The Doha Round and Financial Services Negotiations

The outstanding of Qatar heartbeat and pecuniary Services Negotiations AEI STUDIES ON SERVICES TRADE NEGOTIATIONS Claude Barfield, series editor THE expectant of Qatar ROUND AND pecuniary SERVICES NEGOTIATIONS Sydney J. Key INSURANCE IN THE GENERAL AGREEMENT ON TRADE IN SERVICES Harold D. Skipper Jr. LIBERALIZING world-wide TRADE IN ENERGY SERVICES ray of light C. Evans REDUCING THE BARRIERS TO INTERNATIONAL TRADE IN ACCOUNTING SERVICES integrityrence J. White The Doha Round and fiscal Services Negotiations Sydney J. Key The AEI Press Publisher for the American Enterprise Institute WA S H I N G T O N , D . C . 2003Available in the United States from the AEI Press, c/o Client Distribution Services, 193 Edwards Drive, Jackson, TN 38301. To order, call toll free 1-800-343-4499. Distributed outside the United States by arrangement with Eurospan, 3 Henrietta Street, London WC2E 8LU, England. Library of Congress Cataloging-in-Publication Data Key, Sydney J. The Doha round and fisca l serve negotiations / Sydney J. Key. p. cm. Includes bibliographical acknowledgements and index. ISBN 0-8447-4182-5 (pbk. ) 1. Financial supporter industryLaw and legislation 2. Foreign pile pattern. I. Title K1066.K49 2003 343. 087dc 22 2003063553 3 5 7 9 10 8 6 4 2 Printed in 2003 by the American Enterprise Institute for Public Policy Research, Washington, D. C. The views expressed in publications of the American Enterprise Institute atomic number 18 those of the authors and do non necessarily reflect the views of the staff, advisory panels, officers, or trustees of AEI. The views expressed by the author in this publication should non be interpreted as representing the views of the Board of Governors of the landed estateal Reserve System or any unrivalled else on its staff. Printed in the United States of America Contents QFOREWORD, Claude Barfield ACKNOWLEDGMENTS 1 2 INTRODUCTION INTERNATIONAL TRADE IN monetary SERVICES E-Finance 6 Modes of Supply 7 Services Provided a cross Borders 8 Foreign Direct Investment 9 Presence of Natural Persons 9 repose AND REGULATION Three Pillars of Liberalization 12 National Treatment and Market Access 13 Nondiscriminatory Structural Barriers 15 Freedom of dandy Movements 18 fortify Domestic Financial Systems 20 Minimum Standards and Codes of Good Practices 22 Surveillance 23 The Prudential Carve-Out in the GATS 24 NATIONAL TREATMENT AND MARKET entre Binding Existing and Ongoing Liberalization 28 IMF Conditionality 30 Permanence of GATS Commitments 31 Foreign Direct Investment 32 Remaining Barriers to Entry and effect 33 MFN Exemptions 34 Barriers at bottom the Scope of the Prudential Carve-Out 35 Cross-Border Services 37 Binding Gaps versus Remaining Barriers 38 Uncertainty about WTO Jurisprudence 39 v sevener xiii 1 4 3 11 4 27 vi CONTENTSMore Liberal Approaches for Wholesale Services 39 Evolving regulative Responses to Retail Cross-Border Services 40 Negotiating Goals 41 5 NONDISCRIMINATORY STRUCTURAL BAR RIERS Regulatory Transpargonncy 44 Rules about Developing and Applying Rules 44 Sound Financial Systems 46 Effective Market Access 47 General Anti combative Measures 49 Necessity and Domestic Regulation 50 Recognition of Prudential Measures 51 Harmonization 52 Facilitating Access 52 The Intra-EU Approach 53 Remaining Second-Pillar Barriers 54 Applicability of the Intra-EU Approach 55 CONCLUSION 43 6 57 61 87 101 107 NOTES REFERENCES INDEX ABOUT THE AUTHOR Foreword Q In advanced industrial economies, the serve firmament accounts for a substantial portion of distributively kingdoms gross issue product.Despite the increasing importance of occupation in go, the General placement on mess in Services (GATS), which was negotiated during the 198694 Uruguay Round and entered into force in January 1995, marked the first time that rules for opening marts in run were included in the three-way trading remains. The GATS called for periodic negotiating rounds, beginning no later than 2000, to achieve further loosening of trade in dishs. Serious individual sector negotiations, however, did not shift into high gear until a cosmopolitan advanced round of multilateral trade negotiations was launched at the November 2001 ministerial meeting of the World Trade Organization (WTO) in Doha, Qatar. The American Enterprise Institute is sedulous in a research project to focus on the latest round of trade negotiations on renovations.Mounted in conjunction with the Kennedy School of Government at Harvard University, the Brookings Institution, and the Coalition of Service Industries Research and Education Foundation, the project entails analysis of individual frugal sectors pecuniary services accounting insurance electronic commerce energy air freight and air cargo airline passenger services and entertainment and culture. Each study identifies major(ip) barriers to trade liberalization in the sector under scrutiny and assesses policy options for trade negotiators and interested private sector set forthicipants. AEI would like to acknowledge the following donors for their generous support of the trade-in-services project American present Company American external Group CIGNA Corporation FedEx Corporation Mastercard International the Motion Picture Association of America and the Mark Twain Institute. I emphasize, however, that the vii viii FOREWORD conclusions and recommendations of the individual studies ar solely those of authors.Issues for the Financial Services Negotiations In this study, Sydney J. Key analyzes the role of the GATS and the WTO in the liberalization and regulation of the pecuniary services sector and identifies six broad goals for the monetary services negotiations in the Doha round. What overhears her analysis unique is that she integrates the two very different perspectives of trade policy and pecuniary regulative policy. Throughout the study, Key emphasizes the complementary and mutually reinforcing relationship amongst suits to open markets under the GATS and the intensive ongoing outside(a) work on alter house servant financial systems, including prudential regulation and supervision.The study examines the role of the GATS and the WTO in relation to what Key characterizes as the three pillars of liberalization necessary to achieve external contestability of markets (1) opening markets to outside services and service suppliers by path of GATS ladings to provide national treatment and market entrance fee (2) implementing interior(prenominal) structural reforms that would eliminate nondiscriminatory structural barriers to trade in financial services and (3) liberalizing capital movements. Key explains that the GATS deals with third-pillar liberalization only insofar as it affects countries doweryicular(prenominal) commitments to liberalize trade in services in general, liberalization of capital movements is a matter of concern for the International Monetary Fund (IMF).Key emphas izes the importance of focvictimization on fundamental first-pillar liberalization in the Doha round financial services negotiations and sets forth four first-pillar goals first, binding in the GATS existing and ongoing liberalization that provides market access and national treatment second, removing be barriers to national treatment and market access and binding the resulting liberalization third, narrowing or withdrawing the broad exemptions that some countries make taken from the most favored nation (MFN) obligation of the GATS and, fourth, using an incremental approach for cross-border services that combines strengthening GATS commitments and achieving great liberalization in practice. CLAUDE BARFIELD ix How far should the Doha round financial services negotiations fit into the realm of second-pillar liberalization?Like separate authors in this series, Key grapples with the role of the GATS with check to the