United States General Accounting Office GAO Report to the Chairman, Subcommittee on Comrkerce, Consumer, and Monetary Affairs, Committee on Government Operations, House of Representatives llay 1990 EUROPEAN COMMUNITY U.S. Financial Services’ Competitiveness Under the Single Market Program ~AO/NSIAD-90-W National Security and International Affairs Division B-23877 1 May 21, 1990 The Honorable Doug Barnard, Jr. Chairman, Subcommittee on Commerce, Consumer, and Monetary Affairs Committee on Government Operations House of Representatives Dear Mr. Chairman: This report responds to your request that we assess how the European Community’s (EC) Single Market Program might affect U.S. financial firms. It examines the extent to which U.S. financial firms participate in ECmarkets, the potential opportunities and challenges presented by changes in the Community, and how U.S. government agencies are working to assure full and fair access to European markets. As agreed with your office, we did not obtain formal agency comments on this report. As also agreed with your office, we plan no further distribution of this report until it is released at a hearing of your Subcommittee on May 23,199O. At that time, we will send copies to the Secretary of the Treasury, the Secretary of State, the Secretary of Commerce, and the United States Trade Representative. We will also make copies available to others upon request. This report was prepared under the direction of Allan I. Mendelowitz, Director, International Trade, Energy, and Finance Issues, who may be reached on (202) 275-4812. Other major contributors are listed in appendix II. Sincerely yours, Frank C. Conahan Assistant Comptroller General Executive Summary The European Community of 12 nations plans to create a single Euro- Purpose pean market by 1992. The Chairman of the Subcommittee on Commerce, Consumer, and Monetary Affairs, House Committee on Government Operations, asked GAO to assess how the Community’s Single Market Program might affect U.S. financial firms. This report examines the extent to which U.S. financial firms participate in European Community markets, the potential opportunities and challenges presented by changes in the Community, and the efforts of U.S. government agencies to assure full and fair access to European markets. The Community envisions a single, integrated market characterized by Background the unrestricted movement of people, capital, goods, and services across its member states’ borders. The Community aims to complete this pro- gram by the end of 1992. However, some steps towards unification have already occurred, while others will not be completed for some time. New opportunities exist for U.S. financial firms to expand their consid- Results in Brief erable business in the European Community. At the present time, U.S. firms should face relatively few Community-imposed restrictions. This openness is due, in part, to U.S. government agencies’actions, which made U.S. interests known to the Community. New powers and market access granted by the 1992 program will partic- ularly affect retail (consumer) markets, and any financial firm with a presence in the Community could benefit from the increased demand for financial services. Many U.S. financial firms, however, do not plan to expand beyond their existing wholesale (commercial and interbank) operations. Factors such as the burden of meeting increased capital adequacy standards for banks and the problem of allocating limited capital among competing investment alternatives will drive their decisions. In addition, some U.S. financial firms, notably banks, contend that U.S. laws and regulations on certain activities impose serious obstacles to expansion. These restrict the kinds and amount of business U.S. finan- cial firms may conduct, potentially putting them at a disadvantage to European competitors. Page2 GAO/‘NWWW European Co~~~unity Ehcutive Summary Principal Findings U.S. Participation U.S. financial firms have a considerable stake in their Community opera- tions, particularly in Community wholesale markets. U.S. banks are active in every Community country, holding over $200 billion, or 5 per- cent, of total Community bank assets among their hundreds of branches and subsidiaries. U.S. securities houses rank among the world’s largest in their Euromarket activities. While only a few U.S. insurance compa- nies operate in the Community, the 1992 program has sparked renewed interest. U.S. financial firms no longer fear that the Community’s Single Market Program will deny them access or limit participation in Community financial markets. U.S. government, private sector, and media concern over “reciprocity” provisions in draft Community legislation has largely faded in the last year, though protectionism could resurface at any time. Opportunities The formation of a unified financial market in Europe offers many new opportunities and benefits for financial institutions and Community con- sumers. The Community will rival Japan and the United States as one of the world’s largest markets, with 325 million people, a gross national product of $4 trillion, $3.9 trillion traded annually on bond and equity markets, and an insurance market that accounts for roughly a quarter of world premiums. The European Community’s Single Market Program is a part of the deregulation of Community member states’ domestic financial markets, that should enable institutions to consolidate operations and offer more products. Firms offering investment services should also benefit from increased corporate financial activity, such as expansions, restructur- ing, and mergers and acquisitions. Factors Limiti .ng U.S. In general, U.S. financial firms do not plan to expand their presence or Participation activities in the Community. Many U.S. banks, for example, are con- strained by capital limitations. Relaxation of interstate banking restric- tions in the United States has created opportunities for banks to expand domestically, and many banks view such expansion as a better use of their capital. US. banks are particularly concerned that legal limits on the mixing of banking and securities activities in the United States and Page 3 GAO/‘NSIAD9M9 European Community Executive fhmnuuy regulatory limits on their overseas securities activities put them at a competitive disadvantage compared to Community firms that can offer both kinds of services under the Community’s universal banking model. For further discussion of U.S. banking laws and regulations, see Bank Powers: Issues Related to Repeal of the Glass-Steagall Act (GAO/GGD-~S-37, Jan. 22,1988). U.S. Government The U.S. government has responded in a timely fashion to protect US. Activities financial sector interests in the emerging European Community single market. This action was most evident and important in the response to a restrictive “reciprocity” provision in an early version of a Community banking directive. The US. government’s response was one of several factors that led the Community to soften its stance. The Community’s endorsement of the universal banking model for its Matters for more open financial markets gives greater urgency to the ongoing con- Congressional gressional debate over how broad U.S. bank powers should be. The deci- Consideration sion to modify the existing regulatory requirements is a judgmental one. In weighing the pros and cons of the existing structure, consideration should be given to the impact of these requirements on the ability of U.S. banks to compete in the Community after 1992. As requested, GAO did not obtain official comments on a draft of this Agency Comments report. The views of responsible officials were obtained during GAO'S work and are incorporated in the report where appropriate. Page 4 GAO/‘NS’IADWW European timm~ty Page 5 GAO,‘NSIAD9@99 European Community Contents Executive Summary 2 Chapter 1 8 The European Basis for the Single Market Program 8 The Single Market Framework for Financial Services 11 Community’s Single Financial Services Directives 16 Market Program Potential Roadblocks to Integration 20 Objectives, Scope, and Methodology 21 Chapter 2 24 U.S. Participation in EC Marketplace Rivals That of the United States 24 Importance of the Financial Services Sector in the EC’s 26 EC Financial Markets Economy U.S. Financial Institutions in the European Community 29 Chapter 3 34 Access to the U.S. Firms Foresee Increased Opportunities in the EC 34 U.S. Institutional Strategy: Generally Not One of 39 European Community Expansion Appears Open, but Factors and Impediments Affecting U.S. Firms’ Strategy 41 Other Factors May Conclusions Matters for Congressional Consideration 52 53 Limit U.S. Financial Firms’ Participation Chapter 4 54 The Appropriateness Many U.S. Government Agencies and Private Sector 54 Groups Are Monitoring the EC’s 1992 Program of the U.S. The U.S. Government Provided an Early and Coordinated 57 Government’s Response Response Future Concerns and the Framework for Response 61 Appendixes Appendix I: Status of Single Market Program Legislation 66 Appendix II: Major Contributors to This Report 72 Tables Table 2.1: Share of World Insurance Volume Represented 29 by the EC, North America, and Japan (1960-85) Page 0 GAO/‘NSIADW99 European Community Table 2.2:Frequency of U.S. Securities Firms Among Top 31 Ranked Participants in Selected International Financial Markets (1988) Table 3.1: Cross-Border Mergers (January Through June 36 1989) Figures Figure 1.1: The EC’s Cooperation Procedure 12 Figure 2.1: Gross National Products of the EC, United 24 States, and Japan (1988) Figure 2.2: Population of the EC, United States, and 25 Japan (1988) Figure 2.3: The Size of the Bond Market in the EC, United 27 States, and Japan (December 1987) Figure 2.4: The Size of the Equity Market in the EC, 28 United States, and Japan (December 1987) Abbreviations EC European Community ECU European Currency Unit EMS European Monetary System EMU Economic and Monetary Union GAO General Accounting Office GATT General Agreement on Tariffs and Trade OECD Organization for Economic Cooperation and Development UCITS Undertakings for Collective Investment in Transferrable Securities Page 7 GAO/‘TVS~~99 European f3mmn.nlty The European community’s Single Market Program The European Community (EC) has embarked upon a plan to create a single European market characterized by the unrestricted flow of goods, persons, services, and capital. The EC’Sobjective is to create a more effi- cient European economy with lower prices, higher wages, and greater productivity. This goal will be accomplished through a series of legisla- tive steps removing existing technical, fiscal, and physical barriers. Most of these steps are to take effect by January 1,1993, hence the popular name “EC 1992.” Key to this process are the integration and liberaliza- tion of the EC’Sfinancial services sector because of its leading and far- ranging effect on other sectors.’ The Treaty of Rome, signed in 1957, signaled the beginning of European Basis for the Single economic integration. By establishing a common market, the ECintended Market Program to bring the economic policies of member states closer together. The treaty called for the free movement of goods, persons, services, and cap ital within the Community but did not establish a framework to achieve it. The treaty initially focused on providing the grounds to eliminate tariff barriers and promote tax harmonization. The creation of the Euro- pean Monetary System (EMS)Zin 1979 helped stabilize Community exchange rates and paved the way toward future cooperation. Despite these steps toward integration, many internal barriers remained. Many Europeans believed that relatively slow European economic recovery from the global recession of the 1970s was, in part, caused by multiple trade barriers and overly protected markets. The EC’Sdepen- dence on world trade and the increasing internationalization of world economies also added impetus to the EC’Splan to unify its markets. The EC’SSingle Market Program was formally launched in 1985 with the EC’SWhite Paper “Completing the Internal Market.” This paper identi- fied barriers, proposed a series of 300 measures (later reduced to 279) necessary to abolish them, and set forth a regulatory framework to ‘For an assessment of how the Single Market Program may affect U.S. small and medium-sized mer- chandise exporters, see European Single Market: Issues of Concern to Exporters (GAO/NSIAD90-60, Feb. 13, 1990). *The EMS established a new currency, the European Currency Unit (ECU), which is a basket of E~ID pean currencies consisting of specified amounts of the currencies of 10 of the 12 member states. The 12 member states include Belgiuq Denmark, fiance. Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, the United Kingdom, and West Germany. The EMS also employs an exchange rate mechanism that limits to certain defined bands the variance between member states’ currency exchange rates. Page 8 GAO/WSIAD-90-99 European community chapter 1 The European Community’s Single Market FVogram achieve a single European market. Most of these measures are in the form of directives.3 The White Paper set a timetable for enactment of each measure and required the entire program to be in place by the end of 1992. Once a directive is adopted, member states are typically given 2 years to con- form their national laws to it. Thus, to complete the internal market by the end of 1992, most of the directives would have to be adopted by the end of 1990. The Single European Act of 1987 reaffirmed the White Paper’s objec- tives and accelerated the market integration process. It changed the way EClegislation is passed for most Single Market Program initiatives by requiring only a weighted majority of member states to approve the adoption of a proposed directive.4 Previously, unanimity was required, and one member state could block legislation. The act also established greater consultation among the various ECinstitutions during the legisla- tive process. EC Institutions The European Community consists of four supranational institutions: the ECCommission; the Council of Ministers; the European Parliament; and the European Court of Justice. The EC Commission is the executive branch: it drafts and proposes legislation and enforces the implementa- tion of Community law. The Commission, while representative of the various member states, is largely nonpartisan. This arrangement con- trasts with the Council of Ministers, the EC’Smain decision-making body, which represents the views of individual member states. The Council consists of ad hoc groupings of cabinet-level officials from the member states, e.g., for the financial services sector, the Council consists of the finance ministers of each member state. Legislation proposed by the Commission must be approved by the Council before it becomes law. The European Parliament is more populist than the other bodies, as repre- sentatives of this body are directly elected by Community citizens. While the Parliament has limited legislative power because it cannot ini- tiate or enact legislation by itself, it can make amendments to proposed directives; as a result, the Council and Commission are sensitive to the “An EC directive requires member states to ensure that their national regulation conforms to the directive’s objectives but leaves them free to decide how it should be implemented. EC regulations, on the other hand. are used more sparingly and supersede existing national law. 4Known as “qualified majority voting,” voting weights are assigned to each state loosely according to its population and economic power. Social and tax matters still require unanimous approval under the Single Market Program. Page 9 GAO/‘NSL4D9O-99 European Cmmunity chrpter 1 The European Community’s Single Market Fkogmm Parliament’s concerns. The European Court of Justice ensures that EC legislation is interpreted and applied according to the principles of IX law. As the Single Market Program progresses, the Court of Justice will play an increasingly important role in interpreting and enforcing Com- munity law. The Single Market’s Law- Under the Single European Act, the ECfollows a more complex and more Mak :ing Process consultative process in enacting legislation than it did before. In this process, known as the Cooperation Procedure, a Commission proposal must pass through a number of steps before enactment. As it proceeds through the steps, a measure is affected by a host of internal and exter- nal influences and can change substantially. The Cooperation Procedure essentially operates as patterned in figure 1:l. (see pages 12 and 13) Economic and Monetary The single market in financial services is one step toward a longer-term Union (EMU) ECgoal of greater unification of monetary and fiscal policy. In 1989, the President of the Commission, Jacques Delors, released a report propos- ing three stages for achieving an Economic and Monetary Union. The EMUgoes beyond the Single Market Program in proposing fixed exchange rates among national currencies and the eventual creation of a single European currency and central bank.6 At the European Commu- nity’s Madrid Economic Summit in June 1989, leaders of the 12 EC nations agreed to an intergovernmental conference to amend the Treaty of Rome and to begin the first stage of the EMUprocess on July 1,199O. 5The Del013committee report propcees a threestage process towardEMU. ( 1) Greater EC member state coordination of economic and monetary Policy, requiring all members to join the EMS. (2) A transitional phase, establishing an institutional framework to set economic objectives and budget deficit limits for member states. This step includes setting up a European system of central banks similar to the U.S. Federal Reserve System. (3) Locking exchange rates and instituting rules on nuawconomic and budgetary policy. This *P requires establishing one central bank to make FX-wide monetary Policy and creating a single Em pean currency. Page 10 GAO/‘hIS~~ European Gmm~ty chapter 1 The Euro- Chnmdty’e Single MArket Progmm The Single Market Program emphasizes (1) the unrestricted movement The Single Market of capital within the Community, (2) the goal of eventual freedom for Framework for financial firms to operate throughout the Community under the same set Financial Services of regulations, and (3) the use of reciprocity to open other countries’ markets to ECfirms. The EC’Saim is to provide enough financial regula- tion to ensure banks’ safety and soundness while at the same time allowing flexibility and not imposing overly burdensome regulation. Unrestricted Movement of A single market for financial services would not be possible without the Capital unrestricted flow of capital among nations. Free capital movement means that a resident of one ECmember country can use the financial services of any other member state, including banking, stock exchange, and real estate markets. This freedom allows capital, whether intended for savings or investment, to move to the most efficient and competitive marketplace. The ECseeks to achieve this freedom by removing currency exchange controls and other discriminatory barriers on capital transfers and their underlying transactions (i.e., trade in goods or provision of services) and by abolishing discriminatory measures such as taxation of certain investors. PAge 11 GAO/‘IWlAD~ Enropean Commnnity ChApter 1 The European Community’s Siie MArket ProgrAm Figure 1 .l: The EC’s Cooperation Procedure