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PMD: "Strictly Business" interpretations of a WTO rule

Regular readers of the blog will recall we have a wonkish obsession with a much debated provision in the WTO services agreement related to financial regulations taken for prudential reasons. In 2009, we put out a report and literature review on the topic, and have regularly discussed the topic on the blog. For the last several years, we've submitted Freedom of Information Act (FOIA) requests from various U.S. agencies to try to get a better picture of what this and other WTO financial service obligations mean. The disclosures have been interesting, to say the least. And not only because they involve top officials and lobbyists like Tim Geithner that are still running around DC.

But before we get into what these documents show, some background is needed. For those fortunate enough to not be initiated, here is the provision, which is contained in Article 2(a) of the Annex on Financial Services to the General Agreemeent on Trade in Services:

2. Domestic Regulation    Epmd2

(a) Notwithstanding any other provisions of the Agreement, a Member shall not be prevented from taking measures for prudential reasons, including for the protection of investors, depositors, policy holders or persons to whom a fiduciary duty is owed by a financial service supplier, or to ensure the integrity and stability of the financial system.  Where such measures do not conform with the provisions of the Agreement, they shall not be used as a means of avoiding the Member’s commitments or obligations under the Agreement.

We'll call this PMD, and no, that's not a reunited hip-hop crew from Brentwood minus Erick Sermon. But it does mean "strictly business." (Sorry, I couldn't resist.) 

The prudential measures defense (PMD) is highly confusing. Those familiar with other text from WTO agreements will note that the first sentence sounds like it provides a lot of flexibility for financial regulators, while the second sentence seems to take it all away. After all, a country would only need a prudential defense if it were found guilty of violating WTO rules. What good is a defense if you can't use it?

There are a variety of ways a WTO panel could approach the interpretive challenge of the PMD.

Interpretation 1 is that it provides no defense under any circumstances and that a WTO panel would have to give it no weight: no prudential policies are allowed. Interpretation 2 is that it imposes no constraint under any circumstance: every allegedly prudential policy is allowed.

Few people formally advocate for either of these interpretations (although some have called the PMD a "carve-out," which suggests that GATS obligations simply wouldn't apply). You could make a colorable case for either on the basis of some of the literature: trade negotiators have sought to construct political cover to protect themselves from criticisms of some domestic financial regulators (who want strong if not absolute defense) one the one hand, and multinational banks (who don't want government bureaucrats getting in the way of their overseas expansion) on the other. Different snippets of the interagency dialogue could be marshalled to support either view.

Interpretation 3 is the most common in the literature (even among those that sloppily call the PMD a "carve-out"). It goes like this: the PMD has to mean SOMETHING. Lawyers are not politicians, and they require every clause in an agreement to have legal effect (known as the "effectiveness" principle). WTO tribunalists would look to the ample jurisprudence from GATT Article XX and GATS Article XIV, which lays out a host of ways in which countries can violate GATS under certain conditions, like when a measure is "necessary to protect human, animal or plant life or health."

(That doesn't mean that countries get to whatever they want: the phrase "necessary" has a specific meaning ranging from "indispensable" to "making a contribution to" to "the only option." And once a challenged country gets over that hurdle, they'll face another set of hurdles in the "chapeau," i.e. the introductory paragraph to GATS Article XIV that requires less trade restrictive application of service sector regulations. Although WTO panels have rarely allowed countries to use a GATT Article XX or GATS Article XIV defense, they at least provide a defensive tool for respondent countries.)

But there's another interpretation of the PMD: Interpretation 4. This interpretation starts from the point of view that financial services firms were the most active proponents of GATS in the first place, and "regulators" in developed countries were often more interested in exporting financial services than in defending domestic regulations. For this reason, we would expect the WTO rules on financial services to be less protective of financial services policy space than, say, retail services policy space. Financial firms pushed hard for the toughest disciplines, and created different tiers of obligations for concentric circles of coalitions of the mostly unwilling, the mostly willing, and the most willing.