home(prenominal) structural reform take awayed to dress or el iminate nondiscriminatory structural barriers to trade in services. Key believes that the Doha round financial services negotiations should proceed selectively by concentrating on the areas in which the GATS and the WTO have a comparative advantage. She singles out two particularly cardinal second-pillar goals for the Doha round financial services negotiations exploitation stronger GATS disciplines on regulatory transparentness and removing barriers to effective market access and binding the resulting liberalization.Key argues that GATS rules on transparency in developing and maintaining regulations, together with the closely related principle of adjectival fairness in consecrateing regulations, would not only help eliminate barriers created by opaque and unfair regulatory procedures but also help get a line that a area does not use its regulatory border to undermine its commitments to national treatment and market access. Key explains how GATS rules on transparency in f inancial services regulation could twain complement and build upon the work on transparency that is part of transnational motilitys to strengthen domestic financial systems. The opposite second-pillar goal set forth by Key involves anticompetitive domestic regulatory measures that cannot be justify on prudential grounds and serve primarily to keep exotic financial firms from competing in host- acres markets by making immersion impractical or too costlythereby denying them effective market access. Key explains that identifying barriers to effective market access that could be negotiated in the Doha round requires a countrys trading partners to determine whether, in practice, a host countrys measures keep impertinent firms from competing in its markets and whether a critical mass of regulators believes that the measures are inappropriate for prudential purposes. She points out, however, that even if the prevalent regulatory view is that the measures cannot be justified on prude ntial grounds, host-country regulators must(prenominal) be persuaded to accept it. What about barriers to trade in financial services that are created by legitimate prudential measures? Key explains the importance of the prudential carve-out for domestic regulation in the GATS arrogate on Financial x FOREWORDServices it ensures the GATS will not interfere with the ability of national politics to exercise their responsibilities for prudential regulation and supervision to protect consumers of financial services and to kick upstairs the integrity and stability of the financial system. She notes that while prudential measures sometimes impose additional requirements on foreign firms, they may also create barriers simply because they differ among countries that is, financial firms operating on a global basis may ofttimes find it heavy to comply with a multitude of different national rules. Key identifies two approaches for dealing with barriers created by prudential measures.One would have home-country regulatory authorities convince host-country authorities that their prudential concerns can be addressed with less sweeping requirements. These efforts could take place bilaterally or in various internationalist fora, including the financial services negotiations under the auspices of the WTO, where finance ministries play a major role. A second approach would have home- and hostcountry authorities negotiate a recognition arrangement. Although the GATS Annex on Financial Services facilitates unilateral or mutual recognition of prudential measures by permitting a departure from the MFN obligation of the GATS for much(prenominal) arrangements, Key explains why the WTO is not the appropriate forum for their negotiation.In conclusion, Key summarizes the forces affecting the outcome of the Doha round financial services negotiations and the importance of that outcome to the process of financial sector liberalization Success in achieving the financial services go als discussed in this study depends significantly on factors beyond the scope of the negotiations. As the GATS explicitly recognizes, liberalization of trade in financial and other services is an ongoing process. For financial services, this process is being driven in large part by market forces and natural technologies. It is also being driven by the growth recognition among policymakers that market opening can benefit host-country consumers of financial services and, at the same time, open to the resiliency of domestic financial systems.The development of international minimum standards and codes of rock-steady practices for sound financial systems and their implementation by individual CLAUDE BARFIELD xi countries provide a strong foundation for moving ahead with further liberalization of trade in financial services. The negotiations in the Doha round can play an all-important(prenominal) role in helping to accelerate the process of liberalization as wellspring as solidifyi ng its results in the form of binding commitments subject to the WTO controversy settlement mechanism. CLAUDE BARFIELD American Enterprise Institute for Public Policy Research Acknowledgments Q The author greatly appreciates the assistance of the many individuals who read all or part of the manuscript and provided valuable comments and suggestions in their areas of expertise.She would like to thank Alistair Abercrombie, Claude Barfield, Nicholas Bayne, Stijn Claessens, Steven Fabry, Bernard M. Hoekman, Cecilia Klein, Masamichi Kono, Robert D. Kramer, Patrick Macrory, Ann Main, Marilyn L. Muench, Kathleen M. ODay, Patrick Pearson, Mary S. Podesta, Amelia Porges, Peter E. W. Russell, Hal S. Scott, Richard E. Self, Jonathan D. Stoloff, and T. Whittier Warthin for reading the manuscript in its entirety. She would also like to thank Peter Berz, Barbara J. Bouchard, James M. Boughton, David T. Coe, Kenneth Freiberg, Ralph Kozlow, Ross B. Leckow, Michael D. Mann, Juan A. Marchetti, Peter K. Morrison, William A. Ryback, David Strongin, Mark W. Swinburne, Andrew Velthaus, and Obie G.Whichard for reading drafts, and often redrafts, of particular sections. Finally, the author would like to thank Juyne Linger for her work in editing the manuscript. xiii 1 Introduction Q The General Agreement on Trade in Services (GATS), the first global trade agreement to cover financial and other services, is an important sweet element in the international framework for liberalization and regulation of the financial sector. Participation in the GATS, however, does not necessarily mean that a country has made strong commitments to open its markets to foreign services and service suppliers. Indeed, the strength of commitments varies substantially among countries.The GATS thusly requires periodic negotiating rounds on financial and other services to ameliorate commitments and thus achieve a progressively higher level of liberalization. 1 The GATS was negotiated in the Uruguay Round, whi ch was launched in 1986 and formally concluded in April 1994. 2 Financial services, however, was one of several sectors for which negotiations on particul rised commitments were extended, and final agreement was not reached until December 1997. 3 In 2000, in accordance with the deadline established by the GATS for initiating a new round of services negotiations, work began again on financial and other services. This occurred despite the failure of the Seattle ministerial meeting of the World Trade Organization (WTO) in December 1999 to launch a comprehensive new round of trade negotiations.Subsequently, at the Doha ministerial meeting in November 2001, WTO atoms reached agreement on an agenda for comprehensive multilateral trade negotiations that in mergedd the alleged(prenominal) built-in agenda for financial and other services. 