13.3 The European Union and nancial regulation

foreign exchange markets calmed down and, in the middle 1980s, the stability of

the European Monetary System increased, exchange controls were eased in other

member states.

However, there were barriers to free capital mobility other than foreign exchange

controls, and limited capital mobility was only one of many barriers to a single

market in nancial services. Signicant interest rate differentials remained among

member states and exchange rate uncertainties returned in the 1990s. The free ow

of capital was also hindered by differences in tax regimes among countries, particu-

larly relating to the taxation of prots. The intra-EU mobility of capital was also

restricted by differences in capital markets. For example, the takeover of rms was

more difcult in Germany than in the Netherlands or the UK, partly because of the

role of the major banks as shareholders in Germany. Differences in investor and

consumer attitudes may also have been important.

Other important barriers to nancial integration in Europe in the 1970s and 1980s

were the limitations placed on cross-border trade in nancial services and barriers

to the free location of nancial institutions and other suppliers of nancial services.

For example, formal authorisation was needed everywhere for the setting up of

branches by foreign institutions and, in all countries except the UK, dedicated capital

had to be provided. Further, restrictions existed on the acquisition by foreigners of

domestic nancial rms, especially where major domestic banks were the target of

foreign purchase. To this end, most countries required the notication of anything

more than minor shareholdings in banks.

The outcome of these various forces was that although competition and integra-

tion had become international in some areas of nance such as wholesale banking,

other areas such as retail banking and insurance had remained fragmented. Even

for corporate business, EU national nancial systems were, by the 1980s, far from

integrated, with differences remaining between them in regulation, taxation, the

competitive environment and the role of the state. Even those rms allowed into the

markets of other member states were limited to providing the same range of services

that domestic rms were allowed to offer under domestic law. Clearly, host country

regulation reinforced other tendencies towards a fragmented and inefcient nancial

services industry.

Things came to a head in the planning that preceded the Single European Act. The

problem of different national regulations had been eased by a European Court case

in 1979, which had implied that the Treaty of Rome required the mutual recognition

of national laws. This had meant that full harmonisation of national laws was not

needed for the movement to a single market. A refusal to recognise the laws of other

member states required a demonstration that to do so would cause a threat to public

health or the rights of the consumer, or would damage scal supervision or the

fairness of commercial transactions. Mutual recognition of national laws was much

easier to achieve than their harmonisation. The Cockeld Report of 1985 further

proposed that, in cases of mutual recognition, regulation would be based on home

country requirements. In other words, if two members had different regulations in

an area in which the Commission decided that harmonisation was not needed, the

regulations of the country in which the nancial institution was registered or licensed

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Chapter 13 • The regulation of nancial markets

would apply no matter where it was doing business. This accepted the principle

of freedom of establishment and the cross-border provision of services within the

EU since an institution authorised in one country would be deemed to be similarly

authorised in all other member states.

In areas in which the Commission decided that harmonisation was necessary,

it could determine whether national regulations were excessive and constituted a

barrier to trade. In the banking sector, for instance, it was agreed that harmonisation

of regulation was needed in the following areas: authorisation criteria, minimum

capital requirements, the denition of own funds (equity capital), large exposure

limits, deposit-protection arrangements, control of the major shareholders in banks,

limits on banks’ involvement in non-bank sectors, and the quality of accountancy

and internal control mechanisms. Everything else was left to mutual recognition.

The Single European Act of 1986 (SEA) set the end of 1992 as the date for removal

of all controls, and this was the subject of the Capital Liberalisation Directive, adopted

in June 1988. The 1992 Treaty on European Union prohibited all restrictions on the

movement of capital and on payments between member states. This does not mean

that capital is perfectly mobile. Foreign exchange risk still applies between the euro-

zone and the EU countries that remain outside it and even within the eurozone

small interest rate differentials continue to exist.