(Essentially, this breaks into the poorest countries who needed a lot of policy space and/or were not deemed of primary interest to foreign banks, so have few to no commitments in financial services; middle income countries that were pressured to sign up for stronger disciplines or who had neoliberal governments; and rich countries and tax havens who had moved on to a light touch regulation End of History mentality. The latter group even went so far as to create a GATS-plus arrangement known as the Understanding on Commitments in Financial Services, which we discuss elsewhere.)

Under this interpretation, the PMD is "self-cancelling" in certain ways, but not in others. Early in the negotiations, rich countries pushed for dozens of ways to restrict countries' financial regulations, but many countries balked at the more extreme rules.

The "compromise" by the end of 1991 was that countries could choose not to commit financial services, but when they did, they would have to meet a "minimum" set of rules: market access and national treatment. (We discuss the also important free transfers obligation elsewhere.) In essence, these rules state: thou shall not impose size limits or bans; and thou shall not discriminate. They could not utilize any excuse or exception not to comply.

But violations of other GATS rules would be allowed... for prudential reasons. Indeed, if you could prove that a measure was prudential, you wouldn't have to meet the disciplines under Article VI, entitled "Domestic Regulation". That article says that, even if a measure passes muster under Article XVI (market access) and XVII (national treatment), it must still, among other things, not be more trade restrictive than "necessary."

The role of the panel in Interpretation 4 is to determine whether a measure is captured or not by a prudential justification, and to apply the PMD or Article VI disciplines as appropriate.

This differs from other service sectors. In retail services, for instance, a country could discriminate or impose size limits if it could pass the Article XIV exceptions. And, it would also have to meet the Article VI rules. In a sort of inversion, when it comes to financial services financial services prudential measures, countries can't avail themselves of XIV exceptions when it comes to market access, but they also don't have to meet the Article VI rules.

Is there any basis in the GATS for Interpretation 4? Arguably, there is a stronger basis than for Interpretation 3, which assumes that differently worded PMD provisions must mean close to the same thing as Article XIV provisions. On a textual basis, what Interpretation 4 has going for it is that it gives effect to both sentences of the PMD. It gives effect to the title of the PMD: "Domestic Regulation," and notes the appearance of the phrase "Domestic Regulation" in Article VI of the GATS. It gives effect to the use of the joint appearance of the words "commitment" and "obligation" in the PDM, which also appear together in Part II of the GATS (which contains Article VI). It is consistent with the distinction between prudential and non-prudential regulations made by the WTO Secretariat in a key 1998 working paper, where staff argued that the former is governed by the PMD and the latter by Article VI. And it takes account of the fact that trade negotiators wanted the financial services rules to be as restrictive as possible. 

The documents we've obtained under FOIA - as well as from Stanford University's GATT negotiating database - give even more support to Interpretation 4. 

The Uruguay Round of the General Agreement on Tariffs and Trade (GATT) was launched in September 1986. Specific proposals on financial services disciplines took several years to take shape. But Reagan and later Bush administration officials had a negotiating mandate under Fast Track 1984 and 1988 to push for discussions aimed at "reducing or eliminating barriers to, and other distortions of, international trade in financial services."

On September 4, 1989, the GATT Secretariat issued a nearly 50-page analysis of “Trade in Financial Services.” This was one of the first instances of an intergovernmental body acknowledging the legitimacy of the notion that it was meaningful to think about financial services in terms of trade policy. It outlined several types of national regulation that could limit financial services trade: notably, Glass-Steagall type firewalls were singled out repeatedly as posing obstacles to national treatment and market access. The report also suggested that countries’ freedom to choose the prudential regulations they prefer should be limited by trade considerations.

By October 1989, the Bush administration negotiators had tabled a suggested GATS draft. It included a provision on two-track liberalization (one faster, one slower), allowing for plurilateral annexes that went beyond the scope of the basic obligations. It allowed for market access establishment rights “on a basis no less favorable than that accorded in like circumstances to its own persons,” which was still much more focused on non-discrimination than the final GATS text. And it included a proto-prudential measures clause, which stated:

“The Parties recognize the right of each Party to regulate within its territories the provision of covered services, including the right of Parties to introduce new measures consistent with this Agreement. Parties shall ensure that such measures are not prepared, adopted or applied, the intent or effect of which is to nullify or impair the obligations of this Agreement.”

Similar language made it into the negotiating chair's draft text from December 1989.