Commission makes proposal Council begins deliberating Parliament First reading Opinion rendered (no time limit) Council adopts a common positlon by qualified majority Parliamenl reviews and Page 12 GAO/NSIADW99 European Community chapter 1 The European Community’s Single Market Program Council makes de&Ion on proposal I 1. Adopts the Act In 3. Adopts amended accordance with version, but unanimity required withln 3 mos. Commission reviews EP amendments May revise proposal Council I Page 13 GAO/‘NSIAD9099 European Community Single Passport for Central to the liberalization of financial services under the Single Market Financial Services Program is the concept of a “single passport.” Once a financial firm is established and licensed in one member state, its home country, that firm can use a single passport to offer financial services in any other member state, or host country. With a single passport, a firm is free to render its services anywhere in the Community, either directly across borders or through branches. In turn, consumers of financial services will be able to select the institutions offering the lowest cost and best services regardless of where they live. Mutual Recognition The EChas specified a minimum level of regulation, beyond which coun- tries are free to regulate their markets as they see fit. Known as “mutual recognition,” this element requires a minimum level of harmo- nization, or essential equivalence, to ensure the safety and soundness of the financial system. For instance, the Second Banking Directive requires all M: banks to have a minimum capital base, a minimum level of shareholder disclosure, and a maximum limit on the degree of equity participation in nonfinancial firms. Mutual recognition also entails home country control, i.e., a financial firm has the same powers and is subject to the same home country supervision and regulatory limits regardless of where its services are rendered under the single passport. In general, a host country only has authority to supervise branch liquidity or marketing-related activities. Mutual recognition has important ramifications because regulation can vary between countries. If a home country’s rules are more liberal than those in host countries, its financial firms will be able to offer a wider range of services and will not be subject to the same regulatory costs as would the host countries’ own financial firms. The expected result under competitive circumstances will be that member states’ regulation will all eventually converge to the same minimum essential standards and the widest range of permissible powers. This process is known as “regula- tory convergence.” Perhaps the best example of the impact of regulatory convergence will be in the banking sector. The EC’SSecond Banking Directive allows banks a broad range of permissible powers, including participating in securities-related activities, based on the universal banking tradition6 found in some ECcountries. It is fully expected that those member states that do not currently follow a universal banking concept will eventually “Universal banks perform both banIdng and securities-related activities. Page 14 GAO,‘NSL4D9W9 European Community Clupter 1 The European commnnity’s Single IMArket Progmm permit broader bank powers so that their domestic banks are not placed at a competitive disadvantage vis-a-vis other ECbanks operating in their country. Reciprocity The EC’Sapplication of reciprocity for financial services has evolved from a protectionist and potentially mutually restrictive form to one that is liberal. The original provision introduced in the Second Banking Directive of early 1988 appeared to seek identical, or mirror-image reci- procity, that is, U.S.-owned bank subsidiaries in ECmarkets would be permitted only those activities granted to &owned banks in the United States. This provision was one of the primary reasons the United States feared the rise of a protectionist EC,or “Fortress Europe.” The EC,how- ever, reasoned that in a financially interdependent international envi- ronment, its financial firms should enjoy fair access and equivalent treatment in other world markets. Further fears arose, owing to the ambiguity of the reciprocity language in the banking directive and its interpretation by a prominent member of the Commission. That member reasoned that reciprocity could be imposed retroactively, i.e., non-m banks already in the ECwould not be “grandfathered” or allowed to do business in accordance with the new law. Non-m firms were also concerned about the automatic review pro- cedures outlined in the provision, which required automatic suspension of applications from all non-Ec financial institutions pending reciprocity review by the Commission. These firms feared this requirement would delay and impede their ability to enter the EC,acquire other financial institutions, or restructure their businesses in the EC. But the Council of Ministers adopted new language in the Second Bank- ing Directive on December 15, 1989. The new language provided a sub- stantially revised and more liberal reciprocity provision to be effective in 1993. The ECintends to seek reciprocal national treatment with effec- tive market access. This goal means that U.S. banks would be granted the same opportunities in the EC as ECbanks are granted, as long as EC banks are not discriminated against in the United States. The automatic review procedure was eliminated. If the ECdetermined that ECbanks are Page 16 GAO/'NSIAlHO-99 European Ckmmon.ky clulpter 1 The European Community’s Single Market Program not treated equally in the United States, then the ECwould seek negotiations.7 The reciprocity provision in the Second Banking Directive has received much attention, in part because the EChas stated that the form reciproc- ity takes in the banking sector will be used as the model for treating investment services and insurance as well. Of the approximately 30 directives relevant to the Single Market Pro- Financial Services gram’s financial services area, the 9 discussed in this section are key to Directives the program and are critical in understanding its impact on U.S. finan- cial firms. They are intended to integrate ECmarkets and open them to competition. For the status of these and other EC 1992 directives, see appendix I. Second Banking Directive The Second Banking Directive establishes the key principles upon which the EC bases its regulatory framework: a single banking license, home country control with mutual recognition, and reciprocal national treatment. The single banking license allows any bank authorized in one member state to provide a broad array of financial services,8 similar to those con- ducted by universal banks, in any other member state. Non-a banks are also eligible for the single banking license, as long as they incorporate an ECsubsidiary in any one of the member states. ECbanks’ activities outside their home country will be subject to super- vision and regulation by their home country. The primary exceptions to 7Acaxding to the current proposal, 6 months before the directive is implemented on January 1,1993, the Commiss’1011will draft a report examining the treatment given to EC banks in third countries. In those circumstances where EC banks are not afforded effective market access comparable to that granted by the EX to credit institutions from a foreign country, the Commission may submit a propo sal to the Council for negotiations to seek comparable competitive opportunities. In those instances where EC banks do not receive national treatment, the Commiss’ion may initiate negotiations to rem- edy the situation. ‘The list of permitted activities under the single banking license are (1) deposit @king and other forms of borrowing, (2) lending, (3) financial leasing, (4) money transmission services, (6) issuing and administering means of payment (credit cards, travellen checks), (6) guarantees and commitments, (7) trading for their own or customers’ accounts in money market instruments, foreign exchange, financial futures and options, exchange and interest rate instruments, and securities, (8) participation in share issues and the provision of services related to such issues (i.e., underwriting), (9) money brokering, (10) portfolio management and advice, (11) safekeeping of securities, (12) credit reference services, and (13) safe custody. Page 16 GAO/‘NSIhD90-99 European Community ch8pter 1 The European community’s Single Market Program home country control are conduct of business rules and control of mone- tary policy. Supervisory authorities in the host country will retain pri- mary oversight over branch liquidity and exclusive responsibility for monetary policy. The host country will also have authority over market- ing of services within its boundary. Finally, the host country could apply additional restrictions, but only in rare circumstances affecting the public interest. Capital Adequacy The Commission proposed two directives dealing with capital adequacy Directives for banks: the Own F’unds Directive, which defines qualifying capital; and the Solvency Ratio Directive, which determines the quantity of the qualifying capital that is required. The Council adopted the former on April 17, 1989, and the latter on December 18, 1989. Both of these direc- tives are to be implemented in conjunction with the Second Banking Directive on January 1,1993. Investment Services The proposed Investment Services Directive is structured very similarly Directive to the Second Banking Directive, but applies to nonbank financial firms not covered by the banking directive. The directive is based on the same principles as the Second Banking Directive regarding a single passport, mutual recognition, and home country control. The ECintends to implement its directive at the same time as the Second Banking Directive, so that there is no period during which investment firms will be at a competitive disadvantage to banks. However, member states that do not have domestic investment service firms (i.e., if these services are provided by universal banks) may not be as eager to press for timely passage of the Investment Services Directive. Under the proposed Investment Services Directive, ECinvestment firms, like banks, will be free to open branches or to offer their services across borders to any other member state, subject to the same set of regulations as they would be under home country control. The single passport gives any K-authorized firm access to member state stock exchanges. The host country retains control for conduct of business rules and compensa- tion methods to protect investors in case of investment firms’ default or bankruptcy. Page 17 GAO/‘NSLAD90-99 European Community Ckapter 1 The European Canmunlty’s Single Market Program The directive lists permissible activities in which these firms may engage and instruments that they may sell9 Competitive pressures will force regulatory convergence; thus, those countries that currently do not permit some of these activities are likely to broaden permissible powers. The proposed directive still contains the original and restrictive reci- procity language that first appeared in the banking directive. However, the ECpromises that the directive will be revised by the Commission in line with the current reciprocity provision in the banking directive. The EC said it intends to introduce another directive addressing capital adequacy provisions for investment firms. However, there is a lack of agreement on a basis for assessing capital adequacy standards for investment firmsLo UCITS Directive The principal directive concerning funds management is the Directive on Undertakings for Collective Investments in Transferrable Securities (ucrrs). These undertakings are more commonly known in the United States as mutual funds. Under the UCITS Directive, once a fund is author- ized in an EC home country, it can be freely sold throughout the remain- der of the Community. The directive applies to both unit trusts and investment companies. It was adopted by the ECin December 1985 and implemented by most member states on October 1,1989 (Greece and Portugal have until April 1992 to implement it). Insurance Directives Both life and non-life insurance companies had the freedom to conduct business in the EClong before the Single Market Program was initiated in 1985.” But this freedom, unlike banking and investment services, has sPermitted activities include brokerage; dealing as principal; market making; portfolio management; arranging and underwriting transferrabie securities; investment advising; and safekeeping and administration. Salable instruments include transferrable securities; money market instruments; financial futures and options; and exchange rate and interest rate instruments. “‘British, U.S., and Japanese regulators propose that base capital requirements be held to a minimum, but subject to close scrutiny and continual adjustments based on market value of security provisions and other factors. German regulators take the opposite tack, pushing for a much larger base capital requirement (as German banks have) but greater freedom to conduct their activities. ’’Life insurance includes whole, unit, and term life policies. Non-life includes insurance against acci- dent, sickness, damage to and loss of property, liability (e.g., motor vehicle), credit, and suretyship. Under 1964 and 1978 EC directives, firms active in reinsurance and coinsurance markets already emoy freedom of establishment and provision of cross-border services within the EC. Page 18 GAO/‘NSIAD90-99 Enropem community chapter 1 The European Canmunlty’s Single Market Program always been subject to authorization by the host country. The Commis- sion now wants to apply the single passport concept to insurance services. The EChas achieved greater progress in liberalizing non-life insurance than in liberalizing life insurance. The First Non-Life Insurance Direc- tive, implemented in 1973, coordinated member states’ laws governing the establishment of insurance businesses. The directive covers how insurance firms should be legally formed; what the supervision and cooperation among states should be; what the restrictions on providing insurance should be; what the rules on fiscal soundness should be; and what the procedures for setting up branches and subsidiaries through- out the ECshould be. The Second Non-Life Insurance Directive, scheduled to be implemented on June 30, 1990, expands upon the first by establishing specific rules on the provision of cross-border insurance services. However, unlike the banking and investment services directives, home country control is only applicable to wholesale customers, or to large risks.12 The host country still supervises non-life insurance services provided to individu- als, known as mass risks. As for life insurance, a directive allowing freedom of establishment was adopted in 1979, but there have been no proposals as yet on provision of services. A key ECofficial told us that once capital movement is unrestricted and alternative savings and investment vehicles are availa- ble, it will become increasingly difficult for domestic insurers to compete without liberalization. Capital Movement Two EC directives have been key to the market integration process: (1) A Directives 1986 directive ensuring free capital movement for long-term commercial transactions, bond issues, and unquoted securities;L3 and 2) a 1988 direc- tive eliminating all restrictions on short-term and long-term transfer of capital, or of underlying transactions, and eliminating other discrimina- tory measures, such as certain taxes on investments. The latter proposal ‘%arge risks are defined with reference to the nature of the risk, including aviation, marine, and transport, and also to the size of the policyholder, who should meet two of the following minimum thresholds: (1) It should have assets of 12.4 million ECUs ($13 million); (2) it should have sales of 24 million ECUs ($25.2 million); and (3) it should have more than 500 employees. ‘“See appendix I. Capital movements directive adopted by the EZCCouncil on November 17,1986. Page 19 GAO/‘NSIhDw)-99 European Community chapter 1 The European Community’s Single Market F’mgmm will go into effect for most countries on July 1, 199O.l* Thus, a resident of one ECmember state will have unrestricted access to banking ser- vices, stock exchanges, real estate markets, and other financial services in all Ec countries. The European Community is making significant progress in completing Potential Roadblocks the Single Market Program. However, the process is far from complete. to Integration Many uncertainties and potential problems remain. Less economically developed member states that may not currently be able to compete with more developed states could try to slow progress toward financial integration. An economic recession within the Community could increase protectionist sentiment. Problems remain in harmonizing member states’ tax rates and in coordinating home and host country controls. The ques- tion of reciprocity could reemerge. Finally, concern is increasing that member states are failing to implement approved directives, by legisla- tion, promptly. Tax Harmonization Without the harmonization of tax rates among member states, the inte- gration of the financial markets will not be complete. Harmonization of indirect tax rates, such as the value added tax (VAT), is especially important because it affects the costs of goods and services. Differing indirect taxes such as taxes on interest and dividend payments could distort capital flows and encourage tax evasion. Member states have not reached agreement on how to harmonize indirect tax rates. Political sen- sitivities to cede fiscal sovereignty, as well as the difficulties anticipated in administering proposed schemes, have slowed progress. Difficulties in reaching an agreement have been compounded by the need to obtain unanimity on tax issues, as required under the Single European Act. Home and Host Country Coordinating home and host country regulatory controls is crucial to the Control overall regulatory framework for EC 1992. Host countries would have the greatest regulatory control over the insurance sectors and the least control over the banking sector. In theory, giving supervisory authority ‘*Council Directive of June 24, 1988. for the implementation of article 67 of the Treaty of Rome. To be implemented by all EC countries by July 1, 1990, with the exception of Spain, Ireland, Greece. and Portugal, which are granted an additional 2 years. The Federal Republic of Germany, the Netherlands, the United Kingdom, and Denmark already allow free movement of capital. Belgium, Luxembourg, France, Italy, Greece. Portugal. Ireland, and Spain still have one or more restrictions that must be abolished under the directive. Page 20 GAO,‘NSI.AIMO-99 European CcmmtiQ’ Chapter 1 The European Community’s Single Market Program to the home country’s regulator is very appealing in an integrated mar- ket. However, actual implementation could be difficult. U.S. financial firm representatives, consultants, and ECregulators were uncertain about how and where to draw the dividing line between home and host country control. The directives themselves are open to interpretation. For example, it is unclear whether the Second Banking Directive can require banks from other EC countries to comply with local conduct of business rules since these rules may be perceived as providing