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(originally published by Booz & Company)


A Global Financial Governance Primer

2. What role should regulations play? The mix of national and international regulation should ideally provide a level playing field around the world; that is, a globally consistent and transparent governance framework. At the same time, it must take into account the fact that each country already has its own regulatory philosophy. For example, nations have differing views on public-sector participation in the private sector and on demand-side and supply-side regulations.

The only way to fulfill both of these imperatives is to provide a clear articulation of a philosophy of global regulation that will be widely accepted. This philosophy, once established, will largely determine the role that regulators play.

Global groups (such as the G-20) will try to keep national governments from becoming more parochial. Some nations have already pushed to protect their sovereignty by, for example, revising foreign investment rules or encouraging banks to make in-country loans if they are taking deposits. Ensuring global consistency and holistic coverage of regulatory frameworks requires counterbalance at the international level.

Effective regulation and governance will rest on the regulators’ ability to monitor the stability of the global FS system in real time to determine its overall health and anticipate chain reactions and system-wide failures. There will be efforts to oversee complex financial products, in particular, more systematically. For example, regulatory oversight could be mandatory for all products exceeding certain thresholds (perhaps thresholds of absolute financial value). High-risk products such as some securitized packages could be routed through global clearing facilities, which would further reduce systemic risks. This in turn would promote the creation of standardized products and increase transparency, additionally reducing counterparty and liquidity risks.

The designers of this regime should bear in mind that financial services is already one of the most regulated industries. New regulations could have a detrimental impact on innovation and on other FS-dependent industries. A clear lesson also emerges from other industries, and from financial and economic history in general: Incentives that trigger the right behaviors are generally more effective and thus better suited to managing risk than is explicit directive regulation; at a minimum, incentives should complement regulation where possible. It is not yet clear how well the designers of the new regime will understand this principle — or follow it.

3. What needs to change within the industry itself? Any regulatory framework is unlikely to achieve the desired FS stability effect in the absence of a strong risk culture that guides and incentivizes the right behaviors. Contrary to public perception, many managers of financial institutions have taken the lessons of the meltdown to heart. Some of them may have been “bailed out,” but none of them wants to experience this kind of shock again.

However, it’s not yet clear whether corporate leaders will have the motivation and ability to align performance targets and incentives in a way that drives their organizations toward optimal and sustainable risk/reward balances. And if these leaders can’t do it themselves, it’s not clear how regulators can compel them — other than setting up clear parameters and letting the banks with rigid cultures fail.

Talent will be a related, and controversial, issue. It is particularly hard to attract the skills needed to lead change in financial services. Many skilled managers have already left the industry altogether as a consequence of significant capacity reduction. In addition, given the caps on compensation and other measures currently being discussed — such as clawbacks — there is a real danger that high-level banking jobs will be seen as not worth the trouble, especially when the level of public scrutiny, hostility, and reputational risk is considered.

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