I. Introduction
Globalization has been affecting the world progressively, enabling trade to provide greater access to a wider range of products and services to consumers and corporations alike. In most cases, greater choice leads to better choice, which brings better consumer utility in the long run. Nevertheless, the provision of services to consumers has not been as global as theory suggests. This is not due to the theory itself, but the nature of implementation not being universal and the lack of compromise by each country. It is therefore necessary to review the contributions that liberalization of services will have on the economy and how greater welfare gains can be achieved by it. Further, it is necessary to understand the rationale of opposition to trade liberalization by some countries or, more often, lobby groups.
The General Agreement on Trade in Services (GATS) has been the leading force of trade liberalization in services. Freeing trade in services has the potential to bring benefits to the service market's consumers and suppliers. Free trade effectively allows foreign firms to compete in the market with domestic firms by way of specific commitments made by the host country, which prompts competition. However, greater competition makes local service providers feel threatened. This has been a major reason for the opposition towards the World Trade Organization (WTO), and the scepticism towards negotiation with emerging market members.
This article attempts to decipher the implications of GATS in financial services. It explains the schedules of commitments made and the way countries can engage in commitments in financial services. These are critical in understanding how the GATS rules are applied by each member, and whether GATS has been effective.
The so-called ‘prudential carve out’ needs to be addressed in the wider context of financial regulation. The prudential carve out relates to paragraph 2 of the Annex on Financial Services of GATS, which states that members are not prevented from taking measures that are for prudential purposes. Thus, if a regulation is claimed to be of a prudential nature, it will not be subject to the commitments made to GATS. The prudential carve out touches upon the notion of a prudential regulation, and how this can be defined. It also concerns the way in which progressive liberalization can take place in the face of such a clause.
The GATS rules have strong competition policy implications. When a country allows foreign firms to offer goods or services more freely, competition within the sector increases. This would be beneficial from a competition policy point of view, but may not be from a nationalistic stance. Further, the stability of the financial system may become a greater concern than the openness of the financial system at times. This may lead to temporary measures to limit the free flow of trade. This issue needs to be investigated to clarify the theories related to the stability of the financial system and greater competition. Likewise with the effect that paragraph 2 of the Annex on Financial Services, which exempts measures that ensures the integrity and stability of the financial system, on the implementation of GATS.
In this article, the second section describes the impact that GATS has in the financial sector. The third section examines the legal structure of GATS in financial services. The fourth section discusses the nature of prudential regulation and how it is generally interpreted. The fifth section considers the controversial prudential carve out, looking at schedules of some members and the financial stability concern. It concludes with some policy analysis on how this quagmire might be placed in context.
While the need for prudential measures is undisputed, the way in which to define it has proved difficult when financial and capital markets are intertwined. In order to prevent the abuse of the prudential carve out while safeguarding prudential concerns, the use of the ‘recognition’ paragraph in the Annex on Financial Services could become an important step. Through mutual recognition of financial regulations or recognition of prudential standards, the clarity of GATS rules related to financial services could be improved and lead to greater scope of financial liberalization.
II. The Impact of GATS on Financial Services: The Leitmotif of the Liberalization of Financial ServicesFootnote 1
To what extent foreign firms can operate in a certain sector affects the speed at which the financial sector develops. For both emerging and developing countries, opening their financial markets to foreign capital has the possibility of domestic financial institutions being taken over by foreign firms. This may lead to the financial sector being eventually monopolized by foreign capital. In consequence, most countries do not agree to the complete opening of their financial markets, but usually place certain limitations on their liberalization.
The form in which participation of foreign capital is permitted will depend on the benefits that the country perceives it will receive from liberalization. Also, the country will have to take into consideration the competitive effect that liberalization will have. As the possible number of participants in the market increases, there will be greater competitive tension which will equate to a more robust competition policy.
It is imperative that a lively discussion takes place within the country to understand the possible impact and in what form the country would like to achieve a liberalized market. Developed countries tend to demand the opening of markets based on mutual commitments. This is advantageous to countries which already have a developed and liberalized market. Negotiations in financial services have reflected this tendency, with advanced markets making demands for liberalization to developing countries, and developing countries compromising to reach an agreement. This is usually a result of horse trading with the opening of export markets for goods of developing countries.
It becomes essential to understand the benefits of trade liberalization in financial services to comprehend the GATS negotiations. No member is being forced to make specific commitments, but commitments are made for the overall welfare that could be achieved through WTO.
This section considers the general benefits of trade liberalization and those attributable to financial services. The arguments for trade liberalization are generally applicable to finance, although there are additional factors unique to finance as well.
A. Economic Benefits
In general economic theory, the participation of foreign firms in the financial market has multiple beneficial effects and some negative ones. There are a number of barriers and restrictions when a financial institution enters a foreign financial market. Management theory predicts that since foreign firms are not familiar with the customs, information and knowledge of the local market they enter, there will be added information and transaction costs to overcome. This is disadvantageous to foreign firms, and is called the ‘liability of foreignness’.Footnote 2 Thus, local firms have a natural advantage initially.
Despite the difficulties that foreign firms might have in entering a local market, there are potentially great merits from permitting their entrance. This has been widely appreciated for goods,Footnote 3 but not so well for services. Liberalization of financial services would allow foreign financial institutions to participate in the market, improving competition and the efficiency of the market.
Efficiency gains in financial services would be in terms of economies of scale and scope. Economies of scale can be gained by focusing on a specific area, in a number of countries. Fixed costs would become lower, and specialization possible. Economies of scope can be gained when one institution provides services that are cross-sector, capitalizing on their network and resources. Such an institution would be able to better respond to the needs of consumers. Competition from foreign financial institutions that are managed more cost-consciously would bring local institutions to review their management and cost structure. This would result in lower prices and better services for consumers.Footnote 4
Research suggests a relation between market liberalization and economic growthFootnote 5 The improved efficiency of local financial institutions as a result of competition from foreign financial institutions would contribute to the development of the markets. This would in turn enhance the profitability of local financial institutions, and add to economic growth.
Further, efficiency enables the lending cost of financial institutions to be lowered, leading to possible growth.Footnote 6 Often when foreign firms enter the market, it induces foreign capital inflow as well. This adds foreign investment that is a prerequisite for economic growth to a country short of capital.
B. Managerial Expertise
Some of the greatest advantages from market liberalization in services, however, come from the transfer of soft elements, such as information, know-how and technology. In addition, general management, accounting, database processing and corporate governance have the potential to improve with the entrance of foreign financial institutions. These would all be beneficial to the consumer.
The transfer of technology, know-how and personnel would take place, maturing the foundation of the market. This enables local firms to innovate processes and services to cater for the local market and become competitive in their own right.
C. Regulatory Implications
Permitting foreign firms to enter the market is often accompanied by the lowering of entrance requirements and clarification of their contents or vice versa. This is to ensure that all parties are on equal footing, and will be judged on the same criteria. It also corresponds to the specific commitment of GATS: national treatment.Footnote 7 This assists in ruling out arbitrary decisions, encouraging regulatory rules to be better drafted, disclosed and scrutinized.
Foreign firms will enter the market by either establishing a new commercial presence, or purchasing a local business. Either way, clear entry and/or takeover requirements are necessary to determine the appropriate form of market participation.
