BRUSSELS�The European Union has asked national bank regulators in the 27-nation bloc to explain policies that may be preventing free flows of funds across national borders, the first public step in a campaign by EU authorities to combat fragmentation of the region's financial markets.
The free movement of money is a central pillar of the EU's single market, but some actions by national authorities since the onset of the financial crisis in 2008, intended to protect local banking systems, have prevented banks from moving funds to other countries.
A letter sent Friday from the European Commission, the EU's executive arm, to national banking authorities asks them to describe and explain such policies.
The step, a possible early prelude to legal action that could result in fines for offending governments, is a sign of rising concern in Brussels about national regulatory restrictions that threaten to slow healing of the region's battered and fragmented financial markets.
The commission's attention is focused on restrictions that some national regulators have placed on banking groups that have operations in multiple EU countries.
Such policies include preventing national operations within a banking group from transferring capital to one another, prohibiting banking subsidiaries from giving profits to their parent companies and limiting intra-group lending, according to a draft statement about the letter seen by The Wall Street Journal.
The policies of concern generally are aimed at preventing European banks based in Europe's financially distressed south from dragging down operations these groups own in the more-stable north.
"The Commission is very concerned by any such possible measures," according to the draft statement. "The Commission considers that free movement of capital and the great potential of the Single Market should not be compromised for the sake of uncoordinated and disproportionate measures taken with a view to preserving financial stability exclusively at national level."
The commission asked national regulators to respond by the end of February, according to the draft statement. It will then "take further steps as appropriate."
The Journal reported in December that the commission was considering legal action to address the problem, starting a process that could end up at the European Court of Justice. But an EU official said the commission isn't ready to take that step. Instead, it wants to resolve the issue at the European Banking Authority, the London-based coordinating body for national bank regulators. Only if that doesn't work would the commission take more-drastic action, the official said.
A few incidents and policies have been particularly worrisome for the EU. One is pressure that the U.K. has wielded over foreign-owned banks to convert their branch operations, which are overseen by regulators in the country where the foreign-owned bank is headquartered, into banking subsidiaries, which would be supervised in the U.K.
Subsidiaries are required to hold their own capital and reserves of liquid assets, giving them independent means to respond to financial stress even if their parent company lacks the power to save them.
"Any pressure or obligation to transform a branch to subsidiary would go against fundamental single market principles," the EU official said. National regulators must trust other European regulators to supervise bank branches in their own countries, the official said.
The U.K.'s Financial Services Authority last year asked two major Cypriot banks with branches in the U.K., Bank of Cyprus and Cyprus Popular Bank, to change these operations into U.K. subsidiaries. That reflected concerns among U.K. officials about the Cypriot banking system, which is under severe strain after the restructuring of Greek government bonds last year left a big hole in Cypriot bank balance sheets. Bank of Cyprus has already made the switch, while Cyprus Popular Bank said last year that it was in the process of doing so.
In another example, German and Italian regulators quarreled over moves in 2011 by the Italian bank UniCredit SpA to move billions of euros of deposits from its operations in Germany to Italy. With concerns running high at the time that Italy would need a bailout, German regulators attempted to prevent the transfers, fearing they could leave them to foot more of the bill for supporting UniCredit. That dispute ended after UniCredit pledged it would reduce its transfer of funds.
Investors have rushed back into markets for sovereign debt from fiscally stressed euro-zone countries in recent months, driving down yields on Italian, Spanish, Portuguese, Irish and even Greek bonds. But national restrictions on transfers of money by banks could still be preventing lower government borrowing costs from flowing through into the real economy and providing an economic jolt to the euro zone. Cross-border banking restrictions may have also exacerbated the more-acute cases of European financial trauma, such as last summer, when bond yields soared and investors feared a break-up of the euro zone.
The creation of a new euro-zone banking supervisor housed at the European Central Bank should limit conflicts among national regulators within the currency bloc. But it will still be necessary to coordinate supervision of banks in countries, such as the U.K, that won't be covered by the euro-zone regulator, the commission says.—David Enrich contributed to this article.
Write to Matthew Dalton at Matthew.Dalton@dowjones.com