consumer protection and thus be for the “public good.” Basic conditions that must be satisfied before home country control becomes workable are (1) the ability of ECmember state regulators to supervise their own institutions, and (2) the adequacy of minimum essential requirements used in this supervision. Delays in Implementation As the number of directives adopted by the Council grows, so too do the backlogs in passing the necessary implementing legislation in the mem- ber states. The Commission reported in June 1989 that of the 68 mea- sures that should have been implemented by that date, only 2 had been incorporated into the national legislation in every member state. This backlog also creates a substantial administrative burden for the Com- mission, which is responsible for monitoring and enforcing the imple- mentation of directives. Within the financial services sector, where the EC’Ssuccess in passing directives has been swifter than in other areas, the implementation of directives at the member state level is also lagging. The directive allowing Communitywide sale of mutual funds was passed by the ECin 1985 and became effective on October 1, 1989. However, according to an ECofficial, just 2 weeks prior to its effective date, the directive had been enacted by only 2 countries within their own legislation. The Chairman of the Commerce, Consumer, and Monetary Affairs Sub- Objectives, Scope, and committee of the House Committee on Government Operations asked us Methodology to assess the potential impact of the EC’S deregulation of financial ser- vices on U.S. financial institutions. Of particular interest to the Subcom- mittee at that time was the E’S possible application of reciprocity provisions to bar U.S. firms from the Community. To satisfy the Subcommittee’s overall objective, we established three subordinate objectives. First, we sought to identify the nature and extent of U.S. financial firms’ participation in the ECmarkets. Second, Page 21 GAO/NSIAD90-99 European Community ckapter 1 The European Community’s Single Market Program we attempted to identify the opportunities and challenges a single mar- ket in Europe may present to U.S. financial firms. Third, we sought to determine how appropriately the U.S. government is working to assure full and fair access for U.S. financial firms to European markets. To identify the extent to which U.S. financial firms participate in EC markets and, thus, what is at stake for the U.S. financial industry, we collected data in both the United States and in Europe on the number, size, and activities of U.S. firms in the EC.We also collected data on the overall size and importance of EC financial markets. We obtained infor- mation from U.S. and European regulators, U.S. embassies and missions, the European Community, U.S. trade associations, U.S. and EC consul- tants, financial periodicals and reports, and international bodies and experts. We also met with representatives of U.S. banks, securities firms, and insurance companies in five ECfinancial capitals and the United States to identify the variety of activities and markets in which they participate.15 To identify the potential opportunities and challenges a single market might present for U.S. financial firms, we sought the views of U.S. finan- cial firms in the EC and the United States. We also interviewed EC and U.S. government officials, consultants, and other experts, and reviewed their publications to gain a consensus of opinion concerning opportuni- ties, challenges, and resultant strategies. Additionally, because U.S. laws and regulations have a considerable impact on U.S. financial firms’ over- seas activities, we identified key U.S. regulations and analyzed their effect. To determine how the U.S. government has responded to the needs of the U.S. financial industry, we identified which U.S. governmental bod- ies monitor developments in EC financial markets. We analyzed their roles and responsibilities and how they responded to and coordinated with the financial community at large. We asked representatives of the U.S. financial community, the EC,consultants, and the U.S. government how they viewed the U.S. government’s response. Our work was conducted between March 1989 and January 1990 in accordance with generally accepted government auditing standards. The 151nthe EC, we interviewed U.S. fiiancial firm representatives in London, England; Brussels, Belghun; Frankfurt, West Germany; Paris, France; and Madrid, Spain. In total we interviewed rePre- sentatives of 37 US. banks, securities firms, and insurance companies in the EC. These firms represent a broad range of size, activities, and level of commitment in the EC. In the United States, we met with New York headquarters representatives of financial firms. Page 22 GAO/‘NSWW99 European C~mmunfh’ chapter1 The European Cmnmunity’s Single Market Program House Subcommittee Chairman requesting this review asked that GAO not request official comments on a draft of this report. The views of responsible officials were obtained during GAO’S work and are incorpo- rated in the report where appropriate. Page23 Chapter 2 U.S. Participation in EC Financial Markets d An integrated EC economy, the goal of the EC’SSingle Market Program, would be one of the world’s largest economies, with the financial ser- vices sector forming a key component in that economy. An integrated EC market will consist of 325 million people and have a gross domestic product over $4 trillion. It is estimated that the removal of internal bar- riers to create this single market will stimulate an additional 4.5 percent growth in the overall economy. U.S. financial firms have long been active in European financial markets and have established networks of institutions throughout the EC.U.S. banks hold 5 percent of the EC’Sbanking assets, U.S. securities firms are leaders in a number of European investment markets, and U.S. insur- ance companies are increasing their presence in the M: in anticipation of new opportunities. Therefore, these firms have a keen interest in the emerging single market and how it will affect their operations. The gross national product of the ECalmost matches that of the United EC Marketplace Rivals States and nearly doubles that of Japan (see fig. 2.1); the population of That of the United the ECnearly equals the combined populations of the United States and States Japan (see fig. 2.2). Figure 2.1: Gross National Products of the EC, United States, and Japan (1988) 6 Dotkn in Trillions EC United Japan states countrlas Source: Salomon Brothers Inc. Page 24 GAO/‘NSL4Lh9@99 European Community Chapter 2 U.!3. Participation in EC Financial Markets Figure 2.2: Population of the EC, United States, and Japan (1988) 400 Population in Millions 300 250 200 150 100 So 0 EC United Japan states Countries Source Salomon Brothers Inc The United States has strong economic ties with the 12 members of the EC.Bilateral trade between the United States and the ECtotaled approxi- mately $150 billion in 1987, representing one-third of all global trade. The EC'S member states purchase one-quarter of all U.S. exports and receive 40 percent of all U.S. foreign investment. The Single Market Program not only will foster further integration of America’s largest export market but also will increase the size of that market as well. An Ec-sponsored study of the medium-term gains from the Single Market Program’ estimated that market integration could add to the EC’Sgross domestic product from between 4.5 to 7 percent and create between 1.8 and 5 million additional jobs. Combined with a favorable set of government measures, the study estimated that the average added effects could lead to a medium-term rise in gross domes- tic product of 7 percent, with the creation of approximately 5 million additional jobs. The study estimated that the impact of liberalizing ’Four mqor aspects of the Single Market Program were analyzed; these included (1) removal of CUS- tams barriers, (2) opening of procurement markets, (3) liberalization of financial services, and (4) supply-side effects created by businesses’reaction to market integration and tougher competition. The estimated cost of all inefficiencies and barriers and thus the size of potential gains tu be realized upon the removal of the barriers exceeds 200 billion ECI’ ($228 billion). Page 26 GAO/NSIAD-90-99 European Comnunity chapter 2 U.S. Partidpation in EC Finandd ruarketa financial services alone is calculated to contribute an additional 1.5 per- cent to the EC’Sgross domestic product and nearly 500,000 additional jobs. The financial services industries (banking, securities, and insurance) Importance of the play a unique, pivotal role in energizing the overall ECeconomy as major Financial Services employers and contributors. In addition, the EC’s financial markets con- Sector in the EC’s stitute a significant portion of the global financial market. Economy The significance of the financial services sector to the total ECeconomy is illustrated by measures of its contributions to employment, value added to production, and output.2 In 1986, employment in the banking, finance, and insurance industries totaled over 3.1 miIIion, representing 3 percent of the total work force in the EC.In the same year, the value added component constituted 6.6 percent of the combined ECgross domestic product and, based on an EC survey of 8 of the member states, totaled 200 billion ECUS($228 billion).3 The earnings rate of the financial services sector was twice the EC’Saverage. Based on the EC’Ssurvey, bank loans and stock market capitalization in the ECcountries are esti- mated to total 142 percent (or $6.1 trillion) and 116 percent (or $6.0 tril- lion) of the EC’Sgross domestic product, respectively.4 Banking The EC’Sbanking industry is among the world’s largest. m-based banks, for example, represented 2 of the top 10 banks in the world in 1987, 44 of the top 100, and 162 of the top 600.5 Banks in ECmember states constitute a larger source of direct lending to nonbanks than do banks in any other individual country. They account for 34 percent of the world total, just ahead of the Japanese banks. U.S. banks, in contrast, account for only 7 percent of direct lending, less than either French or West German banks alone. ‘The value added by the fiicial swvkes sector equals the total value of financial firms’ output (measured by wages and profits) less the value of inputs purchased from other firms. 3Dollar value based on currency rates prevailing on November 30,1989: 1 ECU = d 1.1392. 4Dollar figures are based on Community gross domestic product as of December 1988. 5Ftanbga are bawd on the size of asets in 1987. Page 26 GAO/‘NSIAlMlW9 European community Chapter 2 US. Partidpation In EC Finrndrl Marketi Securities The combined ECsecurities markets are comparable in size to those in the United States and Japan. Figures 2.3 and 2.4 compare the capitaliza- tion of EC,United States, and Japanese bond and equity markets. At the end of 1987, the EC bond market was three-fifths the size of the U.S. market, and larger than the Japanese market.6 Figure 2.3: The Size of the Bond Market in the EC, United States, and Japan 5.0 Dollara in Trillions (December 1987) 4.5 4.0 3.5 3.0 2.5 . 2.0 \ 1.5 1 .o 0.5 0 \ EC Unltod Jmn Stab countriaa Source: Salomon Brothers Inc “Because the sizes of the bond and equity markets are expressed in dollars, the relative relationships of the markets will vary with the value of the dollar versus other currencies, Page 27 GAO,‘NSIADW99 European Community chapter 2 US. Participation in EC Financial Markets Figure 2.4: The Size ot the Equity Merket in the EC, United States, and Japan 3.0 Dolhn In Trillbn8 (December 1987) 2.8 2.6 2.4 EC United Japan stataa countrlaa Source: Salomon Brothers Inc The capitalization of ECequity markets was also approximately three- fifths the size of the US. market, but only one-half the size of the mar- ket in Japan. Insurance The EC accounts for approximately 22 percent of the $1 trillion private insurance market in the world, making the ECthe second-largest global market after the United States. In comparison, the US. market gener- ates approximately 43 percent of the world’s premiums, while Japan generates approximately 20 percent. Approximately 60 percent of EC premiums are from non-life insurance policies; life insurance accounts for approximately 40 percent of the insurance market and is the faster- growing sector. Since 1965, the insurance market in Europe has grown at a faster rate than the U.S. market. Table 2.1 illustrates the relative share of the world’s insurance markets between 1960 and 1985. Page 28 GAO/NSIANU&99 European timmhty Chapter 2 U.S. Partidpation in EC Pinandai Markets Table 2.1: Share of World Insurance Volume Represented by the EC, North Figures in percent America, and Japan (1960-85) Share 1960 1970 1960 1965 EC 18.4 21.2 27.3 22.2 North America 72.0 63.5 46.9 50.4a Japan 2.2 7.0 13.7 17.3 Other 7.4 8.3 12.1 10.1 Total 100.0 100.0 100.0 100.0 aData for 1985 represent the United States and Canada only Source: Commwon of the EuroDean Commutxtles. While the share of the global insurance market represented by the EC member states increased 48 percent between 1960 and 1980, the EC’S global market share declined between 1980 and 1985. A significant por- tion of this decline is due to the appreciating value of the dollar over the same period. According to an insurance industry study, the prospect that growth in the European insurance markets will continue to outpace the U.S. insur- ance market is good. The development of public social insurance systems in Europe has slowed; this slowdown is expected to increase demand for private insurance. On the whole, public insurance systems have been more important in Europe than in the United States. This fact explains, in part, why the percentage of private insurance premiums in the gross domestic product of Europe is only 4.9 percent, whereas in the United States it is 7.5 percent. U.S. financial institutions have a large and active presence in the EC U.S. Financial financial markets. Among U.S. financial institutions, U.S. banks have Institutions in the been active in Europe the longest and have the largest stake in the EC. European Community Many U.S. securities firms have entered the EC in the last 20 years and are now among the leaders in product innovation, investment expertise, and sales. The presence of the U.S. insurance industry in ECstates is small, but growing. In all three financial sectors, most U.S. firms in the ECare active in the wholesale markets serving large institutions. U.S. Banks in the EC Officials told us that the overseas presence of U.S. banks grew over the last 25 years in part because U.S. banks abroad did not need to comply with U.S. reserve requirements, and their deposits are not subject to Page 29 GAO/TWAMW-99 European Community Chapter 2 U.S. Partidpation in EC Pinandal Marketa Federal Deposit Insurance Corporation assessments. U.S. banks, there- fore, expanded their overseas networks to conduct international bank- ing in Euromarkets, where they were free from U.S. monetary regulations and capital controls. U.S. banks have a presence in every ECmember state. At the end of 1988,33 U.S. banks were operating a total of 149 branches throughout the EC; 17 U.S. banks owned subsidiaries in the EC.The combined assets of these branches and subsidiaries totaled over $2 10 billion and repre- sented approximately 6 percent of the banking assets of the EC. The highest concentration of U.S. branches and subsidiaries, as well as approximately 66 percent of their assets, is in the United Kingdom. In 1986, U.S. banks in the United Kingdom, the largest banking market in the EC,accounted for 11 percent of bank assets there. U.S. banks are also well represented in the next-largest market in the EC,West Germany. In 1987, U.S. banks in West Germany operated more branches and subsidiaries (20) and conducted a higher percentage of business vol- ume (21 billion ECUS,or $24 billion) than did banks from any other for- eign country. Though the U.S. banks still maintain a large presence in the EC,their position has declined during the 1980s. Several U.S. banks have sold retail networks to IX banks, and others have exited or are phasing out of particular markets, such as securities trading and underwriting, com- mercial paper, and government bonds. U.S. Banks Most Active in Within the wholesale banking market, U.S. banks are deemphasizing Wholesale Markets their traditional commercial lending activity and stressing investment banking activities instead. The large multinational corporations that for- merly sought loans from international banks now meet their capital needs directly in the securities markets. U.S. banks have adapted to the changing financial environment by targeting niche markets. For exam- ple, in 1988 US. banks constituted 9 of the top 20 lead managers of syndicated loans internationally. In the same year, U.S. banks also rep- resented 7 of the top 20 dealers of Eurocommercial paper and Eurocer- tificates of deposit. U.S. banks are also among the leaders in the Eurobond markets. Niche markets include mergers and acquisitions, investment management, and leveraged buy-outs, U.S. banks also con- tinue to participate in traditional international banking activities, such as foreign exchange and securities trading, leasing, and trade financing. Page 30 GAO/NSLADgo-93 European Community - Chapter 2 US. Partidpation in EC Finandal Markets Only one U.S. bank is actively pursuing the European retail market. Most US. banks exited from this banking business because of low prof- its. During the 198Os, U.S. banks sold retail networks in Belgium, France, Italy, Spain, and the United Kingdom. Several U.S. banks are entering new markets in Europe as regulatory controls in the ECare liberalized. Some U.S. banks are also beginning to market life insurance, while others are marketing mutual funds. U.S. Securities Firms in the Nearly all major U.S. securities firms are present in the financial mar- EC kets of the EC.For example, 9 of the top 10 U.S. securities firms, ranked by total broker-dealer capital, have a presence in the EC,as do 17 of the top 25 U.S. firms. In London, the EC’Sleading securities market, U.S. firms operated a total of 56 offices in 1988. However, we were unable to determine the exact number, locations, or size of these firms in the rest of Europe. This lack of data may be a result of the federal government’s limited oversight responsibility for the foreign activities of U.S. securi- ties firms. As is illustrated in table 2.2, U.S. securities firms are successful in a number of activities in the EC’Swholesale markets. They are among the top managers of international equities and advisers on mergers and acquisitions. Table P.P:Frequency of U.S. Securities Firms Among Top-Ranked Participants in Number of U.S. Selected International Financial Markets Market Measure securities firm8 (1988) Lead manager9 International equities Top 10b 5 Lead and co-lead managers International equities Top 20b 7 Mergers and acqursitions advisers worldwtde Top 25’ 12 Mergers and acquisitions advrsers Europe buying Top ZOb 11 Into the U.S. Mergers and acqulsitrons advisers U.S buying Top 5b 5 Into Eurooe aLead managers organize the syndtcate and typlcally take on a majority of the risk In return for a higher fee blnstltuttons ranked by value of transactions ‘lnstitutlons ranked by number of transactions Source Euromoney, February, March 1989 Page 31 GAO/NS1AD90-99 European Community Chapter 2 U.S. Pnrtkipation in EC Flnandal Bfarkets U.S. securities firms face competition from the investment subsidiaries of U.S. commercial banks, European universal banks, specialized firms in the EC,and financial firms outside the EC.Industry consultants told us that one of the advantages U.S. firms have in operating in the EC is their “European” composition. U.S. firms in the IX are said to be more inclined to develop a cosmopolitan team representing several member states than might a securities firm indigenous to an ECmember state. Therefore, the proposals developed by U.S. firms could be perceived by ECclients to contain less potential bias. U.S. Securities Firms Are US. securities firms in the ECserve two types of clients: institutions and Active in Both Wholesale individuals. Institutions include member state governments, EC and mul- tinational corporations, and insurance and pension funds. U.S. firms and Retail Markets provide a variety of investment banking and brokerage services, includ- ing fee-based advice (mergers and acquisitions, investments), securities underwriting, sales and trading, corporate finance, and equity place- ments. Brokerage activity has historically served clients with U.S. investment products. With the liberalization of exchange controls, the firms are expanding their portfolios to include European and Japanese products. Representatives of the financial community in Europe told us that U.S. institutions have a reputation within the EC for product innovation. Financial products and practices first developed in the United States have been introduced to the European market by U.S. institutions (e.g., futures, options, and swaps). U.S. Insurance Companies U.S. insurance companies have only a limited presence in the ECmarket in the EC because of market forces and a general lack of interest on the part of U.S. companies. For example, in West Germany, the largest national insurance market in the EC,the market share of U.S.