On March 30, 1990, a FOIA'd document reveals that none other than current Treasury Secretary (and then young staffer) Tim Geithner circulated his team's proposal for the GATS financial services agreement. That version had both a PMD and a General Exception, which read:

Article 10: Financial Regulation

10.1 Nothing in this agreement shall prevent a Party from taking reasonable actions necessary for prudential reasons or for the protection of investors, depositors, or others to whom a fiduciary or other duty is owed by a financial services provider.

10.1.1 However, such actions shall not prevent the establishment by a financial service provider of another Party of an enterprise for the provision of financial services on conditions which accord national treatment...

Article 13: Essential Security Exception

13.1 Nothing in this Agreement shall be construed to require any Party to furnish any information the disclosure of which it considers contrary to its essential security interests, or to prevent any Party from taking any action which it considers necessary for the protection of its essential security interests...

Article 14: General Exceptions

14.1 Subject to the requirement that such measures are not applied in a manner which would constitute a means of arbitrary or unjustifiable discrimination between Parties where like conditions prevail, a disguised restriction on the provision of a financial service, or a means of circumvention of the objectives of this Agreement, nothing in this Agreement shall be construed to prevent any Party from adopting or enforcing measures: necessary to protect public morals, order or safety; necessary to ensure compliance with measures which are not inconsistent with the provisions of this Agreement; or relating to the imposition of indirect taxes.

14.2 Nothing in this Agreement shall be construed to prevent any Party from adopting or enforcing measures involving the imposition or enforcement of direct taxes.

[Marked as deleted is the following text: "14.3 This Agreement shall not apply to the regulation of issuers of securities other than issuers of securities that are financial services providers. 14.4 This Agreement shall not apply to the purchase of financial services by governments for operations for the government's own account." What follows is a staff note, perhaps by Geithner himself, that reads: "Note: We may still require an exception for some operations by governments and Central Banks, but we do not believe it is necessary or desirable to eliminate all operations conducted by governments from the scope of this agreement."]...

16.6 No Party may take any measure affecting the provision of a financial service by the financial service providers of any other Party to remedy or redress any violation of the General Agreement or the Agreement on Trade in Services.

This proposal seems MUCH more protective of national interests than what emerged in the GATS. No cross-sectoral cross-retaliation; unlimited remit to implement non-discriminatory prudential regulations; and a strong set of protections for potentially discriminatory prudential regulations.

Still, on May 4, several developing countries responded with their own draft text for an “International Trade in Services Organization,” which would not cover establishment-related market access, and would allow ample exceptions for such development objectives as costless technology transfer, infant industry protection and “concentration of ownership.”

Rich countries hit back with their own proposal. On May 7, 1990, the Europeans gave the Treasury Department a financial services agreement proposal that contained the following PMD/ XIV-like exception hybrid:

Article 13: Domestic Regulation

13.1 Notwithstanding any other provisions of the Agreement and of this Annex, in order to prevent or to solve a serious economic or financial disturbance, parties may take reasonable measures to safeguard the integrity of the financial system, provided that these measures are not applied in a manner which would constitute a means of arbitrary or unjustifiable discrimination against financial services providers or other parties. Measures taken in accordance with this Article shall be consistent with the party's rights and obligations under the Articles of of the Agreement of the International Monetary Fund. Insofar as such measures impose restrictions on operations liberalised under this Annex, such measures shall be notified to the PARTIES.

The major points that the developed nations advanced in the ensuing discussion in June were that a GATS would mean nothing without rules covering establishment (since cross-border provision of services was relatively limited as of 1990), that national treatment should apply to both de facto and de jure discrimination (with Japan dissenting on this point), and that application of prudential measures should be subject to substantive restrictions and dispute settlement. On the latter point, the Secretariat outlined the substantive options facing the working group:

“The Chairman recalled that the next agenda item concerned regulatory matters such as prudential fiduciary requirements. He noted that one question concerned how and where to draw the line between those measures that were consistent with the agreement and those that might go beyond it. He said that the options in the non-paper ranged from narrow to broad in scope. The first option provided for a prudential carve-out limited to a qualified national treatment provision. The second option was broader, permitting all ‘reasonable’ prudential and fiduciary measures. Option three was a variation of option two, enumerating examples of permissible measures. Option four provided for an unqualified right to take such measures. Option five aimed at defining as precisely as possible the prudential actions that would be permitted, so as to reduce legal uncertainties.” (23)