If liberalization of financial markets is not handled carefully and sequenced, the financial market may become dominated by foreign firms. Often, this does not bode well for national sentiment. The possibility of a sudden outflow of capital in times of shock may also give rise to anti-foreigner sentiments.
However, the threat from foreign firms needs to be viewed in the long run and placed within a larger picture. It can be argued that countries with smaller economies will benefit from open markets as external forces will absorb any major disruption, limiting the systemic risk to the domestic market.Footnote 8 When the host-country economy is either stagnant or in a crisis situation, a foreign financial institution, which has a more diversified portfolio, is said to provide stability to the financial system.Footnote 9
This can be refuted in that when the market is opened and foreign personnel enter the market, the host country may become susceptible to economic difficulties of the home country or the wider international financial market.Footnote 10 Rapid opening of the financial market may have certain repercussions, and therefore appropriate measures need to be considered to limit the negative effect.
Society-wide discussion needs to take place to understand the possible negative and positive effects that liberalization may have on the domestic economy. This is an imperative prerequisite since the initial economic outcome may seem negative. Opening of the market also needs to be carried out in a sequenced manner, for the economy to adjust to changes and to form a consensus on the progress taking place.
Often, the possible impact of liberalization of a market is not well received by the domestic economy. Protectionism can been rife and liberalists have been criticized for sacrificing the local market. However, trade liberalization is not as simple as whether to open or not. Liberalization will take place for any economy that carries out trade. When economies are increasingly globalized, remaining oblivious to trade liberalization is not possible. It is difficult to remain isolated from trade with other countries when all countries depend on trade with other countries for the sale and purchase of goods and services.
If that is the case, perhaps what is required is preparation and planning for a well-coordinated and adjusted liberalization. This would enable countries to reap the maximum benefits of liberalization. If diplomatic negotiations lead to liberalization of markets, it needs to be worked around to accommodate the country as much as possible. For negotiations to provide the benefits to all, negotiations have to be strategically approached.
3. The Framework of the General Agreement on Trade in Services 1994 (GATS)
GATS is the agreement for the liberalization of trade in services and has contributed greatly to the opening of financial markets. GATS has also opened a new avenue for trade liberalization, as advanced economies move away from a manufacturing-based economy to a service-oriented economy. GATS is strongly involved in the regulatory framework of financial services and will continue to be relevant in the development of financial markets.Footnote 11
This section explains the legal framework of GATS and the financial services Annex. It also analyses the schedule of commitments which is the substance of GATS in financial services.
A. GATS and General Obligations
The origin of GATS can be traced to the beginning of the Uruguay Round negotiations in 1986. The agreement itself is contained in the 1994 ‘Agreement Establishing the World Trade Organization’ (the Marrakesh Agreement). GATS constitutes part of the Marrakesh Agreement which is binding on all members.Footnote 12 GATS encompasses all services, excluding ‘services supplied in the exercise of government authority’.Footnote 13
The general obligations in GATS are the most favoured nation (MFN)Footnote 14 clause and the transparency requirement.Footnote 15 MFN requires that Member States must afford the same treatment to all members. The same liberalization policy will apply to all members externally, while domestic or internal institutions may be treated differently. It is a multilateral commitment that is the strength of the WTO.
This does give rise to the possibility of free riders as some Member States may not become involved in negotiations, but take advantage of the liberalization measures agreed. Further, advanced economies will prove much more effective in entering new markets with their greater expertise and capital. There are no special circumstances permitted for the entrance of emerging economies.
However, if a regional trade arrangement is being negotiated, countries may feel the need to give preference to members of this arrangement. This is also the reason that despite having the WTO, many of its members are negotiating regional trade agreements.Footnote 16 Thus, GATS dictates that while the principle is to have MFN applied to all sectors, specific sectors may be exempted from this clause.Footnote 17
GATS requires that law and regulations relevant to liberalization are fair and transparent.Footnote 18 This would entail an annual report to the Council for Trade in Services on alterations in laws and regulations that affect a sector where a commitment has been made.Footnote 19 This is to promote clear rules and reduce the information and transaction costs of entering markets.
B. Specific Commitments of GATS
Specific commitments of GATS are market accessFootnote 20 and national treatment.Footnote 21 These are the main subjects of negotiation in GATS. National treatment requires that the same conditions of competition are applied for both domestic and foreign firms in the market. Market access requires that conditions of market access are stipulated appropriately.Footnote 22
The schedule of commitments lists the obligations to be waived in the form of measures applied to the sector or requirements. It is generally a positive list method, setting out commitments to which the members are obliged. Other commitments that are not part of market access or national treatment are included in the Additional Commitments.Footnote 23
1. Market Access
Article XVI:2 states the types of market access obligations that can be limited by inclusion in the Schedule. This includes:
(a) limitation on the number of services suppliers, whether in the form of numerical quotas, monopolies, exclusive service suppliers or the requirement of an economic needs test;
(b) limitations on the total value of service transactions or assets in the form of numerical quotas or the requirement of an economic needs test;
(c) limitations on the total number of service operations or on the total quantity of service output expressed in terms of designated numerical units in the form of quotas or the requirement of an economic needs test;
(d) limitations on the total number of natural persons that may be employed in a particular service sector or that a service supplier may employ and who are necessary for, and directly related to, the supply of a specific service in the form of numerical quotas or the requirement of an economic needs test;
(e) measures which restrict specific types of legal entity or joint venture through which a service supplier may supply a service; and
(f) limitations on the participation of foreign capital in terms of a maximum percentage limit on foreign shareholding or the total value of individual or aggregate foreign investment.Footnote 24
The various restrictions on numerical quotas and economic needs test are required to ensure that the judgment on the issuance of bank licences and/or other decisions cannot be based on an economic needs test. It must be a result of whether the financial institution has fulfilled the preordained criteria for entry, for example, based on minimum capital requirements. Members can state the number of licences they respectively issue annually or the number of expatriates they will permit per year, per se.
Nevertheless, there are limitations to applying such an obligation. A country may not make explicit the number of licences it will issue, but may have such a policy implicitly. The adverse effect of such an implicit policy could be more damaging than an explicit restriction. The country may not admit to having such a policy, thus limiting the avenues to discuss discrepancy from GATS.
In relation to market access, Article VI provides rules on domestic regulation stating the manner in which domestic regulation can be subscribed. Technical and service sectors are often required to maintain specific high standards for both technical and safety reasons, which affect market access. Thus, Article VI will influence the drafting of market access commitments. On the other hand, Article VI raises the possibility of converging regulatory standards through procedural requirements to ensure transparency.Footnote 25
2. Mode of Supply
The focus of the General Agreement on Trade and Tariffs (GATT, the former body of WTO) was trade in goods. This was more straight-forward than trade in services in that only one mode of supply was possible: cross-border trade. However, trade in services is dramatically different in this respect, in that supply can be envisaged in four modes:Footnote 26
(a) Mode 1 (Cross-border trade);
(b) Mode 2 (Consumption aboard);
(c) Mode 3 (Commercial presence); and
(d) Mode 4 (Presence of natural persons).
