector, and to what extent these indicators are different from those applied to a locally owned banking sector. In principle, and because the majority of the institutions are branches and subsidiaries of other banks, indicators for the Luxembourg aggregated banking sector may at best convey a blurred picture of the soundness of the system, as they are uninformative about the consolidated position of the banks. Thus, the information provided by standard indicators, such as the capital adequacy ratio, the level of provisioning, or the amount of nonperforming loans of the banking sector, could be very misleading: banks may have an incentive to temporarily transfer capital and assets internationally for tax purposes, and sudden reversals would always be a potential source of risk. In this respect, the Luxembourg authorities require subsidiaries to comply with all solvency indicators on a stand-alone basis, and have the understanding that the parent company will assist in case of duress.

D. Alternative Supervisory Arrangements

61. Luxembourg’s current model of financial oversight is based on a combination of direct inspection of banks’ accounts and exchanges of information, and hinges crucially on bilateral arrangements for the supervision of cross-border banking groups.40 Theoretically, this is just one of the possible options available for the supervision of an international banking center. Alternative arrangements could range from the delegation of supervision to a supranational agency (“pan-European approach”) to the shift toward market-based supervision (“New Zealand approach”), where the emphasis is put on transparency and enhanced disclosure of public information rather than on on-site inspections and exchanges of confidential information. These two possible alternatives are discussed in turn.

62. The launching of the euro and the resulting push toward the integration of European financial markets raise the issue of the adequacy of current supervisory arrangements, especially in countries such as Luxembourg, where there is a significant amount of cross-border activity and ownership. Because of the increased need to exchange information at the European level, one possible alternative would be the delegation of supervision to a supranational EU-wide supervisory agency.41 Such an arrangement would have several advantages:

  • It would facilitate the consolidated supervision of European financial institutions, especially for small countries, which may lack the necessary resources for the efficient consolidated supervision of cross-border operations.

  • It would eliminate the need for ad hoc arrangements, especially as the current European banking consolidation trend proceeds to cross-border mergers and acquisitions. For example, the Franco-Belgian banking group Dexia is currently supervised on the basis of an ad-hoc tripartite memorandum of understanding between Luxembourg, Belgium, and France. A European agency would act as a clearinghouse of information that could automatically accommodate any type of cross-border ownership structure.

  • It would lower the risk of regulatory capture and supervisory forbearance that may delay decisive regulatory action, especially as European banking consolidation leads to the creation of “national champions” that may become “too big to fail” when evaluated at the national level.

An EU-wide supervisory arrangement would, however, eliminate the potential benefits of regulatory competition,42 and would need to rely on the superior information of the domestic authorities about their markets. A practical obstacle for such an arrangement would be the selection of the agency to which supervision would be delegated. A first candidate could be the European Central Bank, which, under the provisions of Article 105 (6) of the Maastricht Treaty, could receive supervisory responsibilities by decision of the European Council. This arrangement would, however, entail a potential conflict of interests between the conduct of monetary policy and the efficient supervision of the banking system. As an alternative, EU-wide supervision could be best allocated to a separate independent agency created ex novo.43

63. The opposite extreme to the establishment of a supranational supervisory agency would be to shift the emphasis towards market-based supervision. Because of the difficulties of carrying out consolidated supervision of subsidiaries, some countries with a foreign-owned banking sector, such as New Zealand, have moved to a system of financial oversight based on enhanced public disclosure. The New Zealand supervisory approach encompasses the following main elements:

  • Conditions for licensing are some minimum prudential requirements—including quantitative restrictions related to constraints on connected exposure and minimum capital adequacy requirements—and the requirement that the home supervisor applies the Basle Minimum Standards and carries on consolidated supervision.

  • The Reserve Bank of New Zealand (RBNZ) monitors each bank’s financial condition and compliance with the conditions of registration through quarterly, off-site exams based on publicly disclosed information. On-site monitoring is not conducted. The RBNZ also formally consults with the senior management of banks on an annual basis, to be informed about each bank’s strategic direction.

  • The RBNZ maintains close working relationships with parent bank supervisors on bank-specific issues and policy issues related to the countries where parent banks are domiciled.