The developed country delegations spoke in favor of limiting the prudential policy space as much as possible:

  • Canada: “In order for any prudential carve-out not to be abused, he said that it should be subject to dispute settlement. He sought a clear definition of what was prudential and what was not, recognising the difficulty of making such a distinction.” (23)
  • Japan: “In order to avoid being used as a loophole, the prudential carve-out should be subject not only to dispute settlement but also to obligations such as notification.” (23)
  • EC: “Regulations should be compatible, not only with provisions on national treatment but also with any other provision of the agreement including market access, transparency, and most-favoured-nation treatment.” (24)
  • Sweden: “He considered option four would give too much freedom for regulators to invoke prudential caveats and might lead to the enacting of discriminatory or otherwise inappropriate rules.” (25)
  • United States: “The freedom for prudential regulation had to remain intact for each country so long as the measures were legitimate and reasonable and not taken for the purposes of circumventing the agreement.” (25)
  • Switzerland: “He noted that conflicts arising from the application of regulation should be subject to the dispute settlement mechanism; his delegation would therefore eliminate option four.” (25)

The way the chairman had outlined the options clearly biased the trade-oriented negotiators away from the outlier option most reasonable for financial stability: Option 4. Thus, even South Africa’s delegation suggested it “should not come into the picture at all” (25), while no other developing country delegation spoke clearly in favor of it.  In an indication of the overall bias of the negotiating process, Egypt also questioned whether the chairman was accurately representing the views of all delegations (31)

In congressional testimony on the GATS talks on July 17, Deputy Assistant Treasury Secretary William Barreda told legislators that:

We want to open markets, but, of course, we also recognize we have to provide for prudential regulation to assure the safety and soundness of the banking system, but we need to balance that and ensure that prudential regulation is not used as a way of disguising protectionist measures… The concept we are using now is that we should provide for reasonable prudential measures…

Thailand, in an effort led by Malaysia and seven other Asian countries, codified their in a September 12 proposal and recognized a wide applicability or prudential measures, including limitations on the percentage of a nation’s banking sector that can be owned by a given foreign country.  At Financial Services Working Group meetings on September 13-15, the Asian proposal was slammed by Switzerland, the EC, Canada, and even India and Chile raised doubts.

In what would be the final meeting of the working group, on October 19-20, developing countries (led by India) uniformly rejected the need for a sectoral annotation on financial services, with the possible exception of a specific note on prudential measures. Meanwhile, developed nations (led by the United States) called for a wide-ranging annex, one that contained at least a restriction on prudential measures. Thus, as Canada suggested, it was obvious that the main contribution of an annex that was binding on all parties would be that it would cover prudential measures. But developing nations (led by India) objected to the Canadian delegation’s tactics in raising this issue (namely, by circulating a “non-paper” that apparently not even the Canadian government would formally endorse). The chair closed the meeting committing to transmit notes regarding “the need or not for an annex/annotation and the identification and possible contents of an annex/annotation.” 

Instead, what the chair did was, within two days on October 21, table a “new informal version” of the Financial Services Annex “on his own authority.” (This followed from an action on October 9, when the GNS chairman tabled a proposal for an overall General Agreement on Trade in Services (GATS), which defined the modes of trade and established much of what would become the final GATS text. )

A version of this document, which is not public in the official GATT records, was leaked by the U.S. delegation in materials submitted to the House Banking Committee. Its PMD read:

“Article VII(1-2): The right of a party under paragraphs 1 and 2 of Article VII of the Framework [i.e. draft GATS provisions on Domestic Regulation] to regulate the provision of financial services shall be exercised in a manner consistent with the obligations assumed by a party under this agreement. Nothing in this agreement shall prevent a part from taking reasonable measures necessary for prudential reasons, including, inter alia, for the protection of investors, depositors, policyholders or persons to whom a fiduciary duty is owed by a financial service provider, or to ensure the integrity and stability of the financial system.”

