II Development as an International Financial Center

Historical Developments depository for funds during the 1920s and the 1930s, and Swiss banks received deposits on a massive scale, has a long tradition of capital exports. mainly from . A new Banking Law passed in As domestic savings exceeded domestic spending, 1934, to protect depositors during the worldwide bank- Swiss financiers and governments were already ac- ing crisis of the 1930s, created problems for Switzerland tively engaged in international finance in the eighteenth not only with Germany during World II but also century. Net capital exports continued into the twen- with the after the war. A side product tieth century, except during periods of the nineteenth of the law was rules on bank secrecy, which prevented century, when domestic credit demand increased with banks from providing information on bank accounts industrialization and the building of railroads, and for to outsiders. These rules precluded Switzerland from a time after World War I. The excess of domestic acceding to the demands of the U.S. Government to savings was largely a result of financially sound gov- have German assets held in Swiss bank accounts and ernments in the cantons and towns and was in marked in other placements confiscated for war reparations. contrast to the large financing needs of many other Despite substantial political pressure, the Swiss Gov- European governments, which resulted from contin- ernment did not succumb to the demands but rather uous engagements in war. The financial performance agreed to a compromise whereby only part of the of both the Swiss governments and the private sector German assets in Switzerland would be confiscated 3 was based on several factors. First, the country main- for war reparations. tained political neutrality and thereby did not incur Switzerland's ability to preserve a relatively stable large war expenses. Neutrality was a consequence of and strong currency increased the attractiveness of the multiconfessional and multilingual character of the the Swiss banking system. Only once in the period Confederation, the strategic location in the center of from the end of World War I to 1971 was the Swiss Europe, and the small size of the country.2 Second, franc devalued (in 1936). Switzerland also maintained Switzerland was able to maintain trade with the bel- a very low rate of inflation by international standards. ligerent countries and also benefited, on a large scale, During the 1950s, the increase in consumer prices from income earned from Swiss military service abroad, averaged 1 percent a year. With the strong expansion through treaties concluded with foreign sovereigns. in economic activity, prices accelerated to an annual Finally, in the early stage of industrialization, Swiss rate of 3 percent during the 1960s and 41/2- 5 percent exports of cotton and silk products prospered because in the period 1970-85, closely following the rate of of little competition from abroad. inflation in the Federal Republic of Germany, but Although Switzerland had exported capital for cen- inflation was still low compared with other industrial turies, it was not until the twentieth century that it countries (Chart 1). became a "safe haven" for foreign funds and began Since the early 1960s, international financial trans- to intermediate between foreign savings and credit actions have expanded strongly, with the convertibility demand. After World War I, the currencies in Austria of major currencies and liberalization of capital move- and Germany collapsed and the financial systems were ments. When monetary conditions at home and abroad in disarray. Switzerland, having avoided hyperinflation differed considerably, Switzerland experienced sub- and having been less affected by political unrest than stantial inflows of foreign capital which exerted an other European countries, became attractive as a safe upward pressure on the Swiss franc. During political upheavals abroad, the neutrality of Switzerland and 2 Swiss neutrality as it exists at present developed through centuries. It was recognized formally by the European powers in 3 In 1952, German firms that had their assets held in Switzerland the Congress of Vienna (1815). confiscated were indemnified.

3 II • DEVELOPMENT AS AN INTERNATIONAL FINANCIAL CENTER

Chart 1. Switzerland: Economic Indicators Chart 2. Nominal and Real Short-Term Interest Rates (In percent)