4 The ministerial declaration set January 1, 2005, as the deadline for end the Doha round the declaration called for the bordering ministerial meeting, subsequently scheduled for September 2003 in Cancun, to assess progress and provide any necessary semipolitical guidance. 5 1 2 THE DOHA ROUND AND FINANCIAL SERVICES NEGOTIATIONS For financial services liberalization, four aspects of the GATS and the WTO are particularly significant First, the WTO is a multilateral forum in which the primary goal is reducing or eliminating trade barriers to promote competitive markets and thereby support economic growth and development.The new blow of this goal at the multilateral level complements the intensive work on strengthening domestic financial systems in a variety of other international fora, ranging from institutions much(prenominal) as the International Monetary Fund (IMF) to specialized bodies such(prenominal) as the Basel Committee on Banking Supervision. 6 Indeed, the efforts to liberalize trade in financial services and the efforts to strengthen domestic financial systems, including prudential regulation and supervision, are mutu ally reinforcing. In addition, the WTO is a forum in which all members have the fortune to participate on an equal basis. Multilateral trade agreements are negotiated in the WTO without the conditionality that links IMF or World Bank financial assistance to the implementation of specialised policy measures by a borrowing country. In principle, therefore, GATS commitments to liberalization have domestic self-commandthat is, they reflect a countrys recognition of the need for policy reforma whole step that the IMF has found to be a crucial determinant of the success of its programs. 8 Second, the GATS provides a mechanism for parties to undertake legally binding commitments subject to enforcement under the WTO difference settlement mechanism. A GATS commitment is permanent in that it cannot be withdrawn without compensation of trading partners. Failure to adore a commitment could open a country to a dispute settlement proceeding and, ultimately, WTO-sanctioned retaliatory measu res by its trading partners. Thus, backsliding in the take care of protectionist domestic political pressures could be extremely costly. As a result, binding even the status quo is extremely important.Moreover, for negotiations that stretch over many years, the status quo in the final phase is often different from that at the outset of the negotiations, in part as a result of the negotiating process itself. Third, the GATS is based on the most-favored-nation (MFN) principle, which precludes discrimination among foreign countries. Under the MFN obligation of the GATS, a WTO member must accord to services and INTRODUCTION 3 service suppliers of any other member treatment no less favorable than the treatment it provides to like services and service suppliers of the most favored foreign nation. 9 The reach of the MFN obligation is very broad ecause it applies to all measures affecting trade in services that are covered by the GATS, not just those for which a member has made specific co mmitments to liberalization. 10 Although the GATS does allow members to enter into economic integration agreementssuch as the Treaty establishing the European Community (EC Treaty)11 and the North American Free Trade Agreement (NAFTA)without extending the benefits of the agreements to all WTO members, it establishes stringent criteria for an agreement to qualify for this exception. 12 If a WTO member undertakes liberalizing measures in connection with services obligations in an agreement that does not meet the criteria, it must apply the measures to all WTO members on an MFN basis. 3 Fourth, the GATS negotiating process can itself have a positive impact on domestic policymaking, particularly in rising market economies and other developing countries. Governments that participate in the negotiations are forced to account to their trading partners for the barriers they impose and to explore the possibility of overcoming domestic political constraints to reduce or eliminate those barri ers. A continuing challenge for the trading partners is to use the GATS negotiating process to provide support for and to harness political and market forces that are creating pressures for liberalization within a host country. In this regard, a countrys readiness for reform is critical. Thus, the outcome of the GATS process depends heavily on factors beyond its purview.The next chapter of this study presents a brief discussion of the international planning of financial services and their coverage by the GATS. The third chapter provides a framework for analyzing the role of the GATS and the WTO in liberalization and regulation of the financial sector. The fourth chapter focuses on the barriers to national treatment and market access that need to be addressed in the financial services negotiations in the Doha round. The fifth chapter examines nondiscriminatory structural barriers and identifies certain areas of domestic structural reform that could usefully be dealt with in the GATS negotiations. The final chapter presents the conclusions of this study. 2 International Trade in Financial Services QThe financial sector is a critical component of a nations prudence It not only contributes instantaneously to output and employment but also provides an essential infrastructure for the functioning of the entire economy. The financial system serves as a channel done which nest egg can be mobilized and use to finance investment and, at the same time, facilitates proceeding necessary for internal and external trade. It also helps to manage risks and reduce so-called information asymmetries between providers and users of funds. 1 For these reasons, a sound and efficient financial system is imperative for economic growth and development. A sound financial system also increases the resiliency of a nations economy, thereby helping it to withstand external shocks such as movements in exchange rates or a major increase in global interest rates.International trade in fin ancial servicestogether with enhanced prudential regulation and supervision and other basic structural reformscan play an important role in helping countries build financial systems that are to a greater extent competitive and efficient, and therefore more stable. Financial services trade can enhance capital market efficiency improve the quality, availability, and pricing of financial services stimulate creative use by fashion of the dissemination of new technologies, know-how, and skills and promote the use of international good practices in areas such as accounting, risk management, and disclosure of financial information. 2 The fast growth of trade in financial services in recent years reflects a combination of economic, technological, and regulatory factors. These include new and expanding markets in developing and transition economies, technological advances, and progress in reducing or eliminating a variety of host-country barriers (see chapter 3). 4 INTERNATIONAL TRADE IN FINANCIAL SERVICES 5 Trade in services, as defined in the GATS, includes services provided across borders and through with(predicate) foreign rule investment. The cross-border prep of servicesfor example, the supply of financial services from an office located in one country to residents of another country is by and large analogous to trade in goods. 4 By contrast, foreign direct investment involves the establishment of a moneymaking(prenominal) aim, such as a branch or subsidiary, within a host country. 5 The GATS approach of be international trade to nclude services provided to host-country customers through the establishment and operation of a commercialized front differs from the approach utilize for balance-of-payments purposes, in which once a topical anaesthetic anesthetic branch or subsidiary has been established, the services it provides to host-country customers are treated as domestic. 