-owned companies in 1984 totaled only one-half of 1 percent, based on gross premium reve- nue. In most EC countries, the insurance industry is one of the most strictly regulated segments of the economy, and it has been the most difficult financial industry to liberalize under the Single Market Pro- gram Because the insurance sector is one of the most closed sectors in ECmember state economies, foreign companies usually play only a minor role in the national markets. For example, in the major national markets in Europe, the average market share of foreign firms is approximately 9 percent. A leading industry analyst observed that, even in relatively Page 32 GAO/‘NSL4LMM9 European Community Chapter 2 U.S. Partidpation in EC Finandal Markets open markets within the EC,the presence of foreign insurers is small due to language and cultural barriers. The low penetration of U.S. companies in the ECis indicative of the lack of foreign penetration by American insurance companies worldwide. Though 6 U.S. insurance companies are among the 15 largest in the world,7 only 1 percent of total premium revenue for the U.S. insurance industry is derived from foreign sources. In 1985, worldwide investment by U.S. insurance companies totaled only $7.9 billion, or 3.4 percent of total foreign investment by U.S. business. Of the foreign investment of U.S. insurance companies, however, 70 percent occurred in Europe. A lack of interest by U.S. firms in the ECmarket partly explains the small presence of U.S. companies. A recent survey reported that 80 per- cent of U.S. insurance executives have little or no notion of the market potential of the EC.Other reasons given for the low U.S. penetration in Europe included (1) the conservative nature of the industry and the lack of inclination to explore new territories; (2) the existing saturation of the insurance market, especially in northern Europe; and (3) the pres- ence of competing opportunities in the Far East. The primary business for the few large U.S. insurers in the ECis prop- erty and casualty coverage for large industrial clients. In our interviews with representatives of US. insurance companies in Europe, however, we were told that the U.S.’ presence may grow. Several U.S. companies have plans either to establish operations in the ECor to buy existing companies in the EC.These new entrants are targeting both the life and non-life markets. We were told that the most attractive markets in the ECare in the southern member states-Spain, Italy, Greece-where, his- torically, domestic regulation has been more restrictive and foreign insurance penetration has been low. ‘Based on overall business in dollars in 1987. Page 33 GAO/‘NSL4Lb9O-99 European Community Accessto the European community Appears Open, but Other Factms May Limit U.S. Financial Firms’ Participation U.S. financial firms are apparently assured access to the EC’Sfinancial markets in spite of initial concerns that the Community might bar them from operating there. Whether or not these concerns were well founded, both U.S. financial firms and the U.S. government actively lobbied EC and member state governments for equal access to Community markets. Firms also took organizational steps to insulate themselves better from the possibility of exclusion; some are still considering taking such steps. We found little reason to believe that U.S. financial firms will face overt discrimination in ECmarkets after the implementation of the Single Mar- ket Program. However, the EC’Sprogram for developing a single market is far from complete, and some unsettled issues remain that still could alter this current mood of optimism. U.S. firms do not plan to expand their presence within the EC.Numerous other obstacles and strategic variables could influence their global strat- egies and limit their ability or desire to participate in Europe. US. finan- cial firms are particularly concerned about U.S. regulatory restrictions on their overseas activities and the cost and availability of capital, The 1992 program offers more opportunities than it does barriers, in the U.S. Firrns Foresee view of a majority of representatives of U.S. financial firms we inter- Increased viewed. U.S. financial industry executives, their consultants, and market Opportunities in the experts foresee a more open and liberal financial market in the ECnow that the issue of reciprocity has apparently been resolved. They antici- EC pate new and expanded opportunities in specific market sectors, such as retail and private banking or insurance and investment products, and across sectors, such as in the benefits to be derived from the freer flow of funds and the consolidation of operations. U.S. financial firms believe that they are well positioned to benefit from these opportunities because of their international networks and experience operating across borders, their expertise and their product innovation, and the breadth of services they offer. Retail Banking Historically in the EC,retail markets have been heavily protected through domestic regulation; some countries (e.g., Spain and Italy) restrict foreign acquisitions or participation in domestic banks and the marketing of banking services by foreign institutions across their bor- ders. These and other restrictions in retail banking result in wide price differentials among countries for equivalent banking products. By mak- ing it easier to establish banking offices and by allowing the sale of Page 34 GAO,‘NS~90-99 European ckmm~ty chapter 3 A- to the European Community Appears Open, but Other Factors May Limit US. Finandal Firms’ Partidpation banking products across national borders, the Second Banking Directive may create profitable opportunities for foreign banks to exploit these price differentials. The increased competition arising from new foreign bank activity may also reduce costs for the consumers of financial ser- vices as well as stimulate the introduction of new products and services. All this activity can be expected to further increase consumer demand for financial services in the Community. However, as noted in the prior chapter, most US. banks are no longer active in retail markets, having sold many of their retail franchises in recent years. U.S. banks, with few exceptions, now operate almost exclusively in wholesale banking markets, which we were told already are largely deregulated and are not expected to offer new opportunities akin to those expected in retail banking. Private Banking Services Offering private banking services for high-net-worth individuals is an attractive venture for banks and investment houses. The full liberaliza- tion of capital movement under the Single Market Program will offer a wider range of cross-border investment possibilities, including U.S. investment products, to EC investors. This liberalization will, therefore, boost the demand for private banking services. U.S. banks and U.S. securities firms that offer brokerage services already are actively providing private banking services. U.S. securities firms market U.S. investment products, where the actual accounts are held in the United States and only transactions and servicing are per- formed in the Community. For U.S. banks, offering private banking ser- vices is attractive because these services generate high fee income without a large capital commitment. This fact is especially important in light of the new worldwide capital adequacy requirements for banks Mergers and Acquisitions Corporate finance, specifically the financing and facilitation of corpo- rate mergers and acquisitions, is expected to be a highly profitable activity in the EC. Many EC businesses anticipate the need for greater expansion and market penetration as a result of more open and competi- tive markets after 1992. Concurrently, other ECbusinesses that doubt their competitiveness after 1992 see this as an excellent time to sell their firms. The following data provide an idea of the magnitude of corporate mergers already taking place on a cross-border basis (see table 3.1). Page 35 GAO,‘NSIAD90-99 European Community chapter 3 Access to the European Cmnmunity Appears Open, but Other Factors May Limit US. Financial Firms’ Participation Through June 1989) EC nation of acquired Value of deals company (ECUs in millions)a Number of deals United Kingdom 5,956 101 France 2,299 91 Italy 2,039 52 West Germany 1,774 90 Spain 1,084 65 The Netherlands 511 47 Portugal 310 12 Belaium 180 27 aOne European Currency Unit (ECU) IS roughly equivalent in value to $1 14 Source: The 1992 M&A monthly’s European Deal Revlew. Many U.S. institutions and consultants predict continued growth in this area. U.S. financial institutions that have built merger and acquisition experience in the United States expect to benefit from these increased cross-border mergers. U.S. businesses’European acquisitions, totaling 3.6 billion ECUS($4.1 billion) during the first half of 1989, create a natu- ral customer base for these U.S. financial firms.’ The ECis near agreement on a merger policy that will reduce the barri- ers national governments are able to impose on large cross-border merg- ers. The takeover policy would give the ECthe power to rule on large mergers and leave decisions on smaller takeovers with the member states involved.2 Passing clear ground rules for takeovers in the ECwill facilitate the expansion of firms through mergers and acquisitions and perhaps further increase the demand for merger and acquisition services. Insurance Products Opportunities for U.S. insurance companies in the EC’Sinsurance sector are reflected in several important measures of potential ECinsurance demand. First, as of 1985, premiums per head in Europe were roughly one-third of those in the United States. Second, for the period 1970-85, the average real growth rate in premiums was higher in Europe than in the United States, 4.3 percent versus 3.2 percent, respectively, despite ‘Among all acquiring nations, the value of U.S. acquisitions in Europe trailed only those made by French firms during this period. %nder the current proposal, the European Commission would review a merger if it exceeds all three of the following thresholds: (1) worldwide combined turnover exceeds 5 billion ECUs ($5.7 billion), (2) inter-EC combined turnover exceeds 250 million ECUs ($265 million), and (3) not more than 66 percent of the turnover of either partner is in any one member state. Page 36 GAO/‘NSL4B9O-99 European Commnnity chapter 3 Accessto the EnropeMComnndtyAppeara Open, but Other Factors May Limit U.S. Finandal Firms’ Partidpntion equal growth rates in gross national product. This greater demand for insurance in Europe is reflected in a larger income elasticity of insur- ance demand in Europe as compared with the United States.3 Though other factors, such as differences in our social insurance and legal sys- tems, may account for the greater demand figures in Europe, they would seem to indicate that the U.S.’market is relatively more saturated than Europe. This conclusion is supported by U.S. insurers we interviewed in the EC.They anticipated increased growth, especially in lower-tier EC countries, as the Single Market Program’s impact is felt. To date, the greatest progress in liberalizing insurance markets under the Single Market Program has occurred in the non-life sector for large risk (industrial and commercial) customers. U.S. insurers are concen- trated in this sector and should benefit when the freedom granted by the Second Non-Life Insurance Directive to market policies across Commu- nity borders is implemented in most member states by July 1990. Market participants and experts believe, however, that the greatest opportunities in the EC insurance industry will not occur until the life insurance sector is liberalized and companies are free to promote life insurance products across borders. The life insurance industry has been heavily regulated to ensure consumer protection. This regulation has produced wide price differentials among EC countries for similar prod- ucts. For example, in Portugal, basic life insurance is priced 10 times higher than a comparable policy in the United Kingdom. Market oppor- tunities will be available to those firms able to offer competitively priced insurance products following liberalization. Investment Funds Growth is also likely in demand for new investment vehicles, such as UCITS (or mutual funds), pension funds, and Employee Stock Ownership Plans as a result of the EC’SSingle Market Program. Currently, the mar- ket for these investment products in Europe is half the size of the U.S. market. In fact, U.S. mutual fund industry assets of $810 billion in 1988 are almost equivalent to mutual fund assets in the rest of the world com- bined. Given a comparatively higher savings rate in the EC than in the United States, investors in the ECare likely to seek out new investment products as they become increasingly available. The EC’SUCITS Directive 31ncomeelasticity of insurance demand measures the relationship of the percentage change of insur- ance demand to the percentage change of the gross national product. For the period 1970436,U.S. income elasticity of insurance demand was roughly 1.3. In Europe, only Italy has a lower elasticity Page 37 GAO/WXAB!4O-39 European Community Chapter 3 a4ccemtotheEmro~~mmunityAppearu Open, but Other Factma May Limit U.S. Flnandal Firms’ Partidpetion permits cross-border selling of funds, subject only to host country super- vision of their marketing, once the funds are authorized in one member state. Such authorization should increase sales of these investment prod- ucts. U.S. institutions, with their prior experience in marketing and packaging these products in the United States, should benefit from these liberalizations. Free Capital Flows and The scheduled elimination of exchange controls in the ECis essential to Financial Market achieve integration of EC financial markets because of its cross-se&oral impact on all financial services. The freedom to offer services across Developments borders is, for the most part, irrelevant, unless investors, borrowers, and intermediaries can transfer capital freely across borders. Exchange con- trols are a primary, but not the only, constraint on capital movement. Experts say that other barriers to free capital movement, such as restricted access to foreign brokership licenses, discriminatory taxes on purchases of foreign securities, and limitations on balance sheet hold- ings of foreign securities, indirectly limit capital movement. The EC’S 1992 program will also remove these restrictions. The free movement of capital should offer new and increased opportuni- ties for providers of non-m financial products, including those from the United States. For example, some U.S. securities firms in Spain intend to market US. products to Spanish citizens once exchange controls are lifted there. Currently, Spanish citizens may only invest outside Spain through a Spanish bank, subject to withholding taxes on their investment. A single capital market should also stimulate further development of derivative products, such as futures and options and securitized assets. U.S. financial institutions have a reputation for expertise in such sophis- ticated products and should profit as a result. For example, one U.S. investment firm, with considerable experience in the US. mortgage- backed securities market, recently entered into an agreement with a major French bank to assist it in developing a mortgage-backed securi- ties operation. Cost Savings From The integration of the ECshould enable financial firms to reduce their Consolidation administrative costs by consolidating some of their activities. Harmoniz- ing accounting and financial reporting standards for banking, securities, and insurance firms will allow greater consolidation of accounting and information systems. The integration of markets and the ability to offer Page 38 GAO/‘NSIAD-93-33 European Commnnity chapter 3 A- to the European Community Appeua Open, but Other Factors May Limit U.S. Finanti Firms’ Partidpation services from a centralized location after 1992, coincident with improve- ments in information technology, enable further consolidation of admin- istrative functions. Some U.S. institutions have already begun to consolidate these functions, while others plan to do so in the near future. In some instances, the consolidation will lead to cutbacks in per- sonnel, which could be incorrectly interpreted as a retreat from the mar- ket, even though volume and profit levels are increasing. Most U.S. financial firms that we contacted do not plan on expanding U.S. Institutional their presence in the EC as a result of the Single Market Program. Several Strategy: Generally banks already in the Community are scaling back their commitment and Not One of Expansion retreating from some activities and countries altogether. Other U.S. banks that might seem likely candidates for new entry into the Commu- nity expressed little interest at this time. Securities firms, while perhaps more optimistic about the Single Market Program, have not translated their interest into specific plans for expansion. Only in the insurance industry did we find evidence of increased entry by U.S. firms. U.S. Commercial Banks In contrast to their ECcompetitors, U.S. banks are not expanding in the Are Targeting Their EC despite the new opportunities anticipated under the 1992 program. Instead, U.S. banks are using their limited capital resources to