Source: International Monetary Fund, Data Fund. 1 Compared with the same period of the preceding year. 2 An increase (decrease) in the index indicates appreciation (de- preciation) of the Swiss franc. Sources: International Monetary Fund, Data Fund; and staff calculations. 1 For the Federal Republic of Germany, three-month interbank rates; for Switzerland, three-month deposit rates with the big banks; its bank secrecy also played a role in attracting capital for the United States, three-month treasury bills. inflows. This was the case, for example, when Egypt's 2 Deflated by the increase in the consumer price index in a month accounts in the United Kingdom and in the United compared with the same period of the preceding year. States were temporarily frozen after the Suez crisis and again in the wake of the first major oil price increase in 1974 and also during the political events in in the early 1980s led to an increase in foreign exchange the Islamic Republic of Iran in the late 1970s. Despite denominated deposits with Swiss banks (especially several attempts to discourage capital inflows, the fiduciary deposits) rather than Swiss franc deposits, monetary authorities frequently had difficulty in con- thereby leaving the exchange rate unaffected (Sec- trolling domestic liquidity without allowing a sharp tion V). appreciation of the Swiss franc (Section V). Since the early 1980s, however, international capital flows have not seriously conflicted with domestic Conditions for Development as an policy aims. This is possibly explained by the sharp International Financial Center tightening in monetary policy in the United States and in other countries, which permitted the Swiss author- The history of Switzerland illustrates some of the ities to pursue a monetary policy aimed at securing factors which have been important for the development price stability without threatening external competi- of its financial center. Because of its small economy, tiveness (Charts 2 and 3). The high return on U.S. it is not a natural center for international trade and dollar and other foreign exchange assets is possibly finance as are the large industrial countries (e.g., the also the explanation why the international debt crisis United Kingdom and the United States). Nor has its

4 Conditions for Development as an International Financial Center

Chart 3. Nominal and Real Long-Term Interest the first Swiss banking centers emerged in Geneva and Basle close to and the Federal Republic of Rates Germany. In addition, the use of three main European (In percent) languages (French, German, and Italian) has also facilitated international banking. The hard-working mentality of the Swiss people is no less a factor— working hours in Switzerland continue to be high by comparison with other industrial countries. Although a surplus on the external current account is not a necessary condition for a country to become an international financial center, it certainly promotes it. Swiss capital exports developed because domestic savings exceeded domestic needs. Switzerland contin- ues to have a high savings propensity compared with other industrial countries, such as the Federal Republic of Germany, the United Kingdom, and the United States. During the last two decades, both the gross and net savings ratios have been exceeded only by Japan's and have been substantially above the ratios of Germany, the United Kingdom, and the United States (Chart 4). Despite the relatively small size of the Swiss economy, among industrial countries in 1985,

Chart 4. Gross and Net Savings Ratios1

Sources: International Monetary Fund, Data Fund; and staff calculations. 1 Public bond yields. 2 Deflated by the increase in the consumer price index in a month compared with the same period of the preceding year.

Government promoted it through the creation of off- shore facilities or special tax incentives or bank su- pervision as have the governments of other small economies (e.g., the Cayman Islands, Hong Kong, and Singapore). Rather, it has been a combination of fundamental political and economic factors, such as high economic growth, low inflation, external sur- pluses, sound government finances, political neutrality, bank secrecy, and a universal banking system, that has established confidence in its financial markets. None of these factors is unique to Switzerland. But few countries have, to the same extent, experienced so many of these conditions and maintained them over a long span of years. Switzerland's geographic position, in the heart of Source: Organization for Economic Cooperation and Develop- Europe, also played an important role in its develop- ment, National Accounts Statistics. ment as a financial center. It was no coincidence that 1 Net savings equal gross savings less depreciation.