6 In this study, the term financial services refers to financial service s other than insurance, which is the subject of another study in this series. 7 Although the GATS commentary of financial services encompasses both insurance and insurance-related services and banking and other financial services (excluding insurance),8 they have been negotiated and listed in the financial services schedules as separate subsectors. 9 These subsectors are, however, closely linked.Many of the major commercial and investment banks operating internationally are part of financial conglomerates that also include firms engaged in insurance underwriting, and banks often engage directly in insurance brokerage activities. Moreover, the development of new types of products and instruments is blurring the differentions between financial subsectors. Major financial firms now provide a wide range of financial services to customers in other countries. These include commercial banking activities such as bestow and deposit-taking investment banking activities, such as underwritin g securities and advising on mergers and acquisitions trading activities, that is, brokering and dealing in securities and other financial instruments and asset-management activities, including management of mutual funds and award funds.Other financial services provided internationally include financial information and data processing services investment advisory services payment and money contagion services, including credit cards settlement and clearing for financial assets and financial leasing. 6 THE DOHA ROUND AND FINANCIAL SERVICES NEGOTIATIONS Many financial services provided internationally are wholesale in nature that is, they are provided to sophisticated customers such as corporations and institutions, other financial services firms, and wealthy individuals. 10 Both foreign direct investment and cross-border run are important means of providing wholesale financial services.In the banking sector, when wholesale services are provided through establishment of a commercial presence, direct branches of the foreign bankif permitted by host-country regulationare usually a more efficient form of organization than subsidiaries. Unlike subsidiaries, branches are not separately incorporated in the host country and operate using the firms consolidated worldwide capital (but see chapter 4 regarding lending limits based on branch capital-equivalency requirements). E-Finance Technological advances have long had a major impact on the contribute of wholesale financial activities. Business-to-business electronic transactions within the financial sector have been used for more than two decades, both domestically and internationally.Financial firms have also provided online services to nonfinancial firms over close proprietary networks for a act of years. Widespread access to the open network technology of the Internet, however, offers a whole new range of possibilities to provide services to a much broader base of customers at substantially lower costs. As a resu lt, online services provided to wholesale customersboth within and across national bordersare growing rapidly. This growth includes not only traditional financial services but also new types of services designed to facilitate business-to-business e-commerce activities. 11 The same technological and cost-saving possibilities exist for the provision of electronic banking and other financial services to retail customers.Within some countries, the provision of some types of financial services over the Internet and through weathervane-enabled technologies, such as mobile telephony, is expanding dramatically. Prominent examples include discount brokerage and mutual funds in the United States, and banking services in Finland, Norway, and Sweden. 12 The cross-border provision of INTERNATIONAL TRADE IN FINANCIAL SERVICES 7 financial services to retail customers over the Internet, however, is still in its infancy. In general, the international provision of retail financial services still tak es place primarily through locally incorporated subsidiaries. 13 Indeed, a number of banks are now using their host-country subsidiaries as a base from which to provide electronic banking services to host-country retail customers.The pretermit of widespread development of cross-border retail banking and other financial servicesthrough the Internet or more traditional methodsreflects host-country regulatory requirements aimed at ensuring adequate consumer protection, consumer preferences, and tax considerations. Some countries actually require the establishment of a commercial presence to provide retail financial services. thus far when regulatory requirements for cross-border services involve nondiscriminatory application of host-country prudential standards, firms operating on a global basis may have difficulty meeting a multitude of different national requirements. Perhaps even more important, consumers may prefer dealing with a local commercial presence, particularly because re dress against a local establishment is usually readily available through the domestic legal system.In addition, in a number of countries, consumers receive more favorable tax treatment on financial products that are provided through locally incorporated entities. 14 Modes of Supply In an effort to include all of the ways in which services are provided internationally, the GATS defines trade in services in terms of four so-called modes of supply. Mode 1 and mode 2 cover services provided across borders for financial services, the distinction between these two modes is not always clear. Mode 3 covers services provided through establishment of a commercial presencethat is, through foreign direct investment, a term that is not used in the GATS.Mode 4 covers services provided through the impermanent presence of natural persons, which includes nonlocal employees of a foreign service provider. The GATS uses modes of supply not only to define the scope of its coverage but also as the basis for specific commitments to liberalization that WTO members undertake. 8 THE DOHA ROUND AND FINANCIAL SERVICES NEGOTIATIONS Services Provided across Borders. In this study, the term cross-border services is used broadly without attempting to assign a geographic location to the transaction. Thus, this study does not attempt to determine whether a transaction takes place in the country of the service provider or in the country of the customer.For example, a cross-border financial services transaction could be carried out in a number of different ways (a) a representative of, say, a foreign bank might visit the country of the customer to arrange a loan (b) the customer might travel abroad to visit the office of the foreign bank or (c) the transaction might take place via telephone, fax , or, increasingly, the Internet, which, in this context, is simply another technological means of delivering the service. 15 The GATS, however, distinguishes between services provided to nonresidents from the country of the service supplier (mode 1 or crossborder supply) and services provided in the country of the service supplier (mode 2 or consumption abroad). Usuallybut as currently defined by the GATS, not necessarilymode 2 involves physical movement of the consumer, such as the movement that occurs in tourism. 6 For financial services, however, the line dividing these two modes of supply is not always clear, especially in the case of example (c) in the former paragraph. Indeed, because financial services are intangible, assigning a geographic site to their provision across borders is difficult and often arbitrary and will become more so as the importance of e-finance increases. From a regulatory perspective, a major issue is whether, and to what extent, the rules of the host countrythat is, the country of the customerare applied to the cross-border transaction. 