Currently, the main mode being negotiated and subject to commitment is mode 3. This is the main mode whereby members are willing to receive supply of financial services from abroad. It is the most common and easy in which to track form of supply. Thus, modes other than mode 3 were not significant during the Uruguay Round negotiations. However, it is likely that the importance of different modes will become varied, as technological advance and availability of communication modes make the possibility of supply by other modes more realistic and commercially viable. This will have an effect on the negotiations of the Doha Round. It is possible that negotiations will focus more on liberalizing mode 1 and 2 supplies.
C. Financial Services in GATS
Negotiations in the Uruguay Round for financial services were not smooth from the outset. The liberalization of the financial sector has caused controversy as a result of the financial strength of financial institutions of advanced economies.Footnote 27 For example, banks taking advantage of a domestic market relatively closed and limited in competitionFootnote 28 may oppose liberalization, while the possibility of cheaper capital may gain wider industry consensus in this respect (but perhaps not necessarily the same reaction for the liberalization of their own industry). Further, finance is close to sovereignty.Footnote 29 This complicates matters, with strong sentiments expressed to the liberalization of financial services as a result.
Financial services negotiations were hampered by members' prudential and regulatory concerns. Members differ in their approach to the structure of the financial system, which will affect their outlook on the regulatory structure.Footnote 30 Approaches to financial liberalization will also play a part as well. The experience of financial crises by many countries in the 1980s and 1990s had also made many members hesitant toward financial liberalization from a financial stability perspective.Footnote 31 This required compromises on how far liberalization would impinge on their regulatory system.
1. Fifth Protocol to GATSFootnote 32
Although the Uruguay Round was concluded in April 1994, agreement could not be reached in financial services until December 1997. In July 1995, 95 members had accepted the interim agreement and schedules on market access and national treatment. However, this was only an interim agreement, and further liberalization was institutionally required in GATS.Footnote 33 Unless progressive liberalization takes place in subsequent agreements, the agreement does not fully comply with GATS.Footnote 34 By December 1997, a final agreement was reached which is the Fifth Protocol to GATS. Seventy members improved their commitments from 1995, and 32 members maintained their 1995 agreement.Footnote 35 It became effective on 1 March 1999.
The Fifth Protocol cover note itself does not hold much substance, but refers to the schedule of commitments in financial services. The schedule of commitments that specify the liberalization measures have paramount significance to financial services.
2. Annex on Financial Services of GATS
Besides the main GATS articles being applicable to financial services, financial services has an Annex (on Financial Services), which lists the services that are subject to GATS, and a Second Annex on Financial Services, which set out the conditions for exemption.
Paragraph 5 of the Annex on Financial Services lists the financial services subject to GATS. However, the most significant clause in GATS related to financial services is paragraph 2 of the Annex. Under the subtitle Domestic Regulation, it is the most controversial clause of GATS in financial services which is called the ‘prudential carve out’. To recap the paragraph:
(a) Notwithstanding any other provisions of the Agreement, a Member shall not be prevented from taking measures for prudential reasons, including for the protection of investors, depositors, policy holders or persons to whom a fiduciary duty is owed by a financial service supplier, or to ensure the integrity and stability of the financial system. Where such measures do not conform with the provisions of the Agreement, they shall not be used as a means of avoiding the Member's commitments or obligations under the Agreement.
Article VI:1 of the main body of GATS on domestic regulation,Footnote 36 requires that ‘all measures of general application affecting trade in services are administered in a reasonable, objective and impartial manner’. Article VI:4 states that where there are ‘qualification requirements and procedures, technical standards and licensing requirements do not constitute unnecessary barriers to trade in services …’. Further criteria of regulations are:Footnote 37
(a) based on objective and transparent criteria, such as competence and the ability to supply the service;
(b) not more burdensome than necessary to ensure the quality of the service; …
While the main body of GATS requires that domestic regulation is ‘fair and objective’ with qualitative, not quantitative, requirements,Footnote 38 financial services can be exempted from such GATS provisions. For such exceptions, the regulation must be for prudential or investor protection purposes.Footnote 39 Generally, GATS requires that how ‘necessary’ a measure is must be proved for an exception to be applicable. This is not required for financial services to implement a prudential measure.Footnote 40
When a member is exposed to serious balance of payment and external financial difficulties or a threat of it, the member may adopt or maintain restrictions on trade in services even when specific commitments have been made.Footnote 41 Nevertheless, the restrictions need to be consistent with the International Monetary Fund's (IMF) Articles of Agreement. While capital account restrictions may take place, current account transactions cannot be restricted.Footnote 42 All restrictions need to be promptly notified to the General Council of the Council of Trade in Services.Footnote 43
3. Understanding on Commitments in Financial Services
While not a formal part of GATS, members agreed on the Understanding on Commitments in Financial Services (Understanding); this provides to a certain degree a formula method for financial services commitments. The Understanding is in fact a model schedule of commitments, thus providing members with the possibility of using it to undertake their commitments.Footnote 44
Since it is a model commitment, the contents positively promote liberalization, and go beyond measures that many members were willing to take. Most OECD members did adopt the Understanding in their schedule. It is included by the members, stating in the header of their respective schedules of commitments for financial services that it is part of the schedule.
The Understanding is not legally binding as it is not part of GATS or any other international agreement. By referring to the Understanding in their schedule, it is given the legal effect necessary to become part of the schedule and thus becomes legally binding on them.
Members have applied the Understanding as part of their schedule in quite different ways. Some simply refer to it, while others spell the entire document out in their schedule or its additional commitments. This reflects the divergence in drafting of this international agreement.Footnote 45
4. Other Relevant Clauses
While the prudential carve out is one of the most effective clauses in GATS allowing members to be exempt from GATS, there are a number of other exception clauses for particular reasons.
(a) Universal service
It is possible for a member, especially a developing country member, to earmark financial services as a universal service. A universal service obligation is when the provision of a specific service is required to be universal to all citizens due to the basic lack of it hitherto for the purpose of national or social policy.Footnote 46 The issue has been widely discussed in relation to telecommunications and postal services, and a reference paperFootnote 47 has been written on the subject by GATS' negotiating group of telecommunications.Footnote 48
If a member's financial services are not well developed, and access to financial services is limited, this will have an impact on the member's growth potential. Since the obligation has not been explicitly codified, it has not been applied to financial services. Nevertheless, when a member considers access to financial services by low-income households and rural, agricultural societies to be limited, they may contemplate applying the universal service obligation.
Universal service obligations may conform to a national treatment, with both domestic and foreign institutions having to comply. A universal service obligation would be a market access issue.Footnote 49
(b) Safeguards for balance of payment difficulties
Members are allowed to make temporary restrictions in times of balance of payment or external financial difficulties. This includes imposing trade restrictions on areas to which it has made specific commitments.Footnote 50 Article XII has the effect of acting as a safeguard against capital movements that would further harm the balance of payment or foreign reserves of a member.
Such trade restrictions would be applicable indiscriminately to all members,Footnote 51 in accordance with the IMF's Articles of Agreement.Footnote 52 The restrictions should remain temporary,Footnote 53 and avoid unnecessary damage to the commercial, economic and financial interests of any other member.Footnote 54 In other words, a limited amount of damage is foreseen as a result of the temporary measures, and these would not be subject to a damage claim by the member unless it is proven to exceed foreseen damage. Proving such terms would be extremely difficult as it exceeds material damage, which would be the usual prerequisite for damages to be claimed. But how far beyond material damages would qualify as unnecessary damage is unclear.