target the Opportunities most profitable niche markets and opportunities, while also restructur- ing their operations to reduce costs. In some cases, this restructuring has led to reductions in staffing or withdrawal from some relatively unprof- itable activities. Also noteworthy has been the sale of some U.S. banks’ retail operations in Europe. Representatives of some large regional banks told us that they had no interest in expanding into the EC at present, These banks see better opportunities available in the United States, such as those arising from the removal of U.S. interstate branching restrictions, than might exist in the EC. U.S. Securities Firms Seek While securities firms are optimistic about their prospects in the ECafter Little Expansion 1992, most do not plan on expanding there. Generally, U.S. securities firms are responding more to member state changes in regulation than to the EC'S Single Market Program changes. In Spain and Prance, stock exchanges and domestic securities markets will become more accessible to foreign entry, in part as a response to 1992 liberalizations. To meet local requirements in these countries, U.S. securities firms are forming Page 39 GAO,‘h’SIAD90-99 Eumpean CYmnmunity Chapter 3 Aceem to the European Cmumunity Appears Open, but Other Factors May Limit US. Fhandal Firm& Partidpation separately capitalized and locally incorporated brokerages in order to underwrite and trade domestic securities. West German experts told us that several U.S. securities firms established German banking subsidiar- ies following the recent relaxation of German law, which now permits foreign-owned German banks to underwrite domestic Deutsche mark issues. U.S. securities firms are also looking toward the formation of a German futures and options exchange in the early part of 1990. In the United Kingdom, where the securities markets are larger and more global in character than elsewhere in the EC,U.S. securities firms are generally larger and more knowledgeable about the Single Market Program’s potential impact. Even so, their actions have been more defensive than expansive, Some U.S. securities firms, which had previ- ously operated in London as branches, have established separately incorporated U.K. subsidiaries. Their reasons for doing so are to respond to the concerns of U.K. regulatory authorities that their activities be under some form of supervision and to ensure against reciprocity provi- sions, should they reemerge in the Community, by establishing an EC base. U.S. Insurance Firms’ With the growing prospect of a single market in the Community, there Limited Presence May are indications of increased U.S. insurance industry interest in its mar- P Wr\Xll UlUW kets. Both life and non-life U.S. insurers are establishing themselves in the EC;those already established in the EC are reorganizing to prepare for the single market. Our discussions with representatives of the U.S. insurance industry in the Community indicated that at least eight U.S. companies were either expanding their networks within the EC,establishing distribution alli- ances with EC banks and insurance companies, or opening new offices. Several other U.S. insurers were studying possible entry into the Com- munity. Some companies planned to enter the large-risk non-life insur- ance market, which has been the most attractive to U.S. firms in the EC to date. Most of this activity is expected to occur in the southern-tier EC countries, where penetration by insurance companies has traditionally been low. Two large U.S. international insurers already in the Community have recently reorganized. They are attempting to portray themselves better as “European” and to guard against reciprocity by employing a “hub- and-spoke” strategy. They have established a primary headquarters subsidiary (the “hub”) in the EC,with the remaining network of Page 40 GAO,‘NS~gO-93 European community - Chapter 3 Access to the European Community Appears Open, but Other Factora May Limit U.S. Finandal Firms’ParticipatioIl branches and subsidiaries (the “spokes”) in Europe reporting to the European headquarters. Through this organizational structure, U.S. insurance companies are able to qualify for the single passport, portray a unified European corporate image, and centralize data and administra- tive functions while still maintaining a local presence. U.S. insurance companies have a greater incentive than banking and security firms to establish a subsidiary base in the Community. This is because branches of non-m insurance companies must meet both EC- wide and home country solvency and other requirements, whereas branches of ECinsurance companies need only adhere to their home country requirements. U.S. financial firms are not expanding in Europe to the same degree as Factors and their EC competitors, although they have equal access to the single mar- Impediments Affecting ket and its new opportunities. However, their reluctance may be strate- U.S. Firms’ Strategy gically sound, considering possible impediments and other considerations U.S. financial firms must also factor into their plans. The following section discusses factors institutions cite as affecting their intentions. We did not attempt to weigh the relative importance of vari- ous factors, given that no two institutions are entirely alike. However, U.S. regulatory restrictions on the overseas securities activities of U.S. banks ranked as a primary consideration for a large majority of U.S. banks. U.S. Bank Law Restricts A majority of U.S. bank officials with whom we spoke in the ECbelieved the Nature and Extent of that U.S. bank laws and regulations placed them at a competitive disad- vantage in relation to ECbanks. Regulation K was singled out as having U.S. Banks’ Securities the most detrimental effect. Regulation K4 restricts the absolute and rel- Activities ative size of certain activities of nonbank subsidiaries overseas, most notably their securities dealing, distribution, and underwriting. The Glass-Steagall Act” separates commercial and investment banking in the United States and does not permit nonbank activities to be con- ducted within the bank itself. The Glass-Steagall Act applies only to U.S. ‘Regulation K was issued by the Board of Governors of the Federal Reserve System under the author- ity of the Federal Reserve Act, the Bank Holding Company Act of 1956, the International Banking Act of 1978, the Bank Export Services Act, and three International Lending Supervision Acts “The Gla~~Steagall Act is contained in sections 16.20,21. and 32 of the Banking Act of 1933 (12 USC. Sec. 24, 377. 378, and 78). Page 41 GAO,‘NSIAD9O-93 European Ckxmnunity chapter 3 Acceea to the European Cknnmunity Appears Open, but Other Factora May Limit US. Flnandal Fimd Participation domestic banking activities. International operations permissible for U.S. banking institutions overseas are set forth in Regulation K and allow U.S. banking organizations to be more competitive in foreign mar- kets by permitting them to do a broader range of securities activities overseas than is permitted in the U.S. market. However, Regulation K limits the absolute and relative size of such activities, unlike the EC’S regulatory framework, which is increasingly shifting toward universal banking. The Glass-Steagall Act indirectly affects U.S. overseas banking operations since the volume restrictions provided for in Regulation K depend, in part, on the restrictions on domestic equity underwriting imposed by Glass-Steagall. U.S. banks have also insisted that their inability to offer the same range of services in both domestic and inter- national markets has hindered their efforts to compete with foreign banks.” Regulation K Regulation K limits have become more burdensome in recent years because of trends in corporate and investment finance. Demand for banks’ intermediary role in providing long-term loans has waned during the 1980s as corporate borrowers have increasingly gone directly to investors for funds in order to reduce their borrowing costs7 This increased demand from the banks’ customers for alternative financing vehicles has been matched by the banks’ efforts to reduce their lending activity and boost fee income. In part, this action reflects U.S. banks’ attempt to increase their profitability and, in part, it is a reaction to newly imposed capital adequacy standards that require increased capi- tal to back increases in bank assets. The complexity and size of financial placements have also grown in recent years. Today, financing packages are increasingly requiring a mix of debt and equity. These placements often require the underwriter to assume a portion of the equity. U.S. bank representatives stated that they are unable to compete with large ECuniversal banks for new corpo- rate customers, or even retain their present customer base, without the ability to lead or participate substantially in equity underwriting and distribution. Currently, Regulation K limits equity underwriting by U.S. banks to $2 million per issue per subsidiary. Another provision of the regulation limits the amount of investment by U.S. banks in a subsidiary “For a discussion of Glass-Steagall, see the GAO report, Bank Powers: Issues Related to the Repeal of Glaaa-Steagall Act (GAO/GGD88-37, January 22,1988). ‘Net international bond offerings grew from $28 billion in 1980 to $126 billion in 1986, while net international bank lending decreased from 6160 billion to $106 billion during the same Period. Page 42 GAO/?WABW Enropenn community chapter 3 Aceem to the European Commmi~ Appeara Open, but Other Factma May Limit US. Finandal Firma’ Partidpation joint venture or portfolio investment to a total of $16 million, or 6 per- cent of the investor’s capital and surplus. Some banking institutions have interpreted Regulation K as permitting up to $16 million per issue, or 6 percent of the institution’s capital and surplus. According to bank officials, two methods are used to partially circum- vent the equity underwriting limits of Regulation K. The first is a con- sortium approach, whereby the bank owns up to the maximum 6 percent in a consortium of the associated underwriting risk. In the other method of circumvention, a bank merely spreads a placement, up to $2 million per subsidiary, around its international subsidiaries to a maximum of $16 million per issue. U.S. banks must, therefore, forsake any amount in excess of $16 million to competitor institutions or attempt to pass through these positions by the end of each day.s In addition, the size of individual placements has grown. A representa- tive of one leading U.S. bank told us that the $16 million limit has not been adjusted for corresponding increases in the size of under-writings. Regulation K Forces More Regulation K prohibits U.S. member banks from conducting any non- Costly Organizational bank activities in overseas branches. Such activities are restricted to subsidiaries, although these subsidiaries can conduct a full range of Structure banking activities as well. The requirement that these activities take place within a subsidiary, together with the volume restrictions noted above, has led to costly and complex organization structures for these institutions, according to bank representatives. This result, they feel, is in conflict with the philosophy of the EC’SSecond Banking Directive, which endorses a universal banking model, under which banks are free to conduct a wide range of activities within the parent bank or its branches. Most ECcountries follow this approach, while other member states are expected to assume the directive’s broader powers through the process of regulatory convergence discussed in chapter 1. Our discussions with officials in Spain and France revealed that finan- cial regulatory reform in these countries creates disadvantages for U.S. banks as compared with their ECcompetitors. The latter are free to con- duct the same activities without the additional organizational, licensing, or capital requirements of establishing subsidiaries able to conduct non- banking activities. “Regulation K limits apply only to closeofday positions; therefore, banks are required to sell any intraday holdings in excess of $15 million by the end of the day. Page 43 GAO,‘NSlAD~99 European Chnn~unky chapter 3 Accem to the European CommuniQ’ Appeara Open, but Other Factors May Limit US. Finandal Firms’ Partidpation Spain’s securities markets have recently been deregulated, in anticipa- tion of 1992. As part of this deregulation, banking and securities mar- kets have been opened to foreign financial firms, including those from the United States. Securities underwriting in Spain requires an agency license. This license is automatically granted to banks, including the branches of FE universal banks that conduct securities activities.” However, U.S. banks are only permitted to conduct underwriting activities within a subsidiary under U.S. law and, according to bank officials, these subsidiaries are not viewed as banks by Spanish regulatory authorities. Therefore, U.S. banks’ securities subsidiaries do not receive this automatic license approval. The U.S. banks’ securities subsidiaries must, therefore, apply for separate licenses that require an investment of 700 million pesetas ($6 million) in capital.lO This cost is not incurred by their EC competitors. One U.S. bank manager complained that these additional requirements and costs take away the flexibility to ease into underwriting activities while building a client base. Instead, a high minimum capital investment must be committed from the start with the hope that adequate return on investment can later be generated to justify it. U.S. banks in France are faced with a similar predicament. While FL banks are free to conduct investment banking activities within the bank itself in France, U.S. banks can only conduct these activities in subsidi- aries. Accordingly, US. banks have established French subsidiaries, referred to as Article 99 investment companies (or societe financiere), with a 7.6 million French francs ($1.2 million) capital requirement for each company.” Restrictions on U.S. Bank officials have noted that U.S. interstate branching restrictions Interstate Banking under the McFadden Act and the Douglas Amendment to the Bank Hold- ing Company Act have resulted in a U.S. banking industry that is more “Officials stated that in addition to the agency license needed to conduct securities activities in Spain, separate licensing and capital requirements must be met to obtain a broker or broker-dealer license to operate on the Madrid Stock Exchange. Foreign participation in these brokerships is currently limited to 30 percent, increasing to full ownership in 1992. Only two of the U.S. institutions we interviewed have purchased a broker participation licensed in the exchange. “‘lking an exchange rate of 120 pesetas to $1. in effect on November 30. 1989 ’‘Using an exchange rate of 6 French francs to L 1, in effect on November 30. 1989 Page 44 GAO/NSIAlMO-99 European Community Chapter 3 Access to the European Community Appears Open, but Other Factora May Limit U.S. Finandal Firms’ Partidpation fragmented than Europe’s Slowly, states are relaxing branching restric- tions on a regional basis, but some U.S. international money center banks are still excluded from these regional compacts. The banking sector in Europe is more concentrated than in the United States, in part because of geographic restrictions limiting expansion in the United States. For example, of the world’s top 600 banks in 1987 as measured by total assets, 162 are from the EC,while only 28 are from the United States. The EC’S1992 program will likely increase banking concentration in the Community, as ECbanks expand their presence from a national to a European scale. Thus, U.S. banks will encounter even larger and more powerful ECcompetitors while facing handicaps from restrictions on their ability to grow domestically. These develop- ments have led not only bankers but other observers, including the Fed- eral Deposit Insurance Corporation, to argue that present restraints are no longer appropriate in today’s financial marketplace. Securities and Exchange U.S. disclosure requirements make U.S. markets less desirable to foreign Commission Disclosure issuers and U.S. investment products less attractive to foreign investors, according to U.S. institutions active in EC securities markets. Bankers Requirements told us that the Securities and Exchange Commission requires that their financial statements adhere to US. generally accepted accounting prin- ciples. Thus, some foreign issuers must maintain a separate set of accounting records and release more information than they would if they raised funds in EC markets. For example, some issuers may hesitate to disclose management compensation, as required by the Securities and Exchange Commission, owing to the prevalence of kidnapping in some countries. As ECsecurities exchanges grow and improve, corporate issu- ers may increasingly turn to them as an alternative to US. capital mar- kets to avoid U.S. disclosure and other requirements. We were told that some EC investors, particularly high-net-worth indi- viduals, are reluctant to invest in U.S. products and, therefore, to deal with the U.S. firms that market them, because of Securities and Exchange Commission disclosure requirements. According to some U.S. investment services firms, mandatory disclosure of acquisitions either in excess of 5 percent of capital or following a takeover deters those inves- tors who prefer anonymity. Page 45 GAO/NSIADSO-99 European Community Chapter 3 Access to the European Community Appeam Open, but Other Factma May Limit U.S. Flnandal Firma’ Participation Some EC and Member The liberalizing nature of the 1992 program does not mean that all the State Impediments May barriers presently encountered by U.S. financial firms in the ECwill immediately disappear or that others will not be erected. For example, Remain U.S. banks will encounter the dilemma of whether to continue to con- duct most of their activities in a branch structure in the EC for cost con- siderations or to opt for an Ec-incorporated subsidiary network in order to enjoy the single passport and other freedoms. The Single Market Pro- gram also should not eliminate the dominance of some ECfinancial firms. Finally, because the EC’Sliberalization will be an uneven and imperfect process, some opportunities may not be forthcoming until sometime after 1992. The Organizational U.S. banks have created separate subsidiaries in the ECto conduct non- Dilemma for U.S. Banks bank activities, but a majority of their overseas banking activities are conducted in branches, rather than subsidiaries, primarily for cost rea- Operating as Branches sons However, under the Single Market Program, branches from third countries are not entitled to single passport powers. In addition, they may face further member state capital and other requirements. Thus, U.S. banks that operate in the EC as branches of their U.S. parent bank will not benefit from the new powers available under the EC’SSec- ond Banking Directive, including the single passport power to offer ser- vices freely across borders and to establish branches anywhere in the EC without obtaining prior authorization. These freedoms and expanded powers will only be available to banks incorporated in the EC,while non- EC branches will remain under the authority of individual member states. Second, even after the 1992 program is complete, some countries, nota- bly Germany, may continue to set capital requirements for branches of non% banks.