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(originally published by Booz & Company)


A Global Financial Governance Primer

The solutions are not yet obvious; smaller FIs with smarter people, better management information, and better risk management could all be part of the solution. Some financial institutions may simply be too big and complex to thrive in the new environment.

Fundamentally, do we care about talent in FS? The answer should be yes. Securing top-grade talent is critical, if only to guarantee the success of current industry restructuring initiatives. Banks also need to ensure over the long term that they have the right capabilities to succeed in a complex and uncertain environment. That is why future compensation schemes will probably be based on actual profits rather than accounting profits, and on an adequate profit distribution between the individual and the bank, as opposed to the revenue-sharing agreement that many banks currently have in place.

According to one common belief, banks should also be required to hold more capital. This would give them the leverage they need to balance exposure to a variety of risks: in lending, investment, trading, and operations alike. However, simply increasing overall capital requirements is not a panacea for the problems that caused the current credit crisis. It fails to take into account the different types of risk and the differences among FIs.

Sooner or later, capital requirements will need to become flexible enough to fit every FI’s individual business model and address the risks inherent in the business, taking into account national as well as global requirements. For most countries, the risks of supporting global institutions are high and even threaten sovereign default. Recent history seems to indicate that bailouts, if they are needed, will be performed by national governments and ultimately the taxpayer — the underwriter of last resort. Consequently, the ability of a nation to bail out FIs will tend to influence the maximum size of financial institutions and other corporations as well: If a potential bailout is too large, then the FI is too big and needs to be downsized to make a bailout palatable for the national taxpayer.

In addition, increased capital requirements will need to be aligned with each organization’s risk taking and risk capacity. Modern regulators tend to assume, often erroneously, that risks are a precisely quantifiable property of an asset. Apart from the fact that risks come in many forms (credit, market, liquidity), different parts of the financial system have different capacities to hedge risk. Accordingly, risk has as much to do with the holder of the asset as with the asset itself. In that context, regulators will hopefully reconsider the popular notion that there are “safe” instruments that should be promoted at the expense of “risky” ones — and that the riskiest ones might even have to be banned. Banks, for example, should be able to hedge effectively against credit risk by diversifying their lending and proactively using the information they have about potential borrowers. Regulators should follow one essential rule: Know well the individuals with whom you are interacting and strive to answer the key question, Can we trust them?

4. How should the structure of financial services change? As we have noted, jurisdictions around the world are increasingly demanding that global banks hold capital locally to underwrite local operations. This makes it likely that, in many countries, operations will need to shrink to match the availability of local capital. In addition, regulators are considering whether to separate retail or deposit-taking activities, which typically exemplify low risk, from higher-risk activities such as trading and investment banking. These might be legal separations, requiring oversight and isolation within banks, or they might represent a return to the Glass-Steagall Act parameters, in which financial institutions had to choose one approach or the other, but not both.

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