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.

What is at stake is decades of financial integration in Europe. Unlike most other parts of the world, capital in Europe has flowed from rich to poor countries – essentially from West to East and South.

Within Eastern Europe, capital has sought out the countries with the most rapid growth, following the overwhelming pattern in emerging markets.

Overall, financial integration has greatly contributed to economic growth in Eastern Europe. Industries that depend heavily on external finance grew faster in countries with large capital inflows than in countries with more modest inflows.

But the rapid expansion of credit brought about by foreign financial intermediaries using various channels (including direct lending, lending via banking subsidiaries, and lending via leasing subsidiaries) has fueled asset booms and heightened exposure to foreign-exchange risk.

In the absence of effective regulation, financial integration has made the region vulnerable to a sudden and massive contraction of capital inflows.

The options currently on the table leave the home-regulator principle largely intact. Yet this model has conspicuously failed to protect host countries against the systemic risk of excessive capital inflows.

Giving increased powers to host countries over parent companies located outside their jurisdiction is problematic. Most host countries have limited resources to penetrate the complex structures of sprawling financial groups, and their powers to enforce regulation and supervision are limited.

The EU’s proposed "college of supervisors,” even with the addition of a European "systemic risk board,” is only a partial solution, because it endorses the leadership of the home-country regulator and fails to address the potential conflict of interests between home-country and host-country regulators.

Host countries could address their needs by adopting a radical solution that would unilaterally impose capital controls and other measures to protect their domestic markets.

Of course, this could very well reverse much of what has been achieved in terms of financial integration.
As an alternative, we propose a set of common standards for "effect-based jurisdiction.”

That is, when the effects of a financial institution’s activities are sufficiently large, the country affected should be allowed to assume regulatory power, irrespective of the institution’s domicile.

Such effect-based jurisdiction has a long tradition in both American and EU extraterritorial application of their respective anti-trust laws. It would allow host countries to impose restrictions on credit expansion, regardless of how a financial institution chooses to channel capital to its market, and would strengthen host countries’ rights to request information from home-country regulators.

Within the EU, effect-based jurisdiction might raise concerns about the free mobility of capital. However, the EU Treaty recognizes public policy exceptions.

Moreover, several EU directives acknowledge the interest of the country where financial transactions (such as life insurance contracts) are carried out by allocating to it jurisdiction over such transactions.

The best way to protect cross-border banking and financial integration in Europe would be to establish an effective EU-wide regulator and supervisor, or, even better, a global institution that could monitor the home country-host country relationship.

Without sufficient progress in that direction, however, host countries must be provided greater protection. We believe that an effect-based approach, based on an agreed threshold, would minimize the negative consequences of more host-country intervention in regulation and supervision.

Erik Berglof is Chief Economist, European Bank for Reconstruction and Development. Katharina Pistor is Professor of Law, Columbia Law School.