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(originally published by Booz & Company)


A Global Financial Governance Primer

Government leaders are designing the next regulatory regime for banks; their answers to four basic questions will determine how well it works.

One year after the global financial crisis began, the design of a new global governance framework for financial services is being debated and developed. The Group of 20 (G-20) nations, individually and collectively, are considering global measures for assessing systemic financial risk (since neither banks nor rating agencies are trusted to do so by themselves), assigning responsibility for mishap, and linking performance to compensation. Old-fashioned virtues such as capital strength, high levels of liquidity, and a sustainable funding base are making a comeback. These principles will be reflected in the new governance structures and practices that emerge this year.

If it succeeds, regulatory reform will be both strong enough to ensure the macroeconomic stability of global financial markets and flexible enough to allow innovation and efficiency. But the details and impact of the new governance framework aren’t clear yet, and probably won’t be clear until mid-2010. Businesspeople trying to assess how the coming reforms will affect them need a means to understand events as they occur.

All of the complexity can be boiled down to four key questions that regulators must address in the forthcoming wave of regulatory reform. The way they answer them will determine the effectiveness of the new regime.

1. How can the financial-services industry be restored to health? The global nature of financial markets means that oversight and regulation will have to take place on two levels simultaneously: within nations and across international borders. Only this approach can ensure the holistic and transparent oversight of a global industry, and avoid the threat of regulatory arbitrage (in which some businesses move operations to the most lenient or convenient regulatory location) or other gaps in regulatory coverage.

The new system will also undoubtedly cover all financial institutions (FIs), not just those that have traditionally been regulated and supervised by national governments. These FIs should include the “shadow banking system,” as it has come to be known: hedge funds, private equity firms, and special-purpose vehicles (firms created to deal in securitized assets, isolate risk from parent companies, or perform other specific functions). If banks and other financial institutions continue to hold trillions of dollars in asset-backed commercial paper conduits, tender option bonds, variable-rate demand notes, tri-party repurchase agreements, and other complex investment vehicles, they will be forced to become more transparent — if only for the sake of their own industry’s health.

At the same time, the roles and responsibilities of finance ministries, central banks, and regulators are ripe for reevaluation. Ratings agencies, in particular, played a central role in creating financial instability. We now know that the industry relied too heavily on these agencies to evaluate risk and reliability. Their business model gave them incentives to ensure that their assessments and ratings matched the commercial interests of FIs, which, in turn, paid them most of the time. Even now, ratings agencies are subject to little oversight, and thus far they have evaded the scrutiny that the rest of the financial-services (FS) industry has received. That will probably change.

Given ratings agencies’ importance to the overall stability of the system, some key issues will be addressed. Do ratings agencies have the right capabilities in place? Are they close enough to the information flow to be able to assess risk? Do they have the risk management talent they need? Some evidence suggests that ratings agencies have relatively immature capabilities and do little more than ask basic questions from a formulaic template. If that is the case, then their ability to assess risks and offer insight could be improved.

Finally, regulators will probably seek to increase the stability of the financial system by creating a regulatory environment in which risks flow to those financial institutions that have the greatest ability to hedge them. This could mean requiring hedge funds, private equity firms, and other shadow banking institutions to maintain a lower leverage rate. Most previous regulation, from the 1990s through 2008, took the opposite approach, requiring banks to set aside more capital for credit risk than non-FIs do. That, too, will change.

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