"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".
But Luxembourg's Finance Minister Luc Frieden said its financial sector is not in danger, because it would be up to the foreign banks or their governments to bail out their subsidiaries in the country.
"In a case of emergency, it is first of all up to the parent companies and their governments to help, that reduces the burden for Luxembourg," he was quoted as telling German Sunday paper Frankfurter Allgemeine Sonntagszeitung.
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 lacks transparency and quite often there's nothing we can do about it."
Luxembourg rejects those charges and says it complies with all relevant laws. But on that front too, the pressure is increasing.
In the wake of the publication of details on wealthy people's offshore bank accounts by several international media this week, some of which included references to shell companies based in Luxembourg, Frieden is now signaling the country's willingness to agree for the first time to automated information exchanges with other countries' tax authorities.
"Unlike in the past, we no longer strictly reject that idea. We want a strengthened cooperation with the foreign tax authorities," he was quoted as telling Germany's FAS newspaper.
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.