Article XII has yet to be applied, although the mirroring article for goods in Article XII of the General Agreement on Trade and Tariffs (GATT) 1994 has often been used by members. GATT Article XII is probably applied due to most members' economies relying heavily on trade in goods rather than trade in services.Footnote 55
To adopt such temporary restrictions would require prompt notification to the General Council of WTO.Footnote 56 This is delegated to the Committee on Balance-of-Payment Restrictions.
D. The Schedule of Commitments in Financial Services of GATS
Part III of GATSFootnote 57 requires that specific commitments be made by members in relation to market access and national treatment. Schedules of commitments state the specific condition of market access and national treatment that members grant for each sector.
1. Structure of Schedule of Commitments
As discussed in section A, general obligations of GATS are basically non-negotiable so they are not included in the schedule of commitments. On the other hand, specific obligations are subject to negotiation and then listed in the schedule of each member. Part III and Part IV of GATS need to be read together to understand the way in which a schedule of commitments is drafted,Footnote 58 its contentsFootnote 59 and its modification.Footnote 60 The schedule of commitments is an important legal document in that it provides the particulars of market liberalization for each member, and is the final product of negotiations between members.
Progressive liberalization is an objective of GATS as set out in Part IV. This is achieved by amending and modifying the schedule to allow greater liberalization in successive rounds.Footnote 61 These clauses prevent members from taking measures that are regressive or trying to retain the status quo. Members must endeavour to improve commitments from the 1995 financial services agreement, making their 1995 schedules a minimum requirement for future negotiations.
As discussed in section B.1, the article on market access prevents members from making commitments that are based on an economic needs test.Footnote 62 This is a negative list, in that commitments must be made to conform to the requirements in Article XVI. Commitments that do not come under the ambit of market access and national treatment can also be negotiated and included in the schedule as additional commitments.Footnote 63
The specifics of what should be specified in the schedule are laid out in article XX. This articulates the commitments, together with article XVI. Each schedule should articulate:Footnote 64
(a) terms, limitations and conditions on market access;
(b) conditions and qualifications on national treatment;
(c) undertakings relating to additional commitments;
(d) where appropriate, the time-frame for implementation of such commitments; and
(e) the date of entry into force of such commitments.
It is envisaged that these items will be included in the schedule, with further instructions on the structure of the schedule.Footnote 65 It is also noted that the schedule of commitments is an integral part of GATS.Footnote 66
2. The Implication of Members' Schedules
The structure of members' schedules will be affected by the internal structure of the country. Due to the USA's federal structure and its state laws, it became necessary for the USA to list all the state laws that differ from the basic agreement negotiated. Insurance regulation in the USA is conducted by state insurance regulators and there is no federal agency responsible for insurance regulation. Thus, in its Additional Commitments, the USA notes that the National Association of Insurance Commissioners is promoting harmonization of state insurance regulation.Footnote 67 This is a result of negotiations with Japan, but if the USA were to harmonize insurance regulation, it would result in significant liberalization measures in terms of GATS. The current structure of insurance regulation in the US is complex and vertically segregated by state. This does hamper foreign firms from entering the US market.
Part IV of GATS requires liberalization to be progressive and this is to be achieved through successive rounds agreeing on greater liberalization. However, the experience in financial services has not been smooth; it has been unable to agree on the Fifth Protocol at the end of the Uruguay Round and has had to extend the deadline to accommodate an agreement.
The progress to date that has been made in the Doha Round that started in November 2001 further indicates the difficulty of depending on negotiation rounds to move forward. In terms of financial services, there remain some countries that have yet to ratify the Fifth Protocol due to domestic constraints.Footnote 68 While much progress has been made with the accession of new members, there remain barriers to the speed of liberalization of pre-existing members.Footnote 69
On the other hand, some members have made extensive commitments in their schedule. Indonesia's schedule on financial services states that ‘[a]ll Market Access and National Treatment limitation specified in the banking subsector will be eliminated by the year 2020 subject to similar commitment by other members’.Footnote 70 This commitment is in the context of negotiations, as the timing given is a far date and the contents abstract, but more the result of Indonesia's commitment to financial liberalization. It has been said that this commitment was related to ASEAN's 30th anniversary. ASEAN Vision 2020Footnote 71 was declared for this occasion, which sets the stone for ASEAN to further integrate and turn into developed nations in a cooperative manner through economic development. As part of this endeavour, Indonesia has committed itself to possible liberalization by 2020. However, this is not an ASEAN-wide commitment, as other ASEAN members have not included this commitment in their schedule.
The EU as a regional community also has a unique approach to GATS. They negotiate as a single entity and list the divergence of each Member State in their schedule. Generally, a member of GATS will make horizontal commitment in services, with sector-specific commitments following. Mode 3, commercial presence, is the mode whereby liberalization has been given priority.Footnote 72 However, the EU claims that horizontal commitments are being abused and particularly affecting the financial services sector by:Footnote 73
(a) Unspecified authorisation requirements;
(b) Economic needs tests;
(c) Certain limitations on the purchase or rental of real estate;
(d) Restrictions on equity holdings;
(e) Nationality requirements;
(f) Certain tax and subsidy measures, etc.
The Uruguay Round focused on the commitments in market access and national treatment in mode 3. More specifically, mode 3 was the mode in which agreement to liberalization could have been achieved at that time in financial services.Footnote 74 Other modes were either not pragmatic in terms of actual business practice, or were subject to hesitation from regulators.Footnote 75
Mode 3 occurs when suppliers of service establish a place of business overseas. Commercial presence in GATS is defined as ‘any type of business or professional establishment, including … juridical person, or … the creation or maintenance of a branch or a representative office’.Footnote 76 The Understanding defines commercial presence as ‘wholly- or partly-owned subsidiaries, joint ventures, partnerships, sole proprietorships, franchising operations, branches, agencies, representative offices or other organisations’.Footnote 77 The Understanding is more comprehensive in the definition, allowing foreign parties to enter a market in more diverse or capital light forms.
The EU insists that commercial presence should be permitted in the legal form of members' choice.Footnote 78 Generally, establishment via local incorporation is more costly than branching. Local incorporation frequently requires higher minimum capital, and regulatory monitoring would be stricter. The local incorporation will need to meet the various regulatory requirements on a single-entity basis rather than on a group basis. In many Asian countries, foreign financial institutions are required to gain licences as a local incorporation. Otherwise, their operational scope is limited and not subject to the local safety nets that are available.Footnote 79 Japan lists in its schedule that it ‘shall not be prevented from taking measures such as non-discriminatory limitations on juridical forms of a commercial presence’.Footnote 80
It is becoming increasingly difficult to distinguish between mode 1 and 2 in financial services as the internet enables cross-border trade to be indistinguishable from consumption abroad. The Committee on Trade in Financial Services has been discussing this issue and will continue to do so.Footnote 81 The protection to consumers will be different for the different modes. In most cases, consumer protection and safety-net measures are not provided to cross-border transactions. While some members request that the definition of modes 1 and 2 be clarified, others consider the difference insignificant as liberalization has taken place without such classification.Footnote 82 Mode 1 causes greater concern to regulators as the identification of the service provider is more difficult via cross-border trade than mode 2 or 3. The uncertainty expressed by regulators is related to the challenge mode 1 poses to bank supervision.Footnote 83
The movement of natural persons, mode 4, is sometimes limited by a member's schedule by way of listing the proportion/number of board members that need to be from the member's nationality. Employing local staff to be general members of staff is not difficult. Only if the local market lacks expertise in the respective sector will it act as a restriction to entry. Filling management posts and jobs requiring high skills will be more difficult with such a limitation.
