Host’s Dilemma: Rethinking EU Banking Regulation in Light of the Global Crisis

Abstract

One of the main objectives of transnational banking regulation over the past two decades has been the standardization of regulatory practices and the allocation of regulatory powers to minimize the regulatory burden for banks. The resulting division of labor between home and host country regulators strongly favors Home over Host; And the regulatory scope has continued to focus on entities rather than activities. This paper argues that this has created several blind spots in transnational regulation of finance. First, Home is unlikely to monitor and respond to risks that are unique to Host, even though they might emanate from activities of banks that are subject to their consolidated regulatory supervision. Second, Host, may have regulatory supervision over a subsidiary of Home’s parent company, but may rely on Home to exert regulatory controls. Moreover, Host has little regulatory leverage if the parent bank side-steps regulatory restrictions imposed on subsidiaries by engaging in direct lending practices, or by channeling capital through entities that are not subject to similar regulations. Second, the continued focus on entity based regulation ignores the fact that the core function of banks, maturity transformation, is increasingly performed by non-bank institutions that escape the existing transnational regulatory framework. Against this background, this paper proposes effect-based regulation, which gives Host the power to regulate any activity that has a systemic effect on its financial system, irrespective of who undertakes it and where it is carried out. The paper uses the recent example of Central and Eastern Europe during the global financial crisis to illustrate the failure of the existing regime.