This text was perhaps the first indication of a stripped down PMD that emphasized that prudential measures must be exercised in GATS-compliant ways, rather allowing deviations in the exercise subject to anti-abuse requirements.

There were also interagency tensions on the homefront. According to FOIA'd documents, on May 31, 1991, the U.S. Securities and Exchange Commission sent the Treasury Department a "reformulation" of the PMD to address their regulatory concerns. It read:

"Article XIV: Exceptions to the Draft Financial Services Annex:

Nothing in this agreement shall be construed to prevent the adoption or enforcement by any Party of reasonable measures for the protection of investors, depositors, policy holders, persons to whom a fiduciary or agency duty is owed by a financial services provider, or other consumers of financial services; to maintain the safety, soundness and financial responsibility of financial services providers conducting business in its territory (cross-border or through establishment); or to ensure the integrity, orderliness, soundness and efficiency of a Party's financial system.

Article XXIII, para. 5: Dispute Settlement and Enforcement

Individual prudential decisions of a Party may be used in a dispute settlement proceeding as evidence of the failure to meet obligations under this Agreement [only if the Party whose financial service provider is affected by the decision alleges that the decision violates the obligations or commitments under this Agreement of the Party that made the decision]. Should a reviewing panel determine that the decision evidences a violation of obligations or commitments under the Agreement, the panel may recommend that the Party reconsider its decision in light of the determinations of the pane. Panel determinations themselves cannot amend, or legallky compel the amendment of, the decision of the Party that was the subject of the dispute. Any information which a Party represents is confidential that is to be disclosed to the panel in a case involving an individual prudential decision shall be disclosed only to persons involved in the dispute settlement proceeding who agree to maintain the confidentiality of such information and to utilize it only for purposes of the dispute settlement proceeding."

This version of the PMD was novel in that it explicitly addressed consumer interests, and it appeared to make rulings against prudential measures less binding on countries.

By June 21, 1991, Treasury was circulating a document (revealed under FOIA) that was the outcome of meetings with European counterparts. It also noted that corporate leaders were meeting (presumably to weigh in on the text) at the Citicorp building in the near future. The PMD in that document read:

Ad Article XIV: Exceptions

1. Nothing in this Agreement shall be construed to prevent the adoption or enforcement by any Party of reasonable measures taken for prudential reasons, including for the protection of investors, depositors, policyholders or persons to whom a fiduciary duty is owed by a financial service provider, or to ensure the integrity and stability of a Party's financial system. Such measures shall not be applied in a manner which would constitute a means of arbitrary or unjustifiable a) restriction on the provision of financial service providers of another Party, or b) discrimination between domestic and financial service providers or between countries.

There are revealing pencil-written notes in the margins, whose author is unknown but is presumably a U.S. regulator. On the left margin, we see "tactical maneuver not to discuss last sentence." A note next to the words "arbitrary or unjustifiable" notes that the SEC would prefer the formulation "arbitrary and unjustifiable." Language similar to the SEC's recommendation in the second paragraph is also included later in the text. And note the disappearance of the word "consumer" relative to earlier drafts.

In GATT meetings in July 1991, developed nations continued to argue for the so-called “two track approach,” while Egypt, India, Yugoslavia, and Malaysia rejected the notion. What was beginning to change was that Latin American countries were softening their opposition to this aspect, with both Brazil and Mexico giving words of support – although not necessarily committing themselves to use the “negative list” approach of what would become the Understanding.

And Singapore argued against the October 1990 version of the PMD, on the grounds that GATT-style exceptions (with the standard non-circumvention language in the second sentence) were inappropriate for the financial sector. But the U.S., Japan and now Mexico pushed back, with the U.S. arguing that the December 1990 Malaysian proposal for a PMD “omitted the possibility of dispute settlement. The basis questions was whether or not to give central banks a blank check; if this were the case there would be no reason to have a financial services annex because any binding commitment could be undermined by actions a country deemed prudential.”

In September 1991 meetings, Malaysia continued to argue against the “two-track approach.” The delegations’ reasoning was sound: “the two-track would only … provide the legal basis for pressurizing countries to liberalize.” In other words, even if not all countries were bound to the Understanding, its mere existence legitimated an extreme deregulatory negotiating standard that countries would be relentlessly herded into.