17 Suppose, for example, that employees of a foreign bank visit the host country to arrange cross-border loans.Ev en when the host country does not have a regulatory framework in place for cross-border banking services, host-country bank regulators sometimes look at factors, such as the frequency and duration of visits and the permanence of the host-country infrastructure for the visiting employees, to determine whether, for regulatory purposes, the cross-border activity rises to the level of a host-country office. 18 Or suppose that a foreign broker-dealer solicits host-country customers to purchase securities. Securities regulators often use solicitation in addition to the actual conduct of business with domestic residentsas INTERNATIONAL TRADE IN FINANCIAL SERVICES 9 criterion for determining whether the foreign firm is subject to hostcountry broker-dealer adjustment requirements. 19 In response to the increasing use of the Internet by the securities industry, a number of regulators also examine factors such as whether a web site is being used to target host-country customers (see chapter 4 ). 20 Besides regulatory jurisdiction, another important jurisdictional issue scrape ups in the event of a dispute here the question is which countrys courts have jurisdiction to try the case and which countrys laws apply. 21 Foreign Direct Investment. The inclusion of foreign direct investment in the GATS reflects its importance as a way of providing services internationally. 2 By contrast, the General Agreement on Tariffs and Trade (GATT) does not cover foreign direct investment for goods, there is only a relatively narrow agreement, negotiated in the Uruguay Round, on trade-related investment measures (TRIMs). 23 Although the GATS includes establishment of a commercial presence as a mode of supply, it does not have a separate framework for investment like that of the NAFTA or the widely used bilateral investment treaties (BITs). 24 These agreements cover portfolio investment as well as direct investment in both goods and services. Moreover, unlike the GATS, they include nutriti on to ensure the protection of investmentsspecific rules governing expropriation and compensation, for exampleand also provide for arbitration of disputes between private investors and host-country governments. Presence of Natural Persons.The fourth mode of supply in the GATS, the temporary presence of natural persons, includes the temporary presence in the host country of employees of firms providing services across borders or through a commercial presence. For example, for financial services, this mode of supply covers the presence of nonlocal staff of a host-country branch or subsidiary of a foreign financial firm as well as agents of the firm visiting the host country to facilitate the provision of cross-border services. 25 Although the presence of natural persons is listed as a mode of supply in the GATS, and members can negotiate sectorspecific commitments, countries usually make commitments for the temporary presence of natural persons as horizontal commitments that 10 THE DO HA ROUND AND FINANCIAL SERVICES NEGOTIATIONS apply to all services sectors. 6 For the financial services sector, however, most countries that belong to the Organization for Economic Cooperation and Development (OECD) have incorporated into their schedules a set of commitments allowing the temporary entry of senior managerial personnel and certain types of specialists in association with the establishment of a commercial presence. 27 3 Liberalization and Regulation Q Policymakers, particularly in emerging market economies, are increasingly recognizing that opening markets to foreign financial firms can benefit both consumers of financial services and the domestic economy as a whole. As noted in chapter 2, the presence of foreign firms can create more competitive and efficient markets for financial services, thereby encouraging economic growth and development and contributing to a more resilient domestic financial system.At the same time, however, ensuring adequate prudential regulat ion and supervision of financial firms and markets, together with other fundamental domestic structural reforms, is essential to obtain the maximum benefits of liberalization while minimizing the risks. Basic structural reforms include increasing transparency and accountability in both the private and public sectors introducing effective risk management techniques and developing the institutional infrastructure, such as insolvency laws and appropriate judicial procedures. Because measures to promote competitive markets and to strengthen domestic financial systems are complementary and mutually reinforcing, the relationship between financial sector liberalization and regulation has two distinct dimensions. On the one hand, liberalization requires reducing or removing anticompetitive regulations that pose unnecessary barriers to trade in services. On the other hand, liberalization requires increasing the strength and quality of certain regulations and, in some areas, introducing new r egulations. Thus the process of liberalization involves, inter alia, reaching a consensus on where to draw the line between regulations that are simply anticompetitive barriers to tradeand should therefore be eliminatedand regulations that serve legitimate purposes. For financial services, the GATS contains a prudential carve-out for domestic regulation. 2 In the GATS, the term prudential is used broadly 11 12 THE DOHA ROUND AND FINANCIAL SERVICES NEGOTIATIONS o encompass not only measures to promote the integrity and stability of the financial system (as the term has traditionally been used in banking regulation) but also measures designed to protect consumers of financial services. The prudential carve-out, discussed later in this chapter, is designed to ensure that any obligations undertaken or commitments made in the GATS will not interfere with the ability of national authorities to exercise their responsibilities for prudential regulation and supervision. Whether a particular measure is prudential or simply being used to vacate a countrys obligations and commitments under the GATS is, however, an issue that could be brought before a WTO dispute settlement panel. All countries impose certain rules that are clearly prudential.Even if a measure is prudential, however, it may create a barrier to trade in financial services. This could occur because a host country imposes additional prudential requirements on foreign financial firms vis-a-vis their domestic counterparts. Such barriers could also be created simply because prudential rules differ among countriesthat is, even if each host country applies the same rules to foreign and domestic firms, financial services firms operating on a global basis often find it burdensome to comply with a multitude of different national prudential rules. A critical question is whether such barriers could be addressed without jeopardizing prudential goals.Specifically, in what areas and under what conditions might financial services regulators be able and willing to recognize each others regulations and supervisory practices as being as effective as their own? The GATS is permissive with respect to such recognition arrangements. However, as will be explained in chapters 4 and 5, the WTO is not the appropriate forum for financial services regulators to negotiate recognition of prudential measures. Three Pillars of Liberalization International contestability of markets refers to the creation of markets that are competitive and efficient on a global basisa goal that can be achieved by removing all types of barriers to foreign participation in hostcountry markets. International contestability is, in effect, based on three pillars of