Ryan Greenaway-McGrevy wades through the TPPA's financial services chapter, questions whether theory will translate into practice

This is the fifteenth in a series of articles Interest.co.nz has commissioned reviewing the key chapters and issues for New Zealand in the Trans-Pacific Partnership Agreement (TPPA). Links to all the analysis in this series are below.

By Ryan Greenaway-McGrevy*

New Zealand has an impressive track record when it comes to banking supervision and regulation. As Charles Calomiris at Columbia University and Stephen Haber of Stanford point out, New Zealand is one of a handful of countries that have managed to supply abundant credit without creating a single banking crisis.

There isn’t much room for improvement. And so any potential changes to our financial sector should be treated with caution.

The financial services chapter of the TPPA therefore deserves careful scrutiny. It covers activities such as commercial and investment banking, credit provision, insurance, asset management, and other related services. 

Fair warning: this is one of the more complicated chapters in the agreement. Bear with us as we attempt to navigate through it. 

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What the chapter entails 

The chapter applies many of the usual provisions found in trade and investment treaties to the establishment and operation of financial institutions, as well as trade in financial services. Here is a quick run-down of the major clauses:

The National Treatment clause (Article 11.3) prohibits discrimination against financial institutions and owners of financial institutions from other TPPA countries. Governments must afford the same rights, privileges and benefits to these foreign institutions and investors that they grant to their domestic counterparts operating in their financial sector. 

The Most Favoured Nation clause (Article 11.4) states that financial institutions, investors in financial institutions, and financial service providers from TPPA countries must be offered benefits no less favourable than those afforded to a country’s non-TPPA trading partners.

The Market Access clause (Article 11.5) prohibits governments from imposing limitations on the size or value of the operations of financial institutions from TPPA countries operating within their territories. 

The Cross-Border Trade clause (Article 11.6) requires Parties to permit the importation of a limited subset of financial services from TPPA trading partners. Annex 11-A lists the financial services for each country. For New Zealand, these services include insurance for trade in goods and maritime transportation; reinsurance; and financial data services.

Although these sorts of clauses are standard in trade and investment agreements, their application to financial services, institutions and investments has raised concerns from academics and legal experts. For example, National Treatment of financial institutions has raised the possibility that governments will be forced to bail out foreign-owned banks during a crisis. Meanwhile the Market Access provision has some experts concerned that it could be used to challenge regulatory safeguards, such as Glass-Steagall types of legislation that separate commercial and investment banking. 

There is also a New Financial Services provision (Article 11.7), which states that if Parties would permit a domestic business to sell a new financial product under their existing laws, they must also permit foreign-owned financial institutions to sell that same product. Governments worried by the possibility of new destabilising or predatory financial services being introduced into their markets may therefore have to be proactive when it comes to financial legislation. Our Credit Contracts and Consumer Finance Act, for example, sets general standards for consumer loans and other credit products, but it does not set specific regulations for the financial products that fall under its mandate. 

Dispute Settlement 

Like much else in the TPPA, these provisions are subject to the state-state dispute settlement protocols outlined in chapter twenty-eight. This means that foreign financial enterprises or investors cannot directly take governments to task for alleged transgressions of these specific articles. Instead, they must lobby their respective governments to initiate a dispute. 

However, when it comes to investments made by financial institutions, or foreign investments in financial institutions, the investor-state dispute settlement (ISDS) mechanism is still applicable. Let’s take a look at how these investments are treated in the chapter. 

Investment and ISDS 

Investments in financial institutions, as well as investments made by financial institutions, are dealt with under the financial services chapter – not the investment chapter (see Article 9.3.3 therein). As stipulated in Article 11.2.2, the financial services chapter incorporates many – but not all – of the provisions of the investment chapter, most of which are subject to the investor-state dispute settlement process (see Article 11.2.2(b)). 

The rights afforded to financial institutions and investors are, however, not quite as broad in scope as those of general investors covered under chapter nine. Article 11.2.2 stipulates which specific articles from the investment chapter are applicable. These include, amongst others, the Minimum Standard of Treatment (9.6); the Treatment in the Case of Armed Conflict and Civil strife (9.7); and the Expropriation and Compensation (9.8) clauses. 

The Expropriation clause prohibits governments from seizing foreign-owned assets by either direct or indirect means, which we have discussed at length here. Meanwhile the Armed Conflict and Civil strife clause suspends many of a government’s obligations should conflict break out. These kinds of provisions are often found in agreements covering financial institutions, such as the North American Free Trade Agreement (NAFTA). 

In contrast, the application of a Minimum Standard of Treatment (MST) provision to financial institutions and investors is a relatively recent addition to investment agreements. For example, NAFTA does not apply MST to financial institutions. And under Annex 11-B to the chapter, Chile, Brunei, Peru and Mexico are exempt from the MST provision for several years after the TPPA is ratified. 

