Tiny Luxembourg's outsized financial sector under increased scrutiny following Cyprus bailout

Published April 07, 2013

| Associated Press

As the European Union's wealthiest country, Luxembourg could have been forgiven for thinking that it would never find itself on the bloc's financial risk list.

With just half a million people living on a tiny patch of lush land nestled between Belgium, France and Germany, Luxembourg is as tranquil as a buzzing financial center gets. Still, some of Europe's regulators and politicians have started wondering aloud whether its banks might be holding the 17-nation eurozone's next ticking bomb.

Following the chaotic bailout for Cyprus last week, European officials have been drawing worrying comparisons between the two countries' oversized financial industries.

Mario Draghi, president of the European Central Bank, cautioned on Thursday that "the recent experience shows that countries where the banking sector is several times bigger than the economy are countries that, on average, have more vulnerabilities."

"Financial shocks hit these countries stronger, simply because of the size of their banking sector."

The increased scrutiny has taken Luxembourg's government by surprise and put it on the defensive. It has rejected calls to shrink its country's main source of wealth to a more manageable size, claiming that its banking industry is much more secure than Cyprus's and any crackdown would not only harm its own economy but that of the wider eurozone.

Cyprus was forced to seek a bailout from its eurozone partners after its once-thriving banking industry collapsed. The country couldn't afford to bail out its financial sector which, thanks to massive deposits of foreigners, had grown to eight times the size of its economy. The 10 billion euro ($13 billion) rescue loan package comes with tough austerity measures attached, as well as a brutal shrinking of the banking industry and significant losses for savers with deposits larger than 100,000 euros.

In comparison, the balance sheets of the banks in Luxembourg have swollen to about 22 times the country's annual economic output of 44 billion euros — making it Europe's richest country per capita. The country is also the world's second-largest center for investment funds, with about 3,800 funds holding assets worth €2.5 trillion ($3.2 trillion) — about 55 times the country's gross domestic product. It has 141 banks based there, with five of them domestic institutions and the remainder being mainly divisions of foreign banks.

"There are no parallels between Cyprus and Luxembourg, and we don't allow any parallels to be forced on us," Prime Minister Jean-Claude Juncker said last week. "Cyprus is a special case; other financial hubs in Europe don't have these problems."

Luxembourg also has relatively little debt, so it could afford to borrow to bail out the odd bank. But if it faced a widespread problem, it might not be able to cope.

"One does not want to imagine what would happen if the whole banking sector were to derail," said lawmaker Joachim Poss, the deputy caucus leader of Germany's Social Democrats, the country's main opposition party.

If things in Luxembourg's financial sector were to go wrong, the country might not get help from its eurozone partners so easily. For one thing, it won't be able to say it wasn't warned.

Jeroen Dijsselbloem, the plain-spoken chairman of the bloc's 17 finance ministers, warned other countries with outsized banking sectors to "deal with it before you get in trouble."

"Strengthen your banks, fix your balance sheets, and realize that if a bank gets in trouble the response will no longer automatically be we'll come and take away your problems."

Stung by the comparison with Cyprus and concerned for the future of its banking industry, Luxembourg's leaders have begun to fight back. They have accused EU officials, and Germany in particular, of bullying smaller countries and seeking to "strangulate" its financial industry — which represents 27 percent of the country's annual economic output, a third of the tax revenues and employs 20 percent of the workforce.

German Finance Minister Wolfgang Schaeuble, representing Europe's biggest economy, openly wondered last month whether a business model relying too heavily on banks can still be seen as viable after the Cyprus debacle. That immediately prompted an outcry in Luxembourg.

"Germany does not have the right to define the business models for other countries in the EU," said Foreign Minister Jean Asselborn.

Luxembourg's government says its financial sector "acts as an important gateway for the euro area by attracting investments, thus enhancing the eurozone's competitiveness as a whole while being effectively supervised".

The government rejects the idea of looking at the size of its financial sector only in relation to its GDP.

"What matters are primarily two aspects: while the first aspect touches on the quality and solidity of the financial sector, the second element relates the size of the financial sector not to a national economy but to the euro area or single market as a whole," it said.

Until January, Luxembourg was mostly shielded from criticism and wielded much greater influence in the EU as its tiny size would normally allow, because long-time Prime Minister Juncker chaired the Eurogroup of finance ministers.

Overall, the International Monetary Fund reported last year that Luxembourg's banks were healthy and well-capitalized. The banks registered in the country are mostly subsidiaries of foreign banks. This means that the danger associated with domestic banks making risky bets abroad — which caused havoc in Cyprus — is avoided.

Still, the IMF urged Luxembourg to strengthen financial sector oversight and develop bank resolution plans.

"The banking sector's main risk is its exposure to foreign parent banks," according to the IMF's most recent country report, which added that "further efforts are needed to clarify the roles of its supervisory authority and central bank".

The success of Luxembourg's financial sector was initially fueled by lax regulation, secrecy and low taxes. This made it a popular tax haven and money-laundering spot. The country later changed many of its laws following pressure by its European partners. But critics say the financial industry still lacks the necessary transparency.

"The name Luxembourg always comes up when companies try to move profits across borders, through the so-called aggressive tax planning, to avoid paying taxes," said the president of the German tax inspectors' association, Thomas Eigenthaler. "It's very intransparent and quite often there's nothing we can do about it."

Luxembourg rejects those charges and says it complies with all relevant laws.

The heat could come off Luxembourg once the EU's banking union is up and running. Under that plan, the European Central Bank will have central oversight of all European banks, accompanied by a common bank resolution mechanism and a joint bailout fund. That would reduce the risk on a single country of propping up an outsized banking sector. But the plan won't take effect before next year at the earliest, with many details have yet to be hammered out.

Until then, Luxembourg will have to resign itself to increased scrutiny — as made clear again in the warning issued by ECB chief Draghi.

"I think countries ought to learn from the present experience and should follow this advice, namely run both, the country and the banking system much more conservatively," he said.

"In fact, you realize that a country has a wrong business model only when a crisis arises," Draghi said.

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