*2 Member states remain free to apply these requirements under the EC’SFirst Banking Directive. In applying these separate capi- tal standards, non-m branches are treated like stand-alone subsidiaries for capital adequacy purposes. “‘Non-EC banks with branches in West Germany are concerned that they will have to meet capital requirements not prescribed for branches of EC banks. The United States has raised this issue with the EC, but was told that this was a bilateral German-US. problem and did not concern the EC. The U.S. Peawry Attache in Bonn believes that basing different requirements on country of origin is discriminatory, and that it is a violation of U.S.German treaty obligations. According to the ‘TreasurY Attache, this dispute has not been resolved. Page 46 GAO/NSIAD~99 European commonity chapter 3 Acceea to the European CommuniQ Appear Open, bnt Other Factore May Limit U.S. Finandal Firma Partidpntion Third, it is uncertain how non-M: branches will be treated in matters other than those concerning capital requirements. The First Banking Directive states that non-m branches may not receive more favorable treatment than ECbranches. This provision would seem to indicate that where host country regulations are more lenient than the EC’S,there will have to be a “leveling up” of host country requirements. Furthermore, each member state will be free to apply its own reciprocity provisions against non-rzc branches. Local Consortiums Remain Close relations, legal and otherwise, between financial services suppliers Powerful and their customers and a high level of industry concentration dominate particular market sectors in some EC states. The result is that individual institutions are able to wield considerable economic power. This power is strengthened by ties among government, industry, and the financial community in some EC countries in the form of interlocking directorates, as well as in equity holdings. It is difficult to separate the impediments for foreign firms posed by special supplier/customer relationships from the natural advantages enjoyed by any domestic institution in its home market. While U.S. financial firms generally stated that they are not experiencing overt reg- ulatory discrimination, the influence and power EC financial firms wield in their home markets are often far greater than U.S. firms enjoy in the United States. Consortiums, or evidence of high industry concentration, are present in Spain, France, and West Germany-three of the four countries we visited. In Spain, close ties are presumed to exist between domestic banks and industry, based on Spanish banks’ large equity holdings in nonfinancial firms. Non-life catastrophic insurance is controlled by an industry car- tel, which U.S. insurers are hoping will disappear after 1992. In addi- tion, a government-owned insurance company until recently had a monopoly on the coverage for state-owned industries. Though state owned industries may now obtain coverage from private sources, the traditional arrangements are expected to change slowly. In West Germany, the “Big Three” private German banks (Deutsche, Dresdner, and Commenbank) wield considerable power. The universal banking structure has allowed German banks to take large equity posi- tions in some of Europe’s biggest corporations. For example, officials stated that Deutsche Bank owns 28 percent of Daimler Benz, one of Page 47 GAO/WZAD~93 Ehuqean Cmnmmity chapter3 Accem to the European Cmnmunity Appears Open, but Other Facturn May Limit U.S. NnancialFlrnu’Partidpation Europe’s largest corporations. I3 German banks’ power extends well beyond their voting rights because of the proxy votes they control under their customers’ accounts. One leading U.S. institution in West Germany complained that German banks’ power has been institutionalized in the syndication of German debt. I4 No foreign bank is allocated more than 1 percent of each syndica- tion and, in total, foreign banks are limited to 20 percent, whereas Deutsche Bank alone is given a 16 percent share. France is the most heavily concentrated major banking market in the EC, containing large, domestic, often state-owned institutions. The three largest banks are all owned by the government. The next three largest were only recently privatized. In 1987, the 5 largest banks in France controlled nearly 80 percent of total banking assets in France, represent- ing over half of the entire financial system. This extent of concentration leads some analysts to believe that short of outright acquisition, the large French banks’ domestic position is impregnable. Some Impediments May As explained in chapter 1, the Single Market Program, by the EC’Sown Remain, While Others W ‘ill design, does not standardize all ECregulations for financial firms and markets. Rather, the EC’Splan is to establish m-wide minimum essential Only Slowly Disappear standards, allowing competitive market forces eventually to bring about an equilibrium level of harmonization. The interim result may be a slow, sometimes uneven, integration process. This process could, in some instances, work to the disadvantage of U.S. firms. Some member states may not remove some barriers for a while in order to protect domestic firms or to ensure safety and soundness. Officials said that the EC’S 1992 program does not eliminate member state restrictions on the types of foreign investment products that domestic firms may invest in or on the types of products that may be “‘Under the Second Banking Directive, an EC bank’s ownership in stock of any nonfinancial firm is limited to 15 percent of bank capital and 60 percent in aggregate. West Germany, however. is opposed to this restriction, which could force divestitures by German banks. ‘%ovemment debt in West Germany is sold via a consortium rather than a free auction system, as used in the l’nited States. Page 48 GAO,‘NS~W99 European Ckmmdty chapter 3 AcceaatotheEuropeanCo~~App~.ara Open, but Otbez Factom May Limit U.S. F'inandall'Putidpation sold. For example, West German insurance companies, the largest insti- tutional investors in Germany, are prohibited from investing the major- ity of their assets in foreign investment products.15 Insurance companies in Germany, foreign and domestic, are also restricted in the types of products they can sell. For example, certain types of insurance that are sold in the United States and for which U.S. insurers have developed a market edge, such as cancer insurance or corporate officers’ and direc- tors’ liability insurance, cannot be sold in West Germany. Business Considerations While not discriminatory, there are certain “natural” advantages enjoyed by domestic institutions in their home markets that act as barri- ers to foreign firms. The barriers that U.S. financial firms encounter affect their strategic planning for new market entry or expansion. Among the advantages naturally accruing to domestic institutions are the loyalties and cultural links with domestic customers, familiarity with the local language, and knowledge of legal and regulatory norms. These ties are especially important in retail markets. For example, a domestic bank’s easier access to retail deposits can result in a lower cost of funds than is available to foreign banks, which typically rely on more expensive interbank loans. A U.S. bank manager in Spain said that U.S. banks also have a difficult time attracting qualified personnel. Other Factors Influence In tandem with 1992 developments, a number of international market U.S. Financial Firms’ and regulatory trends are also occurring that could affect U.S. financial firms’ participation in the EC. For banks, the Basle Committee’s new cap- Strategies ital adequacy standards, less developed country debt burdens, and new market opportunities opening in the United States affect their strate- gies. Greater competition and increasing trends toward market speciali- zation are other factors that affect the strategies of all financial firms, including banks. ‘“Similar restrictions apply to Italian life insurance companies and to French mutual funds, called s1c4vs. Page 49 GAO/NSIAD9O-99 European Community chaptfs 3 Accemt.otheE~~~peanCommnnityAppeam Open, but Other Facto- May Limit U.S. Finandal Fim~’ Partidpation New Capital Adequacy The world’s major banks, including those from the United States, are bound to adhere to a minimum standardized capital adequacy ratio Requirements Raise Ban .k “--L- ux!xs beginning in 1991 .I6 Many banks do not meet this minimum ratio and, therefore, may have to raise more capital or reduce their assets, or both. Those banks under most pressure to meet capital adequacy guidelines are being forced to sell off portions of their organization to raise capital and reduce their asset base. Cutbacks have already occurred in U.S. banks’ EC retail operations, which tend to require large amounts of fixed capital. Raising new capital has been hampered by U.S. bank stocks’ poor performance in recent years. U.S. money center banks’ earnings have lagged behind both regional banks’ and the Standard & Poor’s 600 stocks’ earnings. Because bank stocks have become a less desirable investment, it is more difficult for these banks to raise needed capital. These concerns may lead even relatively healthy U.S. banks to be more cautious in approaching new and unproven markets or activities. Less Developed COWntry U.S. banks’ profitability, especially the earnings of international money Debt Problems Have center banks, is being reduced by increased loan loss provisions on less developed country loans made during the 1970s. Banks’ exposure to Reduced Banks’ these loans has raised their cost of capital by reducing stock market val- Profitability uations. This exposure has also expended key management resources, has possibly made management more wary and cautious of new ven- tures, and has cut into banks’ profit because of the need to set aside specific reserves. Some U.S. banks are substantially increasing their reserves for these loans, but doing so requires capital that might other- wise have been used to expand in the EC.Meanwhile, ECbanks have not suffered as greatly from less developed country loan problems. Accord- ing to a U.S. consultant, ECbanks had the strength of their retail bank profits to cover their reserves. In addition, different requirements for set-aside reserves in some ECcountries, notably West Germany, encouraged early action on these loans. Domestic Opportunities U.S. banks told us that the ECis not the only investment alternative Compete for Attention and available to them. Many of the US. international money center and regional bank officials we interviewed are targeting their capital Funding resources toward new domestic opportunities where they expect returns ‘“Under the 1988 Basle Convergence Agreement, the Group of Ten (G-10) countries, actually consti- tuting 11 countries, including Belgium, Canada, fiance, Italy, Japan, Luxembourg, the Netherlands, Sweden, the United Kingdom, the United States, and West Germany, have agreed to a standardized formula for calculating capital ratios of banks. Beginning in 1991, b& should have a minimum capital base of 7.26 percent of risk-adjusted assets. In 1993, the minimum ratio increases to 8 percent. Page 60 GAO/‘NSIADfIO-93 European Community Chapter 3 Access to the European CommuniQ Appears Open, but Other Factora May Limit US. Flnandal Firma’ Partidpation on investment will be greater. The resolution of the savings and loan crisis will allow banks to diversify and to expand by buying failed thrifts at distressed prices. Interstate barriers are falling in many states, providing opportunities for U.S. banks to expand to other parts of the United States. Indeed, the anticipated expiration in 1992 of interstate branching restrictions in California may offer greater opportunities than does the EC.In addition, representatives of some insurance companies and banks told us that the Far East offers more attractive investment opportunities than those available in the Community. Increased Competition in As a result of the EC’SSingle Market Program, increased competition, the EC Is Expected both from EC and non-m financial firms, is expected by most U.S. finan- cial firms, consultants, and experts with whom we spoke. Deregulation should, as a matter of course, lead to greater competition among finan- cial institutions. ECfinancial firms are expected to meet those competi- tive challenges not only by expanding their presence in other EC countries, but also by becoming more competitive at home to ensure their customer base. Expansion by EC financial firms across borders and into other market sectors is a natural outgrowth of the enlargement of the EC’Smarketplace from national boundaries to EC boundaries. Expan- sion is generally taking one of two routes: directly through merger or acquisition, or indirectly via strategic alliances. At the beginning of the Single Market Program (1984-1987) there was a notable increase in the number of ECmergers, minority acquisitions, and joint ventures in the banking sector. For example, the number of bank mergers nearly doubled, from 18 to 35, during this period. Because the number of attractive acquisition candidates is limited, financial firms in the EC are also looking to build cross-border alliances. Alliances allow firms to expand their product distribution without a significant loss of manage- rial control. Increased competition from other non-m countries, notably Japan, is also anticipated as 1992 approaches. Leading Japanese institutions have been established in London for some time. Japanese financial institu- tions have also established banking affiliates in Frankfurt to gain a foot- hold in the important Deutsche mark sector. U.S. regulatory authorities now anticipate that the Japanese will relax restrictions on the overseas securities activities of their banks.” If so, the United States will be the “Current restrictions on the securities activities of Japanese banks are detailed under article 66 of Japanese banking law. Experts say its provisions separating banking and commerce are broadly simi- lar to those in the U.S.’Glass-Steagall Act. Page 51 GAO/‘NSlAIMO-93 European Ckmmunity Chapter 3 Access to the European Community Appear Open, but Other Factors May Limit U.S. FinandaI Finns’ Participation last major financial power to retain this separation of commercial and investment banking. Furthermore, increased demand for financing from the Japanese manufacturing sector in Europe, which is actively expanding in the ECprior to 1992, will undoubtedly mean increased bus- mess for Japanese financial firms. Financial Firms Are Wary, The deregulation of the U.K.‘s financial markets in 1986, often referred Following the U.K.‘s “Big to as the “Big Bang,” led to intense competition there. As a result, many segments of the U.K.‘s market quickly became saturated. For example, Bang” in the U.K.‘s equities market, the number of market-makers (dealers) rose from 5 before the Big Bang to 32 not long after. The market decline in October 1987 contributed to these firms’ losses. Therefore, U.S. finan- cial firms may be wary about entering new markets with a large finan- cial commitment, especially when intense competition is expected. The EC’Sprogress in liberalizing its markets under the Single Market Pro- Conclusions gram has provided ample evidence to the international financial commu- nity that a single market in Europe is likely to emerge. Estimating how it may affect the U.S. financial services industry this early in the process is, nevertheless, very difficult. Some key EC financial services directives still require final passage. Additional directives, notably in the insur- ance sector, will have to be proposed and adopted in order to achieve a fully liberalized and integrated market. Even once all the directives are finalized, much will still depend on how the member states implement them. And, finally, the directives by themselves will not dictate the final form of post-1992 EC financial markets; internal and external economic, political, and technological variables will also weigh heavily on the pro- cess and its result. This report has tried to identify the most likely impact of the Single Market Program on U.S. financial firms in Europe. The evidence and our analysis strongly indicate that the sizable stake U.S. financial firms have built in the EC will not be jeopardized by overt ECactions to bar them. Nor is the EC likely to restrict the future entry of other U.S. finan- cial firms not already there. Therefore, U.S. firms should benefit from the new and expanded opportunities offered by the single market. Equal access and expanded opportunities alone, however, may not be enough to ensure that U.S. financial institutions will prosper in a post- 1992 Community. This is especially true for U.S. banks, which have the greatest stake in the EC among U.S. financial firms, but are also facing Page 52 GAO/NSIADW93 European Community Chapter 3 Access to the Eumpean community Appears Open, but Other Factora May Limit US. Finand Firm2 Participntion the greatest challenges. During the 198Os, U.S. banks have seen their global dominance fade for several reasons, such as poor international lending practices and the competition posed by nonbank financial institutions. The evolving divergence between U.S. and ECregulatory philosophies now poses an additional challenge to U.S. banks that operate in the Community. EC banks are organized under a regulatory structure that allows them to compete better and to profit more easily from broader powers under the Single Market Program. U.S. banks, by contrast, remain governed by a regulatory philosophy that prohibits universal banking. These regulatory developments under the Single Market Pro- gram are occurring against the backdrop of fundamental shifts in corpo- rate and investment finance away from the traditional activities permitted U.S. banks and toward those that are still impermissible or restricted. As a result, U.S. banks are likely to face larger, better capital- ized, and more diverse ECuniversal banks armed with broader powers and capabilities under the Single Market Program. The EC’Sendorsement of the universal banking model for its more open Matters for financial markets gives greater urgency to the ongoing congressional Congressional debate over how broad U.S. bank powers should be. The decision to Consideration modify the existing requirements is a judgmental one. In weighing the pros and cons of the existing structure, consideration should be given to the impact of these requirements on the ability of U.S. banks to compete in the EC after 1992. Page 53 GAO,‘NSLAIMO-93 European Community The Appropriateness of the U.S. Government’s Response Generally, the U.S. government has responded in a timely and coopera- tive fashion to protect U.S. financial sector interests in the emerging EC single market. US. agencies organized early to identify the primary issues and to develop a coordinated policy response. Reciprocity served as the primary test of the adequacy of the U.S. government’s ability to defend U.S. interests and, while US. intervention was not the only fac- tor, it helped to soften the EC’Sstance. U.S. financial firms generally view the U.S. government’s efforts favorably. Numerous U.S. agencies and private sector groups have an active inter- Many U.S. est in the EC’Sprogram