liberalization (1) national treatment and market access (2) the LIBERALIZATION AND REGULATION 13 removal of nondiscriminatory structural barriers, that is, domestic structural reform and (3) freedom of capital movements. For financial services, the GATS has so far dealt mainly with the first pillar. An important question for the Doha round is how far the negotiations should extend into the second pillar. The GATS deals with the third pillar only insofar as it affects countries specific commitments to liberalize trade in services in general, liberalization of capital movements is a matter of concern for the IMF 4 . National Treatment and Market Access. The first pillar of international contestability of markets is liberalization aimed at opening markets to foreign services and service suppliers and ensuring that they enjoy substantially the same treatment as their domestic counterparts. Such liberalization requires reducing or removing barriers that discriminate against foreign services and service suppliers with regard to entry and operation in a host-country market. A host country might, for example, discriminate against foreign financial firms by refusing to grant licenses for their branches or subsidiaries imposing limitations on their ownership positi on in domestic firms or on their aggregate market share or prohibiting them from engaging in certain activities that are tolerable for their domestic counterparts.First-pillar liberalization also requires removing various quantitative limitations on the overall provision of services in a host-country market. Although these barriers may not, on their face, be overtly discriminatory, they are typically used to block entry by foreign services and service suppliers. A country might, for example, limit the number of service suppliers in a particular market by restricting the number of new licenses that may be issued or by relying on an economic needs test, which involves an estimate of needs in the market by host-country authorities. 6 Because these measures have the effect of imposing some type of quantitative limitation on foreign entry, they are similar to the more overtly discriminatory barriers.To deal with these first-pillar barriers, the GATS uses the principles of national trea tment and market access. condition XVII (National Treatment) relies on a generally accepted definition of national treatmentthat is, it 14 THE DOHA ROUND AND FINANCIAL SERVICES NEGOTIATIONS requires a host country to treat foreign services and service suppliers no less favorably than like domestic services and service suppliers. 7 Barriers to entry or operation that discriminate against foreign services or service suppliers vis-a-vis their domestic counterparts would therefore be inconsistent with national treatment. The GATS does not attempt to define market access.Instead, phrase XVI (Market Access) provides a list of inhibitory measures, primarily quantitative, that are typically used by host countries to deny entry to foreign services or service suppliers. A country that does not maintain any of these measures is regarded as providing full market access. 8 The list includes seemingly nondiscriminatory quantitative barriers to entry that apply to both domestic and foreign fir ms, such as limitationsin the form of numerical quotas or economic needs testson the number of service suppliers or their total assets. It also includes quantitative barriers to entry that are clearly discriminatory and thus are also inconsistent with national treatment, such as limitations on foreign ownership interests in domestic firms.As a result, some overlap exists in the national treatment and market access provisions of the GATSthat is, certain measures may be inconsistent with both national treatment and market access. 9 The list of measures in Article XVI also includes restrictions on the type of legal entity through which services may be suppliedfor example, requiring establishment of a subsidiary as remote to a branch. In the GATS, national treatment and market access are specific commitments as inappropriate to general obligations. 10 As a result, national treatment and market access do not apply across-the-board to all services sectors instead, they apply only to sec tors, subsectors, or activities that a WTO member specifically lists in its schedule of commitments. 1 If a member is making only a partial commitment to national treatment or market access within a listed sector, subsector, or activity, any limitations must be listed in its schedule. 12 The use of specific commitments for national treatment and market access instead of obligations applicable to all services sectors is in some respects a structural weakness of the GATS. 13 Under a more ambitious approach, such as that used in the NAFTAs services and investment provisions, national treatment and market access would apply in each sector unless an exception was specifically listed in a countrys schedule of LIBERALIZATION AND REGULATION 15 commitments or one of the public policy exceptions, such as the national security exception, applied. 14 Nondiscriminatory Structural Barriers.The second pillar of liberalization required for international contestability of markets is aimed at removin g nonquantitative and nondiscriminatory structural barriers. Such barriers are associated with national measures that do not discriminate between domestic and foreign services and service suppliers. A secondpillar barrier could arise because a national measure is primarily anticompetitive or fosters anticompetitive behavior by private parties. In some cases, the barrier could be associated with the inadequacy or absence seizure of domestic regulationfor example, the lack of an adequate domestic legal framework for insolvency. A second-pillar barrier could also arise because of differences in national rules, including prudential rules, that make it difficult to conduct operations on a global basis.Removing second-pillar barriers goes far beyond achieving national treatment and market access. Those principles ensure that foreign services and service suppliers can enter a host-country market as currently structured and enjoy equality of competitive opportunities vis-a-vis their domesti c counterparts. By contrast, second-pillar liberalization represents an effort to create maximum potential competitive opportunities in a host-country market. Achieving this could require major domestic structural reform. This would necessarily involve some degree of carrefour of national regulatory systems, either de facto or through negotiated harmonization. A longstanding U. S. rohibition on affiliations between banks and insurance companies in the United States, which was repealed in 1999, created a major second-pillar barrier for many years. 15 Indeed, the European Union had found it difficult to accept that a European financial conglomerate that included both a bank and an insurance company could engage in only one of these businesses in the United States. Regardless of whether this nondiscriminatory restriction was primarily anticompetitive or could have been justified as a prudential measure, it nonetheless constituted a barrier to trade in financial services. Significant s econd-pillar barriers are often associated with national regulatory regimes for asset-management services. 16 These include 6 THE DOHA ROUND AND FINANCIAL SERVICES NEGOTIATIONS across-the-board prohibitions on delegation of functions, such as portfolio management and administrative operations, by the host-country office to a foreign affiliate extremely strict asset-allocation requirements for a domestic mutual fund or pension fund and rules that prohibit such funds from investing in foreign securities. 