In October 1991 GATT documents, Canada, Japan, Sweden and Switzerland formally proposed a text that contained a PMD virtually identical to Treasury's June 1991 proposal. This suggests that the U.S. may have farmed out this proposal to other countries to get them to run with it, or alternatively, that the language was already in the developed countries' conversations from an earlier date. Regardless, it shows the growing consensus that the purpose of the PMD - as the rich countries saw it, was to provide a "minimum requirement" that prudential measures not violate Article XVI or XVII disciplines, even if they violated other softer disciplines in the GATS.

By December 20, GATT Secretary-General Arthur Dunkel had substituted all draft texts for his so-called Dunkel Draft. It included the PMD now contained in the GATS. While it contained some of what could be argued to be "constructive amiguity" over its precise scope, a review of the negotiating history reveals that the main purpose of the PMD is to compel prudential measures to conform to Articles XVI and XVII.

This is borne out in various proposed and submitted schedules, where the very definition of "prudential" seems to be non-XVI/XVII violative. Schedules are a valuable piece of context (for determining the meaning of "prudential" or of other GATS rules) is GATS schedules, as the United States argued in the U.S.-gambling case: "In the United States' submission, the proper context for its Schedule is the Schedules of other WTO Members.”

For instance, in March 1992, the United States submitted an offer on banking services that noted “This offer is intended to represent a standstill with respect to federal, state and local measures in the United States banking and securities sectors pursuant to the Understanding... future and existing prudential measures do not constitute restrictions on market access or national treatment and are thus not scheduled as such.”

China’s schedule states; “b. Criteria for authorization to deal in China's financial industry are solely prudential (i.e., contain no economic needs test or quantitative limits on licenses).” In other words, “prudential” is defined as policies which do not violate XVI. This is consistent with Interpretation 4 of the PMD.

Malaysia, Vietnam, and Poland scheduled various prudential policies as limitations on their market access commitments. Various prudential seeming policies show up in virtually every schedule, suggesting a wide worry that prudential policies and Article XVI don't mesh.

Finally, FWIW, our FOIA request produced an undated document that laid out options for the PMD, which draws attention to the notion that these various options for the PMD are contrasted with exceptions "for other services sectors." Take a look here.


I think the main point of this very long blog post is that negotiators knew full well what they were doing when it came to the PMD. They considered, and ultimately rejected, options that would have given more flexibility to regulators, or provided General Exceptions from the obligation to offer market access or national treatment. By late 1991, the Dunkel Draft of the WTO agreements contained the bifurcation between GATS Article VI and XIV for non-prudential measures, and the PMD for prudential measures that we have today.

Current Treasury Secretary Tim Geithner appears to have advocated for a broader defense that focused solely on "rooting out protectionism." But as the text evolved away from that more precautionary vision, he went on to become one of the foremost advocates for a very pro-deregulation text (as his response to this economist letter shows.)

Sound treaty interpretation requires that we recognize the implications of their decisions, and give a different meaning to the PMD than the GATS General Exception. This argues for Interpretation 4, outlined above. However, it's worth noting that any of the four interpretations is possible, and we don't know how a WTO panel would ultimately rule.

Finally, the PMD is important because it is replicated in our bilateral trade and investment agreements, where private banks can directly challenge government regulations. So, while it may seem unlikely that a country would challenge another country's prudential regulation (for fear of diplomatic reprisals), it is more likely when there is no such diplomatic consideration for a private investor - who, to quote EPMD, are about "strictly business."

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Todd Tucker

One additional find worth noting. The developed country parties that were the main proponents of the GATS financial services rules circulated a note amongst themselves on June 21, 1991 (liberated by FOIA) that read:

"The specific provisions applicable to financial services reflect the special characteristics and requirements of the financial services sector, especially in the regulatory area. The words and phraseology of the provisions of the Annex, as well as the consideration of how and whether particular provisions of the Framework [i.e. main body of GATS] would apply to financial services, were based: a) on the ordinary meaning of the terms, without specific reference to the jurisprudence under the [GATT] and, b) where they have special meanings, on their customary usages in the financial services sector."

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