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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.

(originally published by Booz & Company)

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.

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.

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.

Such measures could raise the barrier to entry for smaller banks, leaving the playing field largely to FIs that are deemed “too big to fail” (TBTF) and that may thus require significant capital injections. The industry would then consolidate into a few global players, supported in effect by the governments of their host countries. If the U.S. is one of only a few economies with the scale to support global institutions, will other nations feel the need to prop up national champions that would otherwise not be competitive? More fundamentally, do we want global banks or national banks to dominate the industry?

Most proposals that address the TBTF problem rely on regulating complex FIs more tightly. An alternative is to address the root cause — namely, to prevent FIs from becoming so big in the first place. Options for doing so include antitrust or anticompetitive measures, and levying capital charges on institutions in proportion to the level of systemic risk they pose. In effect, that would charge these institutions a market price for their TBTF guarantee.

However, if a financial institution ultimately is nationalized, the role of the state as a significant shareholder will need to be understood to avoid potential conflicts of interest (for example, the use of FIs to drive policy). Likewise, government-based shareholders need to determine how they want to manage the potentially conflicting objectives of their portfolios of companies. Do they want to focus on supporting the economy, promoting lending, or making a modest return on their investments on behalf of their shareholders (the taxpayers)?

Overseeing Appropriate Risk

It is debatable whether a heavier degree of regulation will actually make financial institutions safer. Throughout 2008, markets, not regulators, provided the first signals of crisis. The true riskiness of FIs and financial transactions can best be determined closest to the source of risk buildup. Proposals for different types of FIs need to take into account their different risk profiles. This asymmetry of information and the lack of transparency are likely to lead to a more restrictive level of regulation than would be optimal.

In that light, the objective of financial regulation should be not to identify and reduce risk per se, but rather to ensure that the risks are dealt with appropriately by those financial institutions that are best equipped to handle them.

Author profileS:

  • Alan Gemes is a senior partner with Booz & Company in London and the global head of financial services for the firm. He has worked with many of Europe’s leading banks and insurers.
    Peter T. Golder is a Booz & Company principal in London with the financial-services practice, specializing in corporate strategy, capital markets, and risk management.
    Thorsten Liebert is a Booz & Company principal in London with the financial-services practice, specializing in corporate strategy, retail and corporate banking, and risk management.



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