5 II • DEVELOPMENT AS AN INTERNATIONAL FINANCIAL CENTER

the current account surplus of Switzerland (US$41/2 prescribes severe penalties for breach of bank secrecy.6 billion) was exceeded only by that of Japan (US$49 1/2 Just as with violations of official secrecy, breach of billion), Germany (US$13 billion), and the banking secrecy is prosecuted ex officio by law; while (US$5 billion). During the fixed exchange rate system violations of other professional secrecies (e.g., medical that prevailed until 1973, current account surpluses doctors, attorneys, and priests) are prosecuted only and capital inflows resulted in massive exchange rate upon request of the injured party. In most other intervention by the Swiss National Bank, which led countries, bank secrecy is protected only by civil law; to a strong official reserve position of Switzerland. in a few cases (such as Austria, France, and the The valuation of plays an important role for the Netherlands), where breaches of bank secrecy are also ranking of countries. With gold valued at SDR 35 an prosecuted under criminal law, softer sanctions apply ounce in all countries, official reserves of Switzerland and prosecution is not ex officio. (SDR 18 1/2billion ) were the sixth largest recorded in Second, although banks are in certain cases obliged any country by the Fund at the end of 1985. But with to provide information to the public authorities on gold valued at market value in all countries, official clients' accounts, such requirement applies only to reserves of Switzerland (SDR 42 billion) were exceeded cases where criminal acts as defined under Swiss law only by those of the United States (SDR 111 billion), are being investigated. For violations of domestic or Germany (SDR 70 billion), and France (SDR 50 bil- foreign fiscal and foreign exchange laws, bank secrecy lion).4 can be lifted and international judicial assistance granted The existence of a universal banking system in under Swiss law only when fraud is involved. This is Switzerland has given its banks a competitive advan- not possible for tax evasion which, although subject tage over countries in which specialized banking has to administrative sanctions, is not prosecuted at crim- prevailed. The federal structure of the country has inal level in Switzerland. The legal treatment of tax made it important that banks in every canton and evasion, however, is to be interpreted in connection municipality be able to perform all kinds of banking with the 35 percent witholding tax on capital earnings, transactions. The principle of universality was adopted which limits the scope for tax evasion. in the Swiss Banking Law of 1934 at a time when a Bank secrecy and the rules for providing information worldwide bank crisis induced other countries to to the authorities in case of criminal offense or inher- impose restrictions on banking activity. For example, itance apply equally to "numbered" and other ac- the 1933 Banking Act in the United States separated counts. Numbered accounts, however, differ from commercial banks from investment banks. In Europe, other accounts in that the identity of the owner is the Banking Law of 1935 introduced in Belgium pro- known to fewer people within the bank. It is estimated hibited banks from acting as both deposit banks and that less than 10 percent of Swiss banking accounts holding companies; in , the Banking Law of 1936 are numbered accounts.7 They are not a feature specific drew a distinction between short-term and long-term to the Swiss banking system but are used also, for credit institutions. In addition to Switzerland, universal example, in Austria, Belgium, the Cayman Islands, banking systems exist in , the Federal Re- France, Hong Kong, Luxembourg, and Singapore. In public of Germany, Luxembourg, and the Netherlands. some of these banking systems, numbered accounts The financial markets in Switzerland have benefited are truly anonymous in the sense that the identity of from the existence of bank secrecy. Bank secrecy, the account holder is not disclosed to the bank. which protects banks' clients from misuse of confi- In recent years, Swiss bank secrecy has come under dential information relating to their financial transac- attack from abroad in connection with "insider trad- tions, is not unique to Switzerland. But in Switzerland, ing" violations. The Securities and Exchange Com- it is more protective than in most other countries.5 It mission (SEC) in the United States has demanded differs in two major aspects. First, the Banking Law information from Swiss banks about their customers in order to investigate cases of insider trading. Ac- cording to present Swiss law, however, insider trading is not a criminal offense. Therefore, bank secrecy 4 International Monetary Fund, International Financial Statistics; foreign exchange reserves include foreign exchange from swaps cannot be lifted and judicial assistance granted to with the private banks. The market price for gold in London in 1985 foreign authorities. In retaliation, the SEC threatened on average (US$317 a fine ounce) has been used to calculate the to bar certain Swiss banks and their customers from value of gold holdings at the end of 1985. 5 Since 1981, when a new law on bank secrecy took effect in the U.S. securities market. Consequently, in 1982 a Luxembourg, the regulations concerning bank secrecy in Luxem- bourg and Switzerland have been almost identical. In cases of inheritance, however, Luxembourg banks are not allowed to disclose 6 Violators may be punished by a prison term up to six months information on foreign-owned accounts to heirs, in contrast to Swiss and a fine of up to SwF 50,000. banks. 7 Meier (1983).

6 Conditions for Development as an International Financial Center compromise was reached, whereby the Swiss banks possibility of blocking the accounts in question. Con- signed a Convention (''Convention XVI") that speci- vention XVI is meant to be only a transitory solution. fied certain procedures to be followed. According to On May 1, 1985, a proposal was made by the Swiss the Convention, a request by the SEC for information Federal Government to Parliament concerning an on a bank's customer in connection with insider trading amendment of the criminal law according to which investigations will be considered by a specially ap- insider trading would become a criminal offense. Such pointed Commission comprising Swiss citizens who an amendment would enable the Swiss authorities to are independent of banks. The banks will provide grant judicial assistance to foreign countries provided information to the Commission on the customer's that the conditions mentioned in the bilateral treaties transactions, and if the case fulfills certain criteria, or the Federal Law concerning International Mutual information will be forwarded to the SEC with the Assistance in Criminal Matters are met.

7