From the standpoint of facilitating the transfer of knowledge and know-how to developing countries, and to make the commitment acceptable nationally, however, it may be necessary to accept some nationality requirement.
IV. The Concept of Prudential Regulation
Generally, financial regulation can be classified into prudential and systemic regulation. The division is not clear cut, with some regulatory methods belonging to both. But the objective of regulations will usually fall into either or both objectives.
Systemic regulation is concerned with the safety and soundness of the overall financial system. Prudential regulation is to safeguard the safety and soundness of individual financial institutions for the purpose of protecting consumers.Footnote 84
Prudential regulation occurs mainly from information asymmetry, which inhibits consumers from being able to make a valid assessment of the financial institution's financial condition. Financial institutions have a general fiduciary duty to consumers, requiring them to act with duty of care.Footnote 85 As the value of the contract can only be determined after the conclusion of the transaction, there is the possibility of receiving compensation from deposit insurance or investor protection funds. This would require due care to be taken by the authorities to prevent any unnecessary depletion of the funds.
A. Methods of Prudential Regulation
The Basel Committee's Basel Core PrinciplesFootnote 86 provide a comprehensive list of prudential regulations, but widely used methods of prudential regulation are minimum capital requirements, capital adequacy ratio, legal lending limits or large exposure limits, and fit and proper requirements of management.
1. Minimum capital requirement
The minimum capital requirement becomes significant when the required legal entity of a financial institution requires extra capital to be registered upfront. This is especially prominent for foreign financial institutions as the legal requirements for establishment will be specified. The minimum capital requirement may be higher for foreign firms, given their lack of trust in the local market and influence from headquarters.
2. Capital adequacy ratio (CAR)
Capital adequacy ratio is one of the most widely applied and cited methods of prudential regulation. Capital adequacy ratio was standardized by the Basel Committee on Banking Supervision (Basel Committee) in 1988.Footnote 87 The so-called Capital Accord agreed that internationally active banks maintain a minimum 8 per cent of their assets in capital. The Capital Accord was first published as a result of increasing pressure to create a ‘level playing field’ for financial institutions competing in the global markets.Footnote 88
Initially, capital adequacy ratio was developed from the USA's CAMEL banking supervisory system. CAMEL is an acronym for Capital adequacy, Asset quality, Management, Earnings and LiquidityFootnote 89, the items it comprises. CAMEL was designed to enhance the objectivity of bank supervision, using these items to calculate a numerical index. While the supervisory method of each country is different, the items subject to monitoring would be more or less similar with CAMEL. Capital adequacy ratio is one of the main components of CAMEL.
Capital adequacy ratio has become the standard method of defining the strength of a financial institution. Capital acts as a cushion to absorb losses from credit risk. Capital adequacy is based on the concept that banks should have a certain amount of capital against their assets (loans). Financial regulators will often implement structural early intervention based on the CAR of financial institutions.Footnote 90
Capital adequacy ratio is not a perfect tool for determining a bank's solvency. However, it provides objectivity to regulation.
3. Legal Lending Limit (LLL)
The legal lending limit is applied to limit the lending of a financial institution to single or connected parties. When the legal lending limit is not fully complied with, the lack of diversification in its investment portfolio may result in financial difficulties when an external shock is perceived.
The lack of legal lending limit standards and/or the non-compliance with the legal lending limit is considered one of main problems which exacerbated the Asian financial crises. Banks were lending heavily to corporates which were linked by family or political connections. Legal lending limits are being gradually brought to the level of 10–25 per cent of bank capital.Footnote 91
4. Fit and Proper Requirement
The ‘fit and proper’ test usually requires that management and the board of directors are vetted to ensure that they do not have past experience of badly managing a financial institution or are not persons with criminal records. The experience and integrity of the CEO are often examined to ensure that only competent professionals are allowed to manage banks.Footnote 92
Basle Committee's ‘Core Principles for Effective Supervision’ state this in the licensing principle (‘an assessment of the banking organisation's … directors and senior management’).Footnote 93 This is further elaborated as:
… an evaluation of the competence, integrity and qualifications of proposed management, including the board of directors. The licensing agency should obtain the necessary information about the proposed directors and senior managers to consider individually and collectively their banking experience, other business experience, personal integrity and relevant skill. This evaluation of management should involve background checks on whether previous activities, including regulatory or judicial judgements, raise doubts concerning their competence, sound judgement, or honesty. It is critical that the bank's proposed management team includes a substantial number of individuals with a proven track record in banking.
B. Changing Methodology of Prudential Regulation
With the increasing complexity of financial transactions, conglomeration of financial institutions and globalization of business, the need for a regulatory structure that is robust but flexible has become stronger. Further, as economies mature and are liberalized, the scope for the regulatory authority to use discretion is becoming limited. With foreign parties entering the market, it becomes difficult to justify the use of discretionary policy decisions which lack clarity.
This has lead to many markets promoting the use of principle-based financial regulation. The principle of regulations is provided to financial institutions, and financial institutions can apply them to their operations.
Principle-based regulation requires financial institutions to manage their risk profile appropriately. The use of market discipline is also an important development in terms of regulatory methods. The Basel Committee's proposal on an updated Capital Accord, Basel II,Footnote 94 includes market discipline as a core element. Basel II includes methods for disclosure of greater qualitative and quantitative information to raise awareness among, and information for stakeholders.Footnote 95 This enables the market and investors to make qualified evaluations of the financial institutions. It acts as a counterweight to increased discretion accorded to banks in estimating their capital requirement.
All such methods are designed to take advantage of competition and the market's capacity to distribute resources according to supply and demand. There are mainly four methods being used for prudential regulation in recent years.
The principle-based method sets out the principles of regulation, allowing flexibility towards new products and systems. It aims to promote innovation of financial institutions through greater freedom of management. This enhances financial institutions' ability to make improvements on management, risk control and compliance, without being hampered by regulatory barriers. A more flexible approach to new products and transactions is also an important part of this approach.Footnote 96
The risk-based method expects each financial institution to better grasp the risk of their assets, improving their risk-management capacity. This would enable financial institutions to understand their various risks faster and more accurately. It is closely related to the subsequent market discipline.
Market discipline envisages that stakeholders of the financial institution will monitor the financial institution. If issues that the stakeholder feels problematic are not resolved quickly, the stakeholder may decide to withdraw his investment, or sell the shares of the financial institution. This is a real threat to the financial institution, as it may lead to insolvency if they are withdrawn quickly enough.Footnote 97
The self-regulation method is imposed when an industry group agrees to a code of conduct on marketing, sales and other aspects of business and monitors compliance and penalizes non-compliance. A stock exchange is the typical self-regulatory body, with the stock exchange imposing rules on members listing and trading on the exchange. Self-regulation is considered to be complementary to principle-based regulation, shaping the specifics of regulation.Footnote 98
Penalties have been used by way of imposing sanctions against wrongdoing of financial institutions, in tandem with greater personal liability of the management. Both of these moves are to impose greater self-discipline on financial institutions' activity and to limit the desire to make illegal or inappropriate transactions. This heightens the reputational risk of financial institutions taking such actions.