Granting MST to financial institutions and their shareholders clearly gives pause to some of the parties to the agreement. Let’s take a closer look at what it entails. 

The MST clause states that;

Each Party shall accord to covered investments treatment in accordance with applicable customary international law principles, including fair and equitable treatment and full protection and security.

The key term here is “fair and equitable treatment”, which has been interpreted in a variety of ways by different bodies. Perhaps, then, it is worth considering what has constituted a breach of fair and equitable treatment in previous cases that involved financial institutions. 

A good example comes from the Czech Republic. In the early 2000s its banks were in trouble, and banks with a significant government shareholding were rescued. One of the more irresponsible banks – IPB – was instead put into forced administration, and subsequently sold off for 1 Crown. (The bank was apparently raided by masked anti-terrorism police when it was taken over – a literal hostile take-over.) A Dutch shareholder in IPB then successfully sued the Czech government for breach of fair and equitable treatment under the Netherlands-Czech bilateral investment treaty.

One can see how choosing to bail out some banks and forcibly taking over others would possibly constitute a breach of fair and equitable treatment (and perhaps national treatment too). But episodes such as this undoubtedly reinforce the aforementioned concerns that the TPPA will force governments to bail out foreign banks should the financial sector get into trouble. 

There is, however, a safeguard built into the agreement that – in theory – grants governments the right to suspend their obligations during a financial crisis, and to enact safeguards to protect their financial systems from structural instability. 

The Prudential Exception 

The exceptions to the rules are outlined in Article 11.11 (Exceptions). All of the obligations contained in the chapter – including those discussed above – do not apply to actions that are undertaken in order to protect the stability and integrity a financial system.

Article 11.11.1 states that;

a Party shall not be prevented from adopting or maintaining measures for prudential reasons, including, but not limited to, the protection of investors, depositors, policy holders, or persons to whom a fiduciary duty is owed by a financial institution or cross-border financial service supplier, or to ensure the integrity and stability of the financial system. 

Where applicable, this clause gives back a substantial amount of power to governments. It could be used to circumvent National Treatment in a bank bailout during a financial crisis, permitting a government to discriminate when choosing which banks to rescue. Prudential reasons could also be used to justify legislation that restricts the structure of banks in order to ensure the stability of the financial system. 

But what exactly are “Prudential Reasons”? Even the experts are not entirely sure. The prudential exception clause (Article 11.11.1) is almost a carbon copy of the World Trade Organisation’s General Agreement of Trade in Services (GATS) prudential clause. (The main difference is that the TPPA clause includes financial institutions as well as financial services, whereas the GATS clause only covers financial services.) 

The problem with the GATS prudential clause is that many experts find the language surrounding the definition of prudential reasons to be too ambiguous. 

Professor Jane Kelsey at the University of Auckland Law School warns governments not to overestimate the applicability of the exceptions clause;

Given these limitations and interpretive uncertainties, governments cannot presume the prudential provision will protect measures that they consider are appropriate to maintain or restore financial stability and support financial and economic recovery in the face of a crisis.

Simon Lester at the Cato Institute also finds the language troubling, stating that prudential clauses are often “badly-worded”, but that they “probably work as an exception”. He thinks the language used in the more recent Canadian-EU FTA could be an improvement, as it provides greater clarity.

Unfortunately, there are not too many disputes involving the prudential defence that we can look to in order to see how the definition has been interpreted in practice. Argentina recently used the defence against a dispute brought by Panama for breach of the GATS. Although the arbitration panel ruled that Argentina’s reasons for their actions were indeed “prudential reasons”, they disagreed with how they were applied. 

Perhaps in anticipation of these problems, the TPPA text does include a footnote which may help clarify just what the term means. Footnote ten to the chapter states that;

The Parties understand that the term “prudential reasons” includes the maintenance of the safety, soundness, integrity, or financial responsibility of individual financial institutions or cross border financial service suppliers as well as the safety, and financial and operational integrity of payment and clearing systems. 

By-passing the ISDS mechanism 

In addition, the Exceptions clause can be used to circumvent the controversial investor-state dispute settlement (ISDS) mechanism.

Suppose a foreign financial institution submits a claim to arbitration under the ISDS provisions incorporated from chapter nine. If the respondent government appeals to the Exceptions provision in defence, it can then request negotiations with the government of the claimant in order to determine whether the prudential defence is valid. 

The details of this mechanism are outlined in Article 11.22.2. The respondent government now has the chance to make its case for the prudential defence directly to the government of the claimant. If the financial authorities of the governments come to an agreement on whether the actions are justified by prudential reasons, their decision is binding on the ISDS tribunal (Article 11.2.2 (b)) and no damages can be awarded (footnote 11). 