17 While asset management activities raise legitimate prudential concerns about ensuring adequate protection of hostcountry customers, these types of measures often serve primarily to restrict competition, particularly competition from foreign firms (see chapter 5).Nondiscriminatory structural barriers to trade in financial services are not limited to financial sector regulation. Barriers in other areas that are particularly important for the effective functioning of the financial ser vices sector, such as lack of adequate frameworks for corporate governance or insolvency, are part of the international work on strengthening domestic financial systems, which is discussed later in this chapter. Ineffective or wanting competition policy regimes, which could foster anticompetitive behavior by private parties, can also create major second-pillar barriers. Differences in national tax systems are even another source of second-pillar barriers.Discriminatory treatment of foreign firms under national tax or competition rules, however, would be a first-pillar barrier. 18 Second-pillar barriers can also arise from a countrys administrative proceduresin particular, a lack of regulatory transparency and procedural fairness. For example, a country might fail to give out all of its laws, regulations, and administrative decisions administer them in an impartial manner establish a meaningful procedure for interested parties to comment on proposed regulations act on application s for licenses within a reasonable period of time or provide a mechanism for independent review of administrative decisions.Because regulatory transparency and procedural fairness can be extremely effective in ensuring that commitments to market access and national treatment are fully implemented, they constitute an important underpinning of first-pillar liberalization. The European Unions single-market program represents the most far-reaching effort to date to remove nondiscriminatory structural barriers among a group of nations. Predicated on political agreement on goals for economic liberalization, that effort is being carried out in the context of LIBERALIZATION AND REGULATION 17 the unique supranational legislative, judicial, and administrative structure of the European Community. 9 Even within the European Union, however, important nondiscriminatory structural barriers to trade in financial services among the member states are still in place (see chapter 5). The GATS addresses certain types of second-pillar barriers. Article III (Transparency) imposes a general transparency obligation on WTO members to publish all measures of general application that are relevant to trade in services. 20 Article VI (Domestic Regulation) addresses, in fairly general terms, barriers created by domestic regulations. It requires countries to apply such regulations in a reasonable, objective and impartial manner to avoid undermining commitments to market access and national treatment. 1 Moreover, countries must have appropriate legal procedures to review administrative decisions affecting trade in services. 22 Article VI also mandates further work to develop disciplines to ensure that licensing requirements or technical standards do not constitute unnecessary barriers to trade in services. pending the completion of this work, countries must refrain from adopting licensing rules or technical standards that are so burdensome, restrictive of trade, or lacking in transparency tha t they undermine the benefits that could reasonably be expected from their commitments to national treatment and market access. 23 The GATS deals with additional second-pillar barriers for individual sectors in members schedules of commitments.The most far-reaching example is in basic telecommunications, where a substantial absolute majority of the countries that have made commitments to national treatment and market access in that sector have incorporated into their schedules using the additional commitments columna reference paper setting forth procompetitive regulatory principles. 24 Designed for a sector where dominant suppliers often control essential host-country facilities, these principles seek to ensure that a countrys national treatment and market access commitments will not be undermined. Countries committing to the principles undertake, among other things, to maintain measures to ensure network interconnection on nondiscriminatory terms and to prevent certain anticompet itive practices. 25 In the financial services sector, most OECD countries addressed nondiscriminatory structural barriers in their 1997 schedules of commitments 18 THE DOHA ROUND AND FINANCIAL SERVICES NEGOTIATIONS imply by making a general best efforts commitment to remove or eliminate any significant adverse set up of such barriers. 26 In addition, the United States and the European Union used the additional commitments column of their schedules to make best efforts commitments to remove specified nondiscriminatory barriers. For example, the U. S. administration pull to try to work with the Congress to remove Glass-Steagall Act restrictions, a goal that was subsequently accomplished, while the European Union pledged that its member states would try to process applications for licenses for banking and insurance subsidiaries within specified periods of time.Japan, under great pressure from its trading partners, went further and made binding commitments regarding removal of certain second-pillar barriersincluding restrictions on asset-management services and lack of regulatory transparency and limitations on lines of business in insurancethat were covered in its bilateral financial services agreements with the United States (see chapters 4 and 5). Freedom of Capital Movements. The third pillar of liberalization involves achieving freedom of capital movements across national borders. Such movements comprise international capital transactionsthat is, the creation, transfer of ownership, or reasoning by elimination of capital assets, including financial assetsand the payments and transfers associated with such transactions. 27 Restrictions on international capital movements are usually imposed on the underlying transactions as opposed to the related payments and transfers. 8 For example, if a country wished to restrict foreign direct investment in the banking sector, it could prohibit foreign financial firms from acquiring significant ownership interests in hos t-country banks it would be unusual to try to achieve this result by permitting the acquisition of the ownership interests while using exchange controls to block payment for them. 29 Although the free movement of capital plays a critical role in allowing efficient allocation of resources on a global basis, the Asian financial crisis of 199798 revived a long-standing debate over the appropriateness and effectiveness of capital controls, particularly on short-term flows. 0 Nevertheless, all parties to the debate agree that capital controls can never be a substitute for sound macroeconomic policies and fundamental reforms of domestic financial and legal structures. Indeed, the Asian crisis itself emphasized that weaknesses in domestic financial systems can create significant vulnerabilities LIBERALIZATION AND REGULATION 19 as capital movements are liberalized. At present, conventional wisdom holds that, although imposition of new capital controls should, in general, be avoided, the imp osition of limited, temporary capital controls to deal with massive temporary inflows or outflows of short-term debt might be useful in some cases. 1 Moreover, it is now widely recognized that removal of existing controls must be carried out with great care. Of particular importance are the ill-use and appropriate sequencing of liberalization of different types of capital flows and of liberalization of capital movements vis-a-vis structural reforms to strengthen domestic financial systems. 