Principle-based regulation is often considered to be counter to rule-based regulation. However, this is not an accurate description of rule-based regulation. Rule-based regulation prescribes detailed rules related to the operational scope and activity of financial institutions. This enables financial institutions to understand the regulatory approach, to restrict the discretion of regulators, and to improve the foreseeability of financial regulation.
The USA is often cited as applying rule-based regulation and the UK as adopting principle-based regulation. Nevertheless, the distinction is not clear, with most combining the two methods. While most advanced economies have adopted principle-based regulation, the reality is that most will also have detailed rules. The UK is a good example, since although the Financial Services Authority has pledged the use of principle-based regulation, in fact it has a prudential rule book that exceeds 8,500 pages.Footnote 99 Japan also combines principle-based regulation with rule-based regulation.Footnote 100 Because rule-based regulation establishes detailed rules upfront, the rules are considered to be clear and fair. Thus, many financial regulators are trying to strike the right balance of combining principle-based and rule-based regulation.
Many of the regulatory approaches mentioned above have been incorporated into the conception of Basel II. One of the main objectives of Basel II is the use of a financial institution's risk-management system for calibrating CAR (Basel II, Pillar I). The second pillar requires supervisory capacity to be able to evaluate the risk-management systems of financial institutions. To enhance market discipline, the third pillar encourages information disclosure.
The substance of prudential regulation may evolve to include some of the methods listed above. The need for principle-based regulation and the conception of Basel II indicate the need for financial regulation to be flexible and timely. This will also reflect on the formulation of prudential regulations.
C. The Process of Compliance with Basel II
While not essential for understanding prudential regulation, to highlight the effect Basel II may have on GATS, this section will analyse the process by which Basel II has come to be recognized as the primary source of prudential regulation in recent years. This could provide insight into how GATS may effectively proceed in the field of financial services.
As explained above, the Basel Committee was formed to agree on standards of financial regulation and supervision that could be used in an increasingly globalized market place. The standards are not formal agreements and are not in any way legally binding.
The Basel Committee did not set out to be a standard-setting body. The Basel Committee on Banking Supervision was initially comprised of central bank governors of the G10 countries. It was established after the failure of the Bankhaus Herstatt in West Germany in 1974.Footnote 101 Essentially, it was an informal group considering measures to improve bank supervision. The Capital Accord of 1988 was agreed to create a ‘level playing field’ between the different markets.Footnote 102 It sought to maintain a low profile, but with financial stability becoming a global concern, the activities of the Basel Committee are now one of the main focal points for bank regulators and bankers worldwide.
There are many theories as to why the Basel Committee's standards have been accepted so widely as an international standard. Transnational legal procedure theory provides an insight into how the process has been brought prominence by the cooperative effect of international law, instead of the enforcement effect.Footnote 103
The other cornerstone would be the international regime theory. The strength of the regime theory results from the regime's authoritative decision on what law is or from the acceptance of norm-related practices by the regime. This can be achieved by ‘internalizing’ norms into the regime by gaining systemic validity.Footnote 104
The strength of the Basel Committee has been the technical nature of the agreements. The standards are more technical than political, defusing political interference. The participants are more technocrats than bureaucrats, enabling substantial discussions. Further, transnational and regime theory agree that the continuous relationship and meetings enhancing the need for participants to cooperate in the process.
Since the Basel Committee's standards are just that, there is no obligation to implement them domestically. As members of a group/club, it is understandable why the members of the Basel Committee apply them. The interesting aspect of the Basel Committee has been their implementation more widely, and its eventual status as an international standard. The threat of domestic financial institutions not being able to operate in foreign markets as a result of non-compliance is a strong incentive for regulators to apply and financial institutions to comply with Basel standards. The reciprocity that Basel entails has been a major incentive for regulators worldwide implementing the standards.
The prestige that application of Basel Committee's standards brings is considerable. The fact that they are technical does assist in causing less controversy. The reputation of a financial market and its participants is raised if Basel Committee standards are adopted. This would mainly apply for the Capital Accord, but is also associated with the other agreements.
The other aspect would be the effect of the International Monetary Fund's (IMF) structural adjustment programmes on the application of the Capital Accord. If a country faces balance of payment or foreign exchange difficulties, the IMF can be tapped into to make emergency loans. In exchange, the country will draw up a Letter of Intent, setting out the policy measure it will follow to ensure repayment of loans. While the Letter of Intent is usually signed by the finance, economic or even the head of State, it has been contended that in many instances the IMF staff have in fact drafted the Letter of Intent or they have been edited by the IMF before being published.Footnote 105
The issue is whether the direction of the policy statement has been altered. Due to the nature of IMF lending, the Letter of Intent becomes the ‘conditionality’ of the IMF's loans.Footnote 106 The Letter of Intent may be altered to include standards such as the Basel standards to safeguard the resources of the IMF. As a result, countries may feel forced to adopt the ‘Washington Consensus’Footnote 107 to relieve their immediate financial distress. The Washington Consensus requires application of more transparent measures and opening markets to foreign parties, and typically includes a certain capital adequacy ratio to be reached by financial institutions. There could also be suggestions to follow other Basel Committee principles on bank supervision.
The application of capital adequacy ratio is accompanied by prestige due to the connotation of financial stability. This is perhaps the strongest rationale for many countries to implement the Capital Accord. These reasons underlie the widespread use of Basel agreements worldwide and its standing as a standard prudential regulation.
V. The Prudential Carve Out
Financial services stand out in the services sector. There is the Committee on Trade in Financial Services, which is the only sector-specific committee, as all other committee analyse horizontally. Financial services negotiators also provided the Understanding, which is a unique product to financial services.Footnote 108
Nevertheless, what is most discussed of the financial services agreement is the prudential carve out. Given the uniqueness of financial services, it was agreed that prudential consideration would be given for financial regulation, and was thus included in the Annex on Financial Services of GATS.Footnote 109
A. The Present State of the Prudential Carve Out
Section 2(a) of the Annex on Financial Services, in effect, allows members to apply regulatory measures that do not comply with their specific commitments. Whether the measure is in fact prudential in nature or not, becomes irrelevant in the current legal structure. The WTO can use the dispute settlement mechanism to interpret the prudential requirement but there is no indication that this will take place. The paragraph permits, theoretically, members to take measures that are applied in the name of prudential concern.
Although most members will act in good faith and not apply measures that would clearly and grossly exceed a prudential concern, the central issue is what constitutes ‘prudential’ has hitherto not been defined or agreed by members.
The lack of discussion and hence an agreement on the substance of prudential regulation confuses the implementation of GATS in financial services and can lead to dismissal of the meaningful dialogue on schedules. It also leaves the impression that financial liberalization may be subject to the discretion of members.