to integrate its financial markets. The U.S. Trea- Government Agencies sury Department is responsible for forming policy and monitoring, and Private Sector assessing, and directing the U.S. government’s response to the EC’S1992 financial services directives, including banking and securities issues, as Groups Are well as for monitoring the general macroeconomic implications for the Monitoring the EC’s United States of the EC’Sprogram. Treasury representatives stated that 1992 Program they keep the other agencies informed of developments and consult them when necessary, but they are primarily responsible for responding to 1992 financial sector developments. Within Treasury, the Office of Assistant Secretary for International Affairs is most active in directing Treasury’s efforts. Treasury relies on its financial attaches located in London, BOM, Paris, and Rome to report and to disseminate information. In the other U.S. embassies and mis- sions in ECmember countries not staffed with an attache, Treasury relies on Department of State personnel to perform the same activities. Many other agencies and private sector groups are also involved in mon- itoring developments in the EC’Sfinancial sector, including the Depart- ment of Commerce, the U.S. International Trade Commission, the Office of the U.S. Trade Representative, the Federal Reserve Board, the Office of the Comptroller of the Currency, the Securities and Exchange Com- mission, the Federal Deposit Insurance Corporation, and the Congres- sional Research Service. These U.S. government agencies have also enlisted the support of pri- vate sector associations and groups with an interest in European finan- cial markets. These groups include the Bankers Association for Foreign Trade, the American Bankers Association, the Investment Companies Institute, the International Insurance Council, the Industry Sector Advi- sory Committee, the National Association of Securities Dealers, the Busi- ness Roundtable Task Force, and the U.S. Chamber of Commerce, along Page 64 GAO/‘NSIAD90-99 European ‘hmmuniQ chapter 4 The Appropriateness of the US. Government’s Ref3ponse with various American Chambers of Commerce throughout the Community. U.S. Policy Coordination The U.S. government is coordinating its overall efforts on ECsingle mar- ket issues through the Trade Policy Review Group’s EC Internal Market Task Force. This task force, formed in February of 1988, is a committee of 16 executive branch agency representatives chaired by the Office of the U.S. Trade Representative. It reports directly to the cabinet-level Economic Policy Council. The task force is divided into 10 functional working groups and has 3 main objectives: (1) to understand the nature of the EC’S1992 program and the directives proposed to implement it; (2) to keep the U.S. government current on events as they occur; and (3) to identify and address potential problem areas. Treasury has not participated at the working group level, but does represent banking and investment issues at task force meetings and coordinates regularly with the relevant task force members. Seeing a need for coordination specific to financial services issues, the Secretary of the Treasury established a subcabinet level group in Sep- tember 1989, called the Policy Group on European Monetary Reform and Financial Liberalization. Chaired by the Under Secretary for Inter- national Affairs, it includes the Departments of State and Commerce and the Office of the US. Trade Representative, with the Federal Reserve Board, the Securities and Exchange Commission, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corpo- ration, and other financial regulators serving in an advisory capacity. According to a senior Treasury official, the group is both devising a strategy for dealing with the EC’Sfinancial market integration and focusing on the structure and competitiveness of the U.S.’financial industry. The group will also report on the broad implications for the United States of EC efforts toward economic and monetary union. Overseas U.S. Government While U.S. policy for responding to the ECis formulated in Washington, Agencies Are Active in the D.C., the front lines of action are the U.S. embassies and missions in the EC,in particular the U.S. Mission to the European Community in EC Brussels, Belgium. These embassies and missions are responsible for information gathering, reporting, and implementing U.S. policy. Agency headquarters direct embassy and Mission officials to collect views and information as well as to lobby on behalf of American interests. Page 65 GAO/‘NSIAD90-99 European Camunity chapter 4 The Approprhteneaa of the US. Government’6 Response For m-related matters, the U.S. Mission to the European Community is the focal point for U.S. government activities. The Mission represents, reports to, and acts on behalf of many different agencies with interests in the EC.For financial services, the Mission reports to and represents the interests of the Treasury, Commerce, Federal Reserve, U.S. Trade Representative, and Securities and Exchange Commission. Even though the Mission is relatively small compared to the EC,and its position is that of an outsider, numerous U.S. government officials stated that it has been very useful and serves as a crucial conduit for U.S. policy. The Mission is staffed by an ambassador and 23 Department of State, Agriculture, and Office of the U.S. Trade Representative officials1 A single State officer monitors EC financial services and monetary issues, with the assistance of a local national economic specialist. State has been criticized by some Members of Congress for not adding more and diverse staff to the Mission in light of its growing importance and responsibilities. In reply, State argues that additional staff at the Mis- sion-already one of the larger U.S. Missions-may not be cost-effective in light of current budget constraints, but it has agreed to add one mid- dle-level officer and possibly more in the future to help with the increas- ing work load. The Mission was also criticized for not staffing a Treasury financial attache to handle financial services. Mission officials counter that it is more important to act as an integrated unit and that semiautonomous agency personnel might hamper that coordination. Treasury was satisfied with the current arrangement at the Mission and believed it was doing a good job handling financial services issues related to EC 1992. While we did not evaluate either the adequacy or appropriateness of the Mission’s staffing, our general impression was that both the former and the current Mission foreign service officers responsible for financial services were well informed and capable. In addition to the U.S. Mission to the EC,American interests in the Com- munity are represented by U.S. embassies in the 12 member states. Some public and private sector officials stated that lobbying member state governments is as important as, or perhaps more important than, lobby- ing the EC Commission. This view is based on the fact that the Ec-a collection of 12 separate countries-requires a qualified majority of ‘As of June 1989, this staff includes a deputy chief of mission; seven economics officers, one of whom IS responsible for the financial services sector; seven political officers; including a single market coor- dinator; five agricultural officers; two public affairs officers; and a customs attache. Page 66 GAO/NSlAIWO-99 European Community Chapter 4 The Appropriateness of the U.S. Government’s lksponae member states, and sometimes full unanimity, to pass legislation. Indi- vidually influencing member states, some believe, can be more success- ful than attempting to influence the unelected Commission. Finally, American interests are also represented in other multinational arena, such as the U.S. Missions to the Organization of Economic Coop- eration and Development (OJSCD), the General Agreement on Tariffs and Trade (GATT), and the annual economic summits of G-72 leaders. These U.S. Missions to the OECD and the GAIT, which also monitor financial sec- tor developments, coordinate with the U.S. Mission to the ECon EC- related matters. While the rapidity with which the EC has moved on its 1992 program The U.S. Government has surprised many, even some members of the Commission, the U.S. Provided an Early and government was able to monitor events and coordinate its various agen- Coordinated Response ties in most cases to act swiftly enough to protect U.S. interests. The EC’Sinclusion of reciprocity as part of its financial services framework has provided, thus far, the greatest threat to U.S. interests and thereby has tested the effectiveness of the U.S. government’s ability to protect those interests. And while the U.S. government’s response was one fac- tor among many influencing the ECto modify its stance on reciprocity, the revision is much more favorable to U.S. financial firms and the U.S. government. U.S. financial firms operating in the EC generally view favorably the manner in which the U.S. government acted. The excep- tion we noted was that this coordination was not as evident regarding EC actions affecting the insurance sector. Despite the passage of the White Paper in 1985 and the Single European Act in 1987, it was not until the ECsurmounted budget disagreements in early 1988 that progress on the Single Market Program accelerated. Shortly thereafter, in March 1988, the U.S. Mission to the ECreported potential issues of concern in a series of seven cables to headquarters agencies. One of these cables high- lighted potential problems for U.S. financial firms. Given the numerous U.S. agencies involved in EC single market issues and the magnitude of these issues, the need for coordination is self- evident. In August 1988, the Trade Policy Review Group’s EC Internal Market Task Force issued general policy guidance to interested agencies ‘The Group of Seven (G-71, which includes the United States, France, Japan, West Germany, the United Kingdom, Canada and Italy, convenes at the annual economic summit, where the natlom are usually represented by their finance ministers or central bankers. Page 67 GAO/NSIAIMO-99 European Community Chapter 4 The Appmpriatenesa of the U.S. Government’s Response and overseas posts identifying the major EC 1992 concerns and the man- ner in which the US. should respond to them. During the same period, the Deputy Secretary of the Treasury delivered a major address high- lighting U.S. government concerns, and he also contacted the finance ministers of all the ECmember states. In October 1988, Treasury offi- cials visited the European Community in Brussels to voice their con- cerns regarding some aspects of the fiiancial services directives. U.S. Policy The US. government sent general guidance that speaking with a single voice, or common line, is the most effective way to communicate U.S. concerns to the EC and that all communications, including public state ments and private communications with the EC and member states, should adhere to this common line. In this way, the US. government emphasized major U.S. policy positions in its discussions with the M: and member states and minimized conflicting signals. This guidance also emphasizes the importance of systematic lobbying of ECmember states through US. embassies and the U.S. Mission to the OECD. The U.S. embassies and missions keep up with ECdevelopments, collect member state views, and communicate elements of the U.S.’com- mon line on ECmatters. Ample evidence of these activities was found in regular cable traffic at the U.S. Mission to the EC,U.S. embassies in Europe, and the Department of State. U.S.-ECinteraction takes place at two levels: a dialogue between high- ranking officials, and a working level of contacts among specialists. The uppermost level of U.S.-ECcommunication begins with ad hoc meetings between the U.S. President and the President of the Commission.3 It con- tinues with ad hoc and formal ministerial level meetings between the U.S. Secretaries of State and Treasury and the U.S. Trade Representa- tive and its European counterparts; ambassadorial contacts in member state countries; and regular subcabinet level and assistant secretary level meetings with ECofficials. At the working level, U.S. officers in the U.S. Mission to the EC,other overseas posts, and Washington agencies maintain a regular dialogue with their working level contacts in Brussels, host member states, through OECD meetings, and the ECdelegation in Washington. These con- tacts are extremely important for early monitoring of ECdevelopments and for influencing draft legislation. 31n 1989, Presidents George Bush and Jacques Mars met twice. Page 68 GAO/‘NSIADso-99 Ehropean commnnity Chfspter 4 The Appropriatemesa of the US. Govemment’s Reqonse The U.S. government also recognizes the importance of involving the U.S. private sector in communicating U.S. interests. Private sector involvement not only allows for an early exchange of information, which benefits both the U.S. government and the private sector, but also adds another channel for communicating U.S. concerns to the EC.The American Chamber of Commerce’s ECCommittee in Brussels is among the best examples of this private sector activism. This committee ana- lyzes and comments on draft EClegislation and regularly lobbies the EC on behalf of U.S. interests. Treasury asked the Bankers Association for Foreign Trade to organize and to represent the views of U.S. interna- tional banks to the Community. In April 1989, the Association released a paper highly critical of the EC’Sapproach to reciprocity. Gap in U.S. Government The sole exception we found to the United States’ providing an effective Coordination for Insurance framework for responding to EC financial services initiatives is in the area of insurance. Perhaps owing to their relatively small presence in Issues the Community and the lack of a federal insurance regulator, insurance matters have not been a priority of the U.S. government. The Depart- ment of Commerce claims responsibility for insurance matters in the EC, but its activities thus far have been primarily informational. Treasury, although not responsible for the insurance sector, has been monitoring insurance directives in terms of their relationship to other financial ser- vices directives. Commerce’s Foreign Commercial Service aids U.S. insurers in establish- ing their businesses and instructs them on local business practices but does not monitor issues dealing with regulatory treatment. Reciprocity Tested the The first and, thus far, greatest test of the U.S. government’s coordi- Effectiveness of U.S. nated policy for protecting American interests came with the EC’Sinclu- sion of a restrictive reciprocity provision in an early version of the Government Policy and Second Banking Directive. The U.S. government employed all facets of Coordination its coordinated policy approach in successfully lobbying the ECto liber- alize these provisions. While it is impossible to quantify or to isolate the effect U.S. government efforts had in relation to other factors-such as the change in ECleadership, member state objections, and internal and external private sector efforts- the end result is a less restrictive form of reciprocity that should preserve access for U.S. financial firms to FL markets. Page 69 GAO/‘NSIADW99 European community Chapter 4 The Appropriateness of the US. Government’s Response Arguments Employed bY The position espoused by the U.S. government in fighting the inclusion the U.S. Government of reciprocity in ECdirectives is based on a number of precepts and arguments. The most fundamental argument has been the threat reci- Before the EC procity poses for continued free trade among nations. Treasury cau- tioned the Commission that using reciprocity as a tool to fight protectionism by other countries would only encourage a trade war among financial markets, affecting not just the individual countries involved, but also the world’s financial system. Treasury also reminded the ECthat adherence to mirror-image reciproc- ity would undermine the single market’s commitment to a free and open market. Denying U.S. firms’ access to the Community could generate protectionist pressures against EC firms in the United States, an obvious concern to those EC countries with a sizable stake in U.S. financial markets. Treasury also argued that the practical implementation of reciprocity is overly burdensome. Reciprocity was abandoned in the United States because it would have required multiple rules and regulations specific to each of the more than 60 countries that operate banks in the United States, all based on the treatment of U.S. banks located in over 70 countries. EC and member state officials were also cautioned by the U.S. govern- ment that the EC’Sreciprocity provisions run counter to IX and member state obligations under bilateral treaties of Friendship, Commerce, and Navigation, the OECD’SCode of Liberalization of Capital Movements, and the EC’Sown Treaty of Rome. The United States maintains that ECmem- ber states would violate such outstanding treaties between the United States and most ECmember states were reciprocity to be invoked against U.S. firms. Under these treaties, U.S. companies are entitled to national treatment. The OECD’SCode of Liberalization for Capital Movements is an agree- ment among all OECDmember states to gradually eliminate barriers to capital movements. While the EC is not a signatory to this code, its mem- ber states are. State Department officials stated that any reciprocity provisions imposed by the ECcould put member states in violation of several of the code’s provisions. In September 1988, the OECDSecretariat found the EC’Sproposed use of reciprocity violates this code. The US. government has taken the position that denying access to U.S.