32 Freedom of capital movements per se is not within the purview of the GATS international capital movements and international trade in financial services are, however, closely related. Establishment of a commercial presence in a host country by a foreign service supplier involves both trade in services under the GATS and international capital transactions.For example, a commitment in the GATS to liberalize financial services trade by allowing foreign financial firms to establish wholly owned sub sidiaries is basically a commitment to allow foreign direct investment that involves the acquisition of 100 percent of the shares of existing or de novo hostcountry financial firms. 33 In scheme it is possible that, once established, the subsidiary could conduct its ongoing activities without engaging in additional international capital transactions however, its activities would need to be limited to transactions with host-country residents involving domestic financial assets. 34 Establishment and operation of branches, which are not separately incorporated in the host country, virtually always involve international capital transactions between the banks head office and the branch. 5 These transactions include both foreign direct investment and portfolio investment. 36 For branches conducting a wholesale business, ongoing activities would typically also involve international capital transactions with unaffiliated parties. For cross-border financial services, international capital transactions are typically either integral to, or closely associated with, the provision of the service. For example, international capital transactions are an integral part of accepting deposits from or making loans to nonresidents. In addition, international capital transactions are usually, although not necessarily, associated 20 THE DOHA ROUND AND FINANCIAL SERVICES NEGOTIATIONS ith financial services such as securities trading or asset management on behalf of a customer residing in another country. 37 By contrast, certain crossborder financial services, such as investment advisory services and financial information services, can be provided without an associated international capital transaction. The usefulness of investment advice might be limited, however, if the customer were disallow from investing in foreign assets. In general, it is difficult to realize fully the benefits of liberalization of trade in financial services without freedom of capital movements. Financial ser vices trade absolutely requires, however, the liberalization of only those capital movements that are necessary for the trade transaction to occur.In recognition of this relationship, Article XI of the GATS (Payments and Transfers) prohibits WTO members from imposing restrictions on capital transactions or associated payments and transfers that would be inconsistent with their specific commitments to liberalization of trade in services. 38 A footnote to Article XVI (Market Access) provides greater detailnamely, a country that has made a specific commitment to market access must allow (a) capital movements that are essential for the provision of a service in mode 1 (cross-border supply) and (b) inward capital movements that are related to a service supplied through establishment of a commercial presence. 39 The bottom line is that if a country makes a commitment to liberalize trade with respect to a particular financial service in the GATS, it is also making a commitment to liberaliz e most capital movements associated with the trade liberalization commitment.The country is not, however, making an across-the-board commitment to freedom of capital movements. The GATS provisions dealing with capital movements, like GATS specific commitments to liberalize trade in services, are subject to a balance-of-payments guard duty. 40 Both the capital movements and balance-of-payments safeguard provisions of the GATS refer to and are consistent with the IMFs responsibilities in these areas. 41 Strengthening Domestic Financial Systems The financial services sector has an elaborate and intensively used framework of international fora that are used, both separately and in combination, LIBERALIZATION AND REGULATION 21 o address overall financial and regulatory policy issues to promote cooperation and coordination among supervisors to set voluntary but widely accepted international minimum standards and codes of good practices and, most recently, to provide surveillance of domest ic financial systems. This surveillance includes monitoring and helping to build institutional capacity for implementation of the international standards and codes. The international fora dealing with these issues include the Group of Seven (G-7), the Group of disco biscuit (G-10), the Group of Twenty (G-20), the Financial Stability Forum, the Basel Committee on Banking Supervision (Basel Committee), and the International Organization of Securities Commissions (IOSCO), as well as the IMF and the World Bank. 2 The international framework for the financial services sector, which has been constructed over the past quarter century and is still evolving, is a response to two major factors the internationalization of banking and other financial activities and the special characteristics of the financial sector, especially the phenomenon of systemic risk. Because of systemic risk, problems with one financial firm can be transmitted to unrelated financial firms, both within and beyond a s ingle country. For example, a chain reaction of problems could be triggered through imitative runs on banks as depositors lose confidence in a banking system, through default on domestic or international interbank obligations, or through domestic or international payment systems.Problems in a countrys financial sector can also affect the real economy, both domestically and internationally, through declines in output and shifts in trade flows. In addition, the existence of global financial firms, with activities falling within many different national jurisdictions, requires cooperation and coordination among home- and host-country authorities to prevent gaps in supervision. Increasingly, these global firms are financial conglomerates, which means that supervisory cooperation and coordination are necessary across financial subsectors as well as national borders. For these reasons, countries have a stake in the quality of each others regulation and supervision of the financial sector a nd also in ensuring cooperation and coordination among supervisors.In this regard it is useful to distinguish between prudential regulation, which includes, for example, capital and other requirements designed to ensure the safety and 22 THE DOHA ROUND AND FINANCIAL SERVICES NEGOTIATIONS soundness of financial institutions, and supervision, which is aimed at making certain that financial firms stay to such requirements. The importance of strong, effective supervision cannot be overemphasized without it, the best prudential rules can be meaningless in practice. The extent to which both experience and good judgment are required for such supervision also needs to be emphasized. Indeed, the role and nature of supervision make it particularly difficult for supervisory authorities to reach recognition agreements based on the harmonization of prudential rules (see chapter 5).While regulation and supervision must be strong and effective, a further forking is that a poorly designed regulat ory systemfor example, an excessively generous deposit-insurance schemecan create an unacceptable degree of moral hazard that is, it may encourage excessive risk-taking by regulated firms. Accordingly, national regulatory and supervisory systems must be designed to complement and support, but not to substitute for, market discipline. Thus, achieving widespread transparency in both the public and private sectors, including accurate and timely disclosure of financial information, is critical