The Annex on Financial Services does not exclude the possibility that members may recognize, on a bilateral or even multilateral basis, prudential measures and how the measures should be applied in financial services.Footnote 110 While the EU has proposed the use of international standards from standard-setting bodies such as the Basel Committee, the International Organization of Securities Commissions (IOSCO) and the International Association of Insurance Supervisors (IAIS) to supplement the notion of prudential regulation,Footnote 111 other members argue that transparency of the regulatory structure is paramount.Footnote 112 Members that are not part of the standard-setting process are reluctant to accept these as prudential regulation.Footnote 113 Members such as Malaysia have strongly opposed the use of standards that ‘were voluntary by nature’ to be applied for the interpretation of the ‘prudential carve-out’.Footnote 114 Thus, the discussion on the definition or interpretation of the ‘prudential carve-out’ has been repeatedly avoided by members, and instead the imperativeness of strengthened transparency of the prudential measures is being emphasized.Footnote 115
In the general GATS context, members are permitted to take measures that are:Footnote 116
(a) necessary to protect public morals or to maintain public order;
…
(c) necessary to secure compliance with laws or regulation which are not inconsistent with the provisions of this Agreement including those related to:
…
(iii) safety[.]
From the text of the articles, for a measure to be subject to the general exemption from commitments in the interest of safety and public order, the measure needs to be proved to be ‘necessary’.Footnote 117
Nevertheless, the Annex on Financial Services does not require a regulatory measure to be proved ‘necessary’ to be deemed ‘prudential’.Footnote 118 Theoretically, whether a regulatory measure is prudential or not could be an issue raised in the dispute settlement system of the WTO.
The paragraph on recognition of prudential measures in the Annex on Financial Services is aimed to promote mutual recognition of prudential regulations.Footnote 119 However, even if a prudential measure were recognized, if it contravenes GATS statutes it cannot be used as a means for avoiding compliance with commitments.Footnote 120
B. Analysis of the Prudential Outlook
The difficulty of the prudential carve out is that while the uncertainty caused by its text is clear, there has not been any indication or the urgent need to revise it. It is unlikely and unrealistic to presume that it will be brought to the dispute settlement system of the WTO for interpretation. The community of international financial regulators is close-knit, and such a confrontational approach does not seem likely. This also conforms to the transnational legal process and regime theories.
However, the matter of defining prudential regulation does become imperative within this context. Because of the lack of a definition to the substance of prudential regulation, monitoring compliance with GATS in financial services has proved difficult. It is possible that members abuse the prudential carve out to apply entry barriers that do not comply with the criteria of commitments. Nevertheless, there is not an effective enough benchmark to counter such arguments at this stage.
Another development that may have an impact on the prudential carve out is the emerging cooperative networks among some of the advanced economy members. The USA and EU have been seeking to reach accords in the field of securities regulation to mutually recognize their regulation. This has been laid out in the ‘Framework for Advancing Transatlantic Economic Integration Between the United States of America and the European Union’.Footnote 121 In this press statement, of the various measures that are scheduled to be taken between the US and EU to further economic integration of the two economies is the ‘mutual recognition in the fields of securities regulation’ and ‘increase cooperation between EU and US financial regulators’.Footnote 122
If such an agreement were agreed and spread more widely, the need to define prudential regulation may become unnecessary. Instead, the ‘Recognition’ clause of prudential measures could be applied.Footnote 123 The case of the EU and the US is compelling, as the result of various international standards negotiations, they are able to share a high degree of mutual understanding of their financial systems and regulations. This has brought their understanding of prudential measures closer as well. If they are able to mutually recognize their prudential measures as effective and efficient means, they are in effect endorsing the adequacy of prudential measures.
Such an agreement could lead to a wider circle of mutually recognized prudential measures, enabling more effective implementation and monitoring of the prudential carve out.
While the contents of such an agreement have not been negotiated by the US and EU regulators yet, a blueprint for a possible agreement has been proposed.Footnote 124 This article was written by the Director of International Affairs of the US Securities and Exchange Commission (SEC) and its senior counsel. While it is not an official view, it presents some of the thinking of the SEC on the direction of securities regulation of cross-border transactions.
The EU has had extensive experience with mutual recognition of its Member States' financial regulation as a result of its banking passport. The arrangement allows credit institutions authorized in an EU Member State to establish branches in another Member State subject only to home-country prudential supervision.Footnote 125 The Consolidated Banking DirectiveFootnote 126 sets out the minimum requirements regarding prudential regulation and supervision of banks.Footnote 127 Other directives establish rules for prudential concerns as well.Footnote 128 The EU has methods and experience in inducing cooperation on a cross-border basis on prudential recognition.
The US, on the other hand, has tended to guard its sovereign rights over prudential regulation, reluctant to accept prudential regulations of other countries.Footnote 129 This has perhaps been a result of the size and depth of its markets, and the comprehensiveness of its regulatory system. When contemplating the status of the financial system within the economy, it is easy to understand the reason why countries are reluctant to delegate the determination of their respective contents to others. Prudential regulation has often been considered a sacred sovereign right of the nation.Footnote 130
However, this tide has been changing in recent years. London's financial and capital markets have been attracting international attention with its willingness to offer a competitive environment to overseas players and its competitiveness.Footnote 131 US markets are increasingly realizing the need to enable US investors to invest in the overseas market safely and vice versa through better mechanisms.
This backdrop affects the way in which financial regulators are approaching regulation in times of greater cross-border trade. The blueprint points out that while borders for financial transactions have blurred for market participants, ‘[borders] are proving as sharp as ever where market regulation is concerned’.Footnote 132
The blueprint proposes methods in which foreign stock exchanges and foreign broker-dealers will rely on substituted compliance of a partner country's regulations. This would allow foreign institutions to access the US markets without registering with SEC. The substitute compliance would be based on the counterpart country providing comparable foreign securities laws and regulation, and supervision by a foreign securities regulator, with oversight powers and ‘regulatory and enforcement philosophy substantively similar to the SEC's’.Footnote 133
This sets out the standard required by the US for prudential recognition to take place. There would need to be, not only substantive similarities of securities regulation, but also closeness of enforcement philosophy. This would require mutual recognition to be based on the same outlook to securities regulation, as well as ongoing coordination to ensure that the policy direction is similar.
While the article highlights prominently the proliferation of financial scandals as the reason for such cross-border prudential recognition, the reality of financial transactions taking place has lead leading financial markets to seek better regulatory mechanisms.
As witnessed by the prudential carve out of GATS, there is a need for countries to be able to assert their sovereign right of prudential regulation while achieving greater financial liberalization. However, on a more pragmatic basis, resolving this issue is essential for GATS to be able to achieve progressive liberalization and greater economic wealth for all members of WTO. The EU–US agreement on deepening mutual recognition of securities regulation is viewed as a tentative step towards achieving prudential recognition.
While the intention to link substituted compliance with GATS is not mentioned, the de facto result is likely to be similar to mutual recognition of prudential standards. It would be beneficial if this could be extended to banking and insurance, where the consumer is likely to benefit most from greater liberalization. It is also a sign of growing regulatory harmonization among countries to a point where it has become possible to consider such endeavours to take place. It is hoped that this can be replicated for a wider range of financial services and to developing countries and/or emerging markets.