- owned, but EC-incorporated, subsidiaries also violates the EC’Sown Page 60 GAO/NSIMHO-99 European Community Chapter 4 The Appropriateness of the U.S. Government’s Response treaty obligations. Under article 58 of the EC’STreaty of Rome, “Compa- nies or firms formed in accordance with the law of a member state and having their registered office, central administration, or principal place of business within the community shall . .. be treated in the same way as natural persons who are nationals of member states.” US. government officials interpret this statement to mean that U.S. firms incorporated in the EC should be assured access to the EC,regardless of the access or powers afforded EC firms in the U.S. Private Sector Views of U.S. financial firms with a presence in the ECgenerally stated that the U.S. Government Response U.S. government responded in a timely and effective manner to their concerns about the EC’Ssingle market program. This view is based pri- marily on their initial concerns over the EC’Sstance on reciprocity and the belief that the U.S. government response was an influence in liberal- izing that provision. As noted in the prior chapter, most of the U.S. financial firms that we interviewed felt confident the revised reciprocity clause would not threaten their ability to enter the ECmarket and enjoy the benefits of the single market. However, these firms warn that the U.S. government must continue to track the reciprocity provision and other ECinitiatives affecting U.S. interests, and they urge the United States to remain vigilant in defending their interests. U.S. financial firms vary widely in their degree of knowledge concerning single market initiatives. Private sector associations lobby the ECto pro- mote their interests, and some U.S. financial firms also lobby their inter- ests directly before the EC. These firms complimented the U.S. government’s response most highly. Generally, responsible U.S. government agency officials view favorably Future Concerns and the EC’S efforts to liberalize its financial markets, However, while the the Frmework for primary concern over reciprocity has largely abated, these officials Response believe it is important to look to the future and assess what new issues may emerge and to ensure that the U.S. government is poised to react. Emerging Concerns Based on our discussions with U.S. financial firms and government offi- cials, there are a few EC initiatives underway that could put U.S. finan- cial firms at a disadvantage and that, therefore, bear close scrutiny. Among these concerns are the possible reemergence of reciprocity in Page 61 GAO/‘NSyLD90-99 European Community Chapter 4 The Appropriateness of the U.S. Government’s Response other directives; the present delays in the implementation of the Invest- ment Services Directive; the lagging liberalization of the insurance sec- tor; and the broader impact of the European Monetary Union. Ongoing Concerns About While the apprehension by U.S. officials and private sector industry EC Reciprocity Proposals groups about the reciprocity provision in article 9 of the Second Banking Directive has largely subsided, U.S. agencies and regulators remain cau- tious. These officials are dismayed that a reciprocity concept is still being embraced by the Community, albeit in a milder form. Access to the ECmarket is still based on U.S. treatment of EC firms, under which the EC may negotiate with the United States if it does not offer, in the EC’S view, effective market access and competitive opportunities comparable to those granted by the Community to non-Ec banks. While the immedi- ate practical effect of this provision may be limited, the precedent this sets for the global financial services industry nevertheless disturbs U.S. officials. The use of reciprocity, as espoused by the EC,versus the standard of national treatment (or equality of competitive opportunity), as applied in the United States, are competing concepts within the current GAIT negotiations. Outstanding GAIT agreements do not cover financial ser- vices, but they are among the primary topics under the current round of GAIT multilateral trade negotiations, referred to as the Uruguay Round, slated for conclusion at the end of 1990. Within the Uruguay Round, the U.S.’position is that financial services should be based upon the princi- ple of national treatment. The EChas proposed a different approach in GATT negotiations, based on the “effective market access” principle. This concept presumes that national treatment alone is not enough to permit market penetration, especially if national treatment coexists in a restrictive and highly regulated environment. The United States fears that the EC’Sposition would restrict the liberalization of world financial markets. Furthermore, the possibility still exists that a stricter reciprocity provi- sion could be included in the Investment Services Directive or in the Life and Non-Life Insurance Directives. While EC assurances are that the more liberal reciprocity provision in the Second Banking Directive will be copied for these other directives, changes in U.S.-ECrelations, or man protectionist elements in the EC,could alter these intentions. Page 62 GAO/NSIAIHO-99 European Communi~ Chapter 4 The Appropriatenew of the U.S. Government’s Response Problems Caused by The EC has stated that the banking and investment services directives Delays in the Investment will not only be parallel in design but also will be implemented simulta- neously, so as not to create an “unlevel” playing field between banks Services Directive and investment services firms. However, while the banking directive has been adopted and is on schedule for implementation on January 1, 1993, the Investment Services Directive is much further behind, with a num- ber of hurdles yet to jump. Some U.S. securities firms in London are especially troubled by the possibility that the Second Banking Directive might be implemented before the Investment Services Directive. In that event, firms that conduct only investment services would not have the single passport power to branch freely and to offer services across bor- ders. They would, therefore, be at a competitive disadvantage to banks, which could use their single passport to conduct investment services under the banking directive. U.S. securities firms (and some British merchant banks) would be notably disadvantaged by this inequity, since investment services in most other EC countries are offered primarily by banks, which would not suffer from any delays in the implementation of the Investment Services Directive. This latter fact leads some to believe that these countries will not be eager to move quickly on the Investment Services Directive. The EC’s Insurance Sector The liberalization of the EC’Sinsurance sector lags behind that of the Liberalization Is Lagging banking and securities markets. The ECis further away from agreeing on a single license for the offering of insurance services than for the other financial sectors, partly because of national tendencies toward protect- ing domestic insurance industries. These delays trouble U.S. government and private sector officials because of the significant opportunities they foresee should the insurance sector be liberalized. European Monetary Union The EC’S program to create a unified financial market by 1993 is only a step toward greater European Monetary Union. The leaders of the EC reaffirmed their movement toward this goal in July 1989, entering into the first of three stages towards implementing monetary union. Such a union could have a considerable impact on U.S. monetary policy and on the global economic system. Progress in achieving such a union is, there- fore, of keen interest to some U.S. government officials monitoring EC actions. . Page 63 GAO/‘NSIAD9o-99 European Ckmmunity chapter 4 The Appropriateness of the U.S. Government’s Besponse U.S. Government Strategy As the EC’SSingle Market Program for financial services evolves, the for the Future U.S. government will continue to use the framework and policy explained earlier in this chapter, primarily through Treasury’s Policy Group on European Monetary Reform and Financial Liberalization. In addition, Treasury has begun work on a 1990 National Treatment Study, which will include a first-time assessment of the EC’Streatment of U.S. banks and securities firms. This study is due to Congress by December 1, 1990. Page 64 GAO/NSLADSO-99 European Communit Page 66 GAO/‘h’SIAD-90-99 European Community Appendix I Status of Single Market Program Legislation The listing below represents the status (to January 1990) of the primary legislative steps necessary to the completion of a single market for financial services outlined in the M=Commission’s White Paper of June 1985, “Completing the Internal Market.” This does not represent an all- inclusive list of Ec financial services legislation. and other financial institutions Adopted by EC Council: December 8,1986 This directive intends to harmonize consolidated accounting practices for banks, including their format, nomenclature, and terminology for their accounting documents. Council Directive on the obligations of branches established in a member state by credit institutions and financial institutions, having their head offices outside that member state, regarding the publication of annual accounting documents Adopted by ECCouncil: February 2,1989 This directive establishes the sufficiency of consolidated accounting documents, and the accounting information required within the docu- ments, for branches of banks from other countries. It effectively elimi- nates the requirement for publication of separate annual accounting documents for each branch. Proposal for a Directive on the freedom of establishment and the free- dom to supply services in the field of mortgage credit Planned adoption by ECCouncil: 1990 This proposed directive would allow credit institutions to grant mort- gage credit secured by real property situated anywhere in the Community. Proposal for a Directive on the coordination of laws, regulations, and administrative provisions relating to the reorganization and dissolution of credit institutions Planned adoption by ECCouncil: 1990 This proposed directive coordinates the practices for the dissolution of credit institutions. The institution’s home country would have primary jurisdiction and apply its law throughout the Community. Council Directive on the own funds of credit institutions Adopted by EC Council: April 17,1989 This directive establishes Communitywide standards for own funds Page 66 GAO/WSIADgo-ft9 Eumpem ‘kmmnit! Appendix I Statas of Shgle Market Program Legislation (capital) of credit institutions. Own funds constitute the numerator for the solvency ratio, which is the subject of a separate Council directive. Commission Recommendation concerning the introduction of deposit- guarantee schemes in the community Adoption by ECCouncil: not necessary for recommendation This recommendation suggests that those member states that do not have a deposit guarantee scheme draw up a scheme according to pre- scribed conditions. This recommendation supplements a proposed direc- tive [COM (85) 7881 that requires each member state to cover the depositors of all authorized credit institutions, including depositors of branches of credit institutions that have their head offices in another member state. Until such time as all member states have a scheme, those member states with a scheme will be required to cover their branches in other member states. A directive has been proposed to replace this recommendation. Commission Recommendation on monitoring and controlling large expo- sures of credit institutions Adoption by ECCouncil: not necessary for recommendation This recommendation attempts to protect depositors by recommending that member states require institutions to report large or excessive exposure concentrations to a single client or group of clients. A directive has been proposed to replace this recommendation. Second Council Directive on the coordination of laws, regulations, and administrative provisions relating to the establishment and pursuit of the business of credit institutions and amending Directive 77/780/EEC Adopted by ECCouncil: December 15,1989 The Second Banking Directive is key to the single market for financial services. The directive grants a single banking license to authorized credit institutions to freely branch or offer services across ECborders. Prudential supervision of each institution is governed by the home coun- try of authorization. Council Directive on the coordination of laws, regulations, and adminis- iecurities trative provisions relating to Undertakings for Collective Investment in Transferable Securities (ucrrs) Adopted by ECCouncil: December 20,1985 This directive harmonizes member state laws pertaining to UCITS (similar to open-ended mutual funds in the United States) and allows their mar- keting on a Communitywide basis. Page 67 GAO/TWAD9O-99 European Community Appendix1 Status of Single Market Program Letckbtion Council Directive amending, as far as concerns the investment policy of certain Undertakings for Collective Investments in Transfer-i-able Securi- ties, Directive 85/6 11 /EEC Adopted by ECCouncil: March 22,1988 This directive liberalizes requirements for the investment in UCITS issued by the same issuer and specifies certain fiduciary responsibilities for the supervision and safekeeping of assets. Council Directive on the information to be published when major hold- ings in the capital of a listed company are acquired or divested Adopted by ECCouncil: December 12,1988 This directive harmonizes reporting and disclosure requirements, espe- cially regarding takeover attempts, for companies whose shares are listed on an official Community stock exchange. Council Directive on the coordination of the requirements for the draw- ing-up, scrutiny, and distribution of the prospectus to be published when securities are offered to the public Adopted by ECCouncil: April 17,1989 This directive provides minimum essential standards for the contents of a prospectus of newly offered securities (both on and off exchange). Second Council Directive on the coordination of laws, regulations, and Insurance administrative provisions relating to direct insurance other than life insurance, laying down provisions to facilitate the effective exercise of freedom to provide services Adopted by ECCouncil: 6/22/88 This directive amends the First Council Directive for non-life insurance by liberalizing cross-border insurance services for large commercial and industrial risks. This directive also provides for home country control for large risk insurance. Council Directive on the coordination of laws, regulations, and adminis- trative provisions relating to legal expenses insurance Adopted by EC Council: June 22,1987 This directive harmonizes member state requirements for insurance against legal expenses. Council Directive amending, as regards credit insurance and suretyship insurance, the First Directive 73/239/EEC Adopted by EC Council: 6/22/87 This directive amends the First Council Directive (DIR 73/239/EEC) Page 68 GAO,‘NSIAD9O-99 European Communil Appendix I Statu9 of Single Market Program Legidation with regard to credit insurance by requiring firms that offer credit insurance to establish equalization reserves. Proposal for a Council Directive on the coordination of laws, regulations, and administrative provisions relating to insurance contracts Planned adoption by ECCouncil: 1990 This proposed directive harmonizes and sets minimum standards for the laws, regulations, and provisions for non-life insurance contracts. Proposal for a Council Directive on the coordination of laws, regulations, and administrative provisions relating to the compulsory dissolution of direct insurance undertakings Planned adoption by ECCouncil: 1990 This proposed directive seeks to harmonize member states’ treatment of insurance contracts in the event of an insurance company’s dissolution. Proposal for a Council Directive on the annual accounts and consoli- dated accounts of insurance undertakings Planned adoption by ECCouncil: 1990 This proposed directive seeks to harmonize the financial reporting stan- dards of community insurance companies. Proposal for a third Council Directive on the approximation of the laws of the member states relating to insurance against civil liability in respect to the use of motor vehicles Planned adoption by ECCouncil: 1990 This proposed directive seeks Communitywide, compulsory third-party liability motor vehicle insurance. Proposal for a Council Directive amending, particularly as regards motor vehicle insurance, DIR 73/239/EEC and DIR 88/357/EEC relating to direct insurance other than life insurance Planned adoption by EC Council: 1991 This proposed directive seeks to allow freedom of services for motor vehicle liability insurance throughout the Community. Proposal for a second Directive on the coordination of laws, regulations, and administrative provisions relating to direct life insurance, laying down provisions to facilitate the effective exercise of freedom to pro- vide services and amending DIR 79/267/EEC Planned adoption by EC Council: 199 1 This proposed directive seeks to establish the framework for freedom of Communitywide services for the life insurance industry. Page 69 GAO,‘NSIAD90-99 European ccmmunity Appendix I Status of Single Market Pmgram Legislation Capital Movements mentation of Article 67 of the Treaty of Rome, on the liberalization of units in Undertakings for Collective Investments in Transferable Securi- ties Adopted by ECCouncil: December 20,1985 This directive liberalizes capital movements for transactions involving UCIls. The following legislative steps are not listed in the White Paper time- Additional Financial table but are generally considered to be part of the Single Market Services Directives Program. and Proposals Council Directive on a solvency ratio for credit institutions Banking Adopted by ECCouncil: December 18,1989 This directive, patterned after the Basle Convergence Agreement, requires that banks maintain their own funds (capital) in a prescribed level to their risk-adjusted assets. Council Directive coordinating regulations on insider dealing Securities Adopted by ECCouncil: November 13,1989 This directive harmonizes member state rules against insider trading. The directive prohibits knowingly taking advantage of inside informa- tion to buy or sell securities on an exchange market. Proposal for Council Directive on investment services in the securities field Planned adoption by ECCouncil: 1990 This proposed directive parallels the Second Banking Directive and would provide freedom of establishment and services for securities- related activities throughout the Community by authorized investment firms. The authorization and prudential supervision of the investment firm would be provided by the home country. Proposal for Council Directive, amending Directive 80/390/EEC, in respect of mutual recognition of stock exchange listing particulars Planned adoption by EC Council: 1990 This proposed directive amends earlier requirements harmonizing the requirements for drawing up and distributing listing particulars and Page 70 GAO/NSIAIWO-99 European Communi Appendix I Statua of Single Market Program Legislation requires the mutual recognition of other member states’ prospectus approvals for entry into any Community exchange. Council Directive, amending the Directive of May 11,1960, on the imple- Capital Movements mentation of article 67 of the Treaty of Rome, liberalizing operations such as transactions in securities not dealt in on an exchange and other capital and securities transactions Adopted by ECCouncil: November 17,1986 This directive lifted exchange controls on direct investment, short- and medium-term trade credits, and some capital and securities transactions. Council Directive on the liberalization of capital movements Adopted by ECCouncil: June 24,1988 This directive eliminates all remaining capital restrictions in most EC member states by July 1, 1990. Page 71 GAO/‘NSIAIMM9 European Community Appendix II Major Contributors to This &port James McDermott, Assistant Director National Security and NinaPfeiffer&alUamr International Affairs Cynthia Kite,‘Intern Division, Washington, D.C. - John Tschirhart, Project Manager European Office Paul Aussendorf, Evaluator-in-Charge Jeffrey K. Harris, Evaluator (486008) Page 72 GAO/NHAIM@99 European Communir Requests for copies of GAO reports should be sent to: U.S. General Accounting Office Post Office Box 6015 Gaithersburg, Maryland 20877 Telephone 202-275-6241 The first five copies of each report are free. Additional copies are $2.00 each. There is a 254, discount on orders for 100 or more copies mailed to a single address. 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European Community: U.S. Financial Services' Competitiveness Under the Single Market Program
Published by the Government Accountability Office on 1990-05-21.
Below is a raw (and likely hideous) rendition of the original report. (PDF)