E. Conclusions

64. The supervision of cross-border financial activities raises the difficult challenge of obtaining a complete, consolidated view of the operations of international banking institutions. Over time, these difficulties have manifested themselves in some major international banking failures, which in turn led to breakthroughs in regulation and supervisory practices: the 1975 Concordat, its revision, and the 1992 Basle Minimum Standards. As a result, the principles of consolidated supervision and home country control form the building block of current cross-border supervisory practices in Luxembourg.

65. Luxembourg’s supervision experience provides a case study with possible lessons for the EU: the ongoing trend toward European banking consolidation suggests that cross-border operations among financial institutions may soon become more widespread. At the same time, the present supervision approach appears to be working well in Luxembourg.

66. However, cross-border operations in Luxembourg are limited to relatively small branches and subsidiaries. Thus, when extending Luxembourg’s experience to the EU level, a question of scale arises: would the “Luxembourg model” be flexible enough to effectively supervise the operations of major pan-European banking groups that may emerge in the future? This chapter discussed two alternative supervision arrangements, namely the delegation of supervision to a pan-European agency, or the shift to market-based supervision, which may avoid the need to rely on ad hoc bilateral or multilateral arrangements.


Table A1.

Luxembourg: Expenditure Components of GDP in Constant Prices

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Source: Statec.

Staff estimates.

Contribution to growth.

Table A2.

Luxembourg: Distribution of Gross Value Added in Constant Prices

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Source: Statec.

Staff estimates.

Table A3.

Luxembourg: Indicators of Economic Activity

(Indices; 1995=100)

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Source: Statec.

Production per month.

Production per working day.

Sales volume.

Table A4.

Luxembourg: Consumer Prices

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Source: Statec.

Harmonized index.

Defined as the general index minus energy and selected food items.

Table A5.

Luxembourg: Employment and Unemployment

(In thousands, unless otherwise stated)

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Source: Statec.


In percent of the labor force; harmonized definition.

Table A6.

Luxembourg: Structure of Salaried Employment by Industry

(In percent of total, unless otherwise stated)

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Source: Statec, Luxembourg en chiffres.
Table A7.

Luxembourg: Current Account Developments

(In billions of Lux F, unless otherwise stated)

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Source: Statec.
Table A8.

Luxembourg: Direction of Trade

(In percent of total)

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Source: Statec.
Table A9.

Luxembourg: Representative Interest Rates

(Period averages; in percent)

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Sources: Central Bank of Luxembourg; and IMF, International Financial Statistics.

Money market rate in Belgium. Since 1999, 3-month Euribor.

Weighted average of yield-to-maturity of all bonds with a date to maturity over 5 years.

Table A10.

Luxembourg: Exchange Rates and Competitiveness

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Source: IMF, International Financial Statistics.

Although since January 1, 1999 the Luxembourg franc is irrevocably fixed to the euro at a rate of 1 euro=40.3399 Lux F, the external exchange rate of the euro is market determined.

Index, 1995=100.

Table A11.

Luxembourg: General Government Finances

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Sources; Statec; and staff calculations.

Provisional outcome data.

Data according to the European System of Accounts 1995 (ESA95).

Gross debt is consolidated and does not necessarily equal the sum of debt issued at different levels of government

On the basis of ESA95. Data for 1999 represent staff estimate.

Table A12.

Luxembourg; National Presentation of State Budget and Outturns 1/

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Sources: Luxembourg authorities; and staff calculations.

Including borrowing, debt redemption and transfers to Special Funds.

Final budget.

Preliminary outturn.

All data are expressed as a percent of GDP outturn.

Based on ESA95. Data for 1999 and 2000 represent staff estimates.

Table A13.

Luxembourg: Structure of State Budget Tax Receipts

(In percent of total receipts)

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Sources: Ministry of Finance; and staff calculations.



Ordinary receipts.

Table A14.

Luxembourg: Structure of State Budget Expenditures

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Source: Ministry of Finance; and staff calculations.


Table A15.

Luxembourg: Transactions of Selected Special Funds

(In millions of Lux F)

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Sources: Ministry of Finance; and staff calculations.


Table A16.

Luxembourg: Social Insurance Fund 1/

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Sources: Statec; Ministry of Social Affairs; and staff calculations.

Data according to ESA95.

Data for 1999 represent staff estimate.