It should be noted that countries are likely to be more reluctant to pursue prudential recognition for banking regulation or insurance regulation than for securities. Banking and insurance both involve consumers on a more fundamental level, and especially banking is seen as an essential channel of economic development in many countries.Footnote 134
The EU experience provides insight and encouragement that a meaningful solution can be reached. The notion that a country can limit its prudential endeavours to internal consideration is unrealistic, unless it is a closed economy. Capital movements and financial transactions will affect the way an economy is run and without appropriate prudential standards, the country will be subject to capital flight and contagion of financial difficulty. The EU Member States transfer their sovereignty voluntarily which is the foundation for their sovereignty being limited.Footnote 135 While such a large transfer of sovereignty is neither necessary nor requested for prudential regulation to be further harmonized, a limited degree of compromise is required for a meaningful outcome to be reached. In addition, more discussions on mutual recognition of prudential measures would be essential, even on a bilateral basis.
The process of mutual recognition of prudential regulation can be considered in terms of transnational legal process and international regime theory. The activities of the Basel Committee provide guidance on how mutual recognition might be achieved effectively. The cornerstone of the Basel Committee's success stems from the concentration on technical issues and repeated meetings among technocrats. This enhances close cooperation and the willingness to support the outcome of the forum. Networks develop among participants, which further enhance the regime to produce meaningful output.
GATS might successfully conduct discussion on prudential regulations through two routes: the use of a forum such as the Basel Committee to consider solely technical issues on a basis of practices already followed. This would build on existing networks, but rework the manner in which non-members of Basel Committee take part. A vertical structure which is sequenced could be a mechanism for fine-tuned development.
The other route may be to take incremental steps by reaching bilateral agreements on prudential regulations, in which the network could be expanded to cover most members, and would effectively give rise to a de facto standard. A neighbouring country or a country with a similar regulatory view may initially seek agreements. This would then lead to discussion on a wider net of regulators which have already aligned interests.
In the structure of the WTO, effective monitoring of compliance with schedules has not been incorporated. This applies to financial services in GATS, in which a comprehensive agreement was reached. There is no mechanism for implementation of GATS to be monitored, while the Doha Round will add an additional layer of obligations on members. The efficacy of such layering of international agreements needs to be carefully considered; as such valuable economic agreements should not limit their effect to the exercise of negotiating them. Members should contemplate the placement of effective monitoring procedures to enforce the agreement.
C. The Effect of GATS on Competition Policy in Financial Services
Members' schedules of commitments effectively indicate the entry requirement of foreign financial institutions into financial markets. The commitments reflect the framework of entry and operational requirements for foreign financial members, and are an important element of the regulatory structure for foreign parties. This is why the negotiation of GATS has a direct impact on the structure of competition policy.
The Fifth Protocol has had a positive impact on the opening of financial markets. It states the general obligation of GATS, and requires members to clarify their specific commitments in market access and national treatment. Significantly, it has contributed to the duty of members to disclose the substance of their requirements for foreign parties to operate in their markets.
Nevertheless, the imperative effect of GATS has been the threat of competition from foreign parties. Members have had to revisit the financial condition of their domestic financial institutions before agreeing on the liberalization of their financial markets. Otherwise, there is a real possibility that domestic institutions will not be able to compete with foreign institutions, leading to their takeovers and decline in profits. This follows the mechanism of market economy, but may lead to negative sentiments towards foreign financial institutions. Domestic institutions should have the opportunity to improve their financial condition and efficiency before opening financial markets. This would result in better service for member countries' consumers, especially those whose market had formerly been relatively closed.Footnote 136 The prudential carve out does not appear to be inhibiting members from entering other members' financial markets.
The main beneficiaries of financial market liberalization are financial institutions of developed countries. They will take advantage of under-developed financial markets of developing members. On the other hand, developing country members may be entering the non-financial markets of developed markets. If such trade does take place, comparative advantage would be achieved as envisaged by the establishing concept of the WTO.Footnote 137
In Asia, many countries seem to regard the consolidation of financial institutions to be an important strategy for prudential regulation.Footnote 138 This stems from the belief that economies of scale are advantageous to a financial institution's competitiveness. Further, the consolidation process is considered to force financial institutions to clean up their balance sheets to improve competitiveness.
However such consolidation, especially those that are not market driven, may not prove to be as beneficial in terms of competition policy as envisaged. It may lead to oligopolistic market structures, discounting the welfare gains possible to consumers.
Importantly, consolidation may lead to financial institutions that are ‘too big to fail’.Footnote 139 Market liberalization may have a negative impact if this tendency of publicly coordinated consolidation is promoted too far.
VI. Conclusion
GATS has enabled liberalization of financial services to take place on a multilateral basis. The first round of negotiations for financial services, the Uruguay Round, could be further improved to achieve greater liberalization. This has been the objective of the Doha Round which began in November 2000. While the Uruguay round resulted in the commitment by 102 members in financial services, greater liberalization is being requested by the US, the EU, Canada, Australia and Switzerland.Footnote 140
The structure of GATS is complex and multilayered. It is imperative to understand that the schedule of commitments of each member is crucial to the substance of the financial services. The text of GATS will not lead to a comprehensive understanding of GATS' impact. GATS' schedules have the leverage and scope for members to attain greater liberalization and realize mutual benefit.
The prudential carve out has come to signify the difficulties of negotiating commitments without being inhibited by prudential concerns of financial regulators and has dominated the shortfalls of the Fifth Protocol. However, this does not highlight the true value that GATS has brought to financial systems. GATS in financial services has contributed to greater MFN treatment and transparency, as well as clarifying the commitments to market access and national treatment. Without such commitments and obligations, the international financial system would lack the promise of establishing clear rules, creating barriers to trade in general. It is easy to criticize GATS, but better to focus on how the deficiencies can be better navigated in this diverse arena of financial systems.
Prudential regulation is at the heart of financial regulation, and within the periphery of national sovereignty. The special treatment that GATS' Annex on Financial Services has received demonstrates the fierce nationalism that members feel is reserved for prudential regulation. On the other hand, prudential regulation is an objective shared by most financial regulators worldwide as exemplified by the Basel Core Principles. So it is more efficient and effective to recognize similarities and apply them using the recognition clause of GATS. There are already rules that have come to be accepted as universal, such as CAR, LLL and fit and proper.
The US–EU agreement is looking into mutual recognition of securities regulations. If an effective mechanism, such as that being proposed in the Blueprint, can be agreed on, progress in financial liberalization could become steady in incremental steps, instead of the standstill that has plagued the Doha negotiations. An agreement between the US and EU would be significant, as it is difficult to imagine other members less keen on financial liberalization to proceed with mutual recognition when more liberal economies have not embarked on such a path.
WTO negotiations are often cross-negotiated, and thus it is difficult to consider the negotiations on financial services in isolation from other talks on trade of goods and services. However, some of the areas being discussed within the Doha agenda for financial services will have a noticeable impact on the trade of financial services in the near future, and members are being required to take a more positive outlook.Footnote 141
Slowly but steadily, a consensus on prudential regulation is emerging, especially in relation to the Basel Committee, and the argument that it is a special reserve for national interest is becoming unrealistic. Greater bilateral discussion will further the understanding and consensus building on prudential regulation. This is likely to lead to clarity of the prudential carve out and further financial liberalization.
