European Financial Regulation’s Wrong Turn

London – With the crisis in financial systems around the world reflecting massive regulatory failures, calls for more and better oversight abound. Such appeals were heard again at the G-20 meeting in Pittsburgh, and the European Union has just responded, unveiling a plan for a new pan-European watchdog.

In a globalized financial system, striking the right balance between home and host country jurisdiction, and between national and supranational oversight, is crucial.  Look at Europe. European financial institutions and markets cross national borders on an unprecedented scale, but national authorities still dominate regulation. Addressing the European problem may help us find solutions to the global challenge.

The EU’s current model – the “single passport” with home-country regulation of financial institutions – has failed on an embarrassing scale. The Baltic economies are perhaps the most tragic victims, but the damage stretches across Central and Eastern Europe and down into the Balkans. After the devastating impact of the crisis on their economies, countries hosting Western banking subsidiaries and branches cannot be expected to accept the status quo .

But the new European watchdogs are likely to fall far short of what is needed. The European Systemic Risk Council (ESCR) has only monitoring functions. The three new EU supervisory authorities for banks, insurance and securities markets will coordinate the existing system of national supervisors. They will have no enforcement powers and national governments are already finding ways to undermine their authority and (financial) capacity. It is high time to think about Plan B – what happens if these reforms do not deliver what is needed to protect the countries at the receiving end. The countries currently holding out – within Europe primarily the UK -- must be made to understand that the alternative to a EU-wide solution is a radical increase in host country regulation. This is even more likely in countries that do not face the same constraints on national solutions as members of the EU -- most prominent among them China or India, which only recently opened their borders to foreign direct investment in the financial sector.