If the two governments cannot agree on the legitimacy of the prudential defence within 120 days, then either government can invoke the state-state dispute settlement protocols to determine whether the prudential defence applies (Article 11.22.2(c)). The finding of the state-state arbitration panel is then binding on the ISDS arbitration panel (Article 11.22.3) and no damages can be awarded (footnote 11). 

Monetary and Exchange Rate Policies 

The exceptions clause also provides some clarification as to how monetary and exchange rate policy fits in to the TPPA. Often these policies operate through the buying and selling of financial assets, such as Treasury bills and bonds. Article 11.11.2 states that;

Nothing in this Chapter, Chapter 9 (Investment), Chapter 10 (Cross Border Trade in Services), Chapter 13 (Telecommunications) including specifically Article 13.24 (Relation to Other Chapters), or Chapter 14 (Electronic Commerce), shall apply to non-discriminatory measures of general application taken by any public entity in pursuit of monetary and related credit policies or exchange rate policies.

Central banks should therefore be able to continue to buy and sell domestic and foreign bonds as they please in order to influence interest and exchange rates. 

But they do not quite have carte blanche. The article continues;

This paragraph shall not affect a Party’s obligations under Article 9.10 (Performance Requirements) with respect to measures covered by Chapter 9 (Investment), under Article 9.9 (Transfers) or Article 10.12 (Payments and Transfers). 

The fact that governments must honour the Transfers article from chapter nine is somewhat restrictive. The article obligates signatories to allow free transfer of investments in and out of their territory “freely and without delay”, which takes some policies off the table – such as capital controls. 

Capital Controls 

Leading up to the signing of the TPP there was some concern over whether the agreement would grant governments the ability to implement capital controls. These can be used to stop hot money flowing out of the country during a currency crisis. Iceland, for example, used capital controls to limit the depreciation of their currency during the global financial crisis. 

A capital control exception is included in the agreement under the Exceptions and General Provisions chapter (chapter twenty-nine). Article 29.3.2 therein states that;

Nothing in this Agreement shall be construed to prevent a Party from adopting or maintaining restrictive measures with regard to payments or transfers relating to the movements of capital: (a) in the event of serious balance of payments and external financial difficulties or threats thereof; or (b) if, in exceptional circumstances, payments or transfers relating to capital movements cause or threaten to cause serious difficulties for macroeconomic management. 

The article is however subject to numerous caveats. Amongst many other things, the Parties implementing the capital control must be transparent and notify other Parties (29.3.7); the measures must be temporary, and not exceed 18 months unless an extension is sought (29.3 (e)); and must be in accordance with National Treatment and Most Favoured Nation clauses (29.3 (a)). 

The Lessons from 2008 

The global financial crisis teaches us that responsible management of the financial sector is vital to economic and social stability. As Carmen Reinhart and Kenneth Rogoff show in their tome This Time is Different, recoveries from financial crises take a long time. 

Financial instability can come about from design – as Calomiris and Haber go to great lengths to point out. They are unsurprised by the fact that the US has had twelve banking crises since the 1840s, while Canada has had none. To them, episodic instability in US financial markets is a predictable outcome from the numerous flaws built into US institutions.

But 2008 also teaches us that sound design may not be enough. A key theme of the post-GFC Murray inquiry into the Australian banking system was the inherent unpredictability of financial crises. This means that regardless of how well we manage the financial system, we need an arsenal prepped and ready to be deployed should the banks need to be rescued. 

Many of the critics of the TPPA are concerned that it will limit our ability to act on both fronts. The prudential reasons clause does – in theory – provide governments with the necessary tools to both pre-empt and mitigate a financial crisis. Our concern going forward is whether theory will be able to translate into practice. 

*In other news: Uruguay recently won the case brought against it by Philip Morris over health warnings on cigarette packaging. This can only be a good sign for those who are concerned about the possibility of ISDS mechanisms limiting the ability of governments to regulate in the interests of public health.


*Ryan Greenaway-McGrevy is a senior lecturer in economics at the University of Auckland. Prior to that he was a research economist in the Office of the Chief Statistician at the Bureau of Economic Analysis (BEA) in Washington DC.

*Amber Carran-Fletcher contributed to this article.

The series so far:

Investor-state dispute settlement

Labour standards

Settling disputes

Intellectual property

SOEs and designated monopolies

Environment

Government Procurement

Sanitary and phytosanitary measures

National treatment and market access for goods

How the TPPA could boost competition in the building materials sector

What TPPA's investment chapter says, including on housing investment

What the TPPA says about remedies for unfair trade

What the TPPA means for SMEs

We can have globalisation and more equitably share the gains

*And here's a video interview with Greenaway-McGrevy where he discusses the series.

We welcome your help to improve our coverage of this issue. Any examples or experiences to relate? Any links to other news, data or research to shed more light on this? Any insight or views on what might happen next or what should happen next? Any errors to correct?

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