Carrot or stick?

While regulation may be a necessary evil in financial services, creating incentives and having strong corporate principles is the best way to ensure a well-functioning sector. Graeme Yell explains

Regulators are used to taking flak when financial markets go wrong, and in the early stages of the UK credit crunch, the Bank of England, Financial Services Authority and Treasury all came under fire. There is some comfort, however, in thinking that stricter, or perhaps better, regulation might have prevented the credit crunch, as it implies there is a simple solution to averting a recurrence. But worrying that the same thing might happen again should not be our biggest concern, as these events tend to be different each time - varying in nature, complexity and intensity.

Regulation is always based on the last crisis. It's like driving while looking in the rear-view mirror - everything always seems one step behind. On the whole, regulation is less effective in complex environments - typified by today's financial services sector. In addition, regulation works less well in the face of significant and rapid change - another fact of life in financial services.

Rules and regulations reduce the benefits and likelihood of transgression, but they are rarely enough to counteract the huge incentives offered by bonus schemes. For a high-flying trader, this year's Aston Martin or Porsche present a much stronger incentive than the abstract threat of future investigations.

Of course, regulation has a role from which the City has long benefited. However, to maintain a healthy and safe financial system, tighter and more complicated regulation is not the answer. The right approach centres on:

• Principles: principles, both ethical and practical, must be prominent, capturing the values and wisdom of the organisation while providing room for discretion. 
• Consequences: firms and individuals must bear the full consequences - both good and bad - of their actions, after which they can decide whether to follow the wisdom in their principles.

When we try to influence behaviour through punishment and rewards, the result is transactional compliance with the letter of the law. However, while we see considerable ingenuity devoted to uncovering loopholes to circumvent regulation, people almost automatically comply with local customs and cultural assumptions, no matter where in the world they are working. So, while we might seek new tax shelters for our income, we do not question whether this quarter's profits fully reflect our success.

Strong principles

A firm's management team must define, communicate and enforce the enduring principles that take precedence over short-term demands. This involves making sacrifices and having the strength to stand up for beliefs and what is known to be right when faced by powerful stakeholders keen for quick financial gain.

Past lessons are too often forgotten, with the assumption that the times and rules have changed. We clearly saw this with the dotcom bubble of the late 1990s, in which internet-based companies seemed to have overturned the laws of economics and, more recently, with the management of sub-prime risk in the US, Europe and worldwide. As with previous booms, the past eight years have shown that bubbles burst.

Against this background, one institution with a long-term approach and outlook is Goldman Sachs. It has shown that partnership or quasi-partnership models of governance work particularly well in creating a sense of ownership of the organisation's principles. Owners have a strong stake in the long-term success of the organisation and act differently from employees.

A culture of strong dialogue and debate between equals counteracts the atmosphere of unspoken collusion in bad decisions. When a crisis is unpicked, it frequently turns out that most people knew something was wrong but were afraid to speak out.

Dialogue enables people to test and articulate their unformed instincts and discover they are among other people with similar feelings and thoughts - and certainly not alone. Unfortunately, few organisations successfully create this sort of environment, and hard-driving chief executives can make dialogue more difficult.

Hay Group research into the performance of 120 senior management teams found that less than 25% are fully effective. It is a different challenge to embed principles in an organisation than to implement strategy, since this involves older skills: recounting compelling stories, establishing clear role models, and creating traditions and celebrations to reinforce principles.

Successful failures

To create genuine consequences, we have to allow for failure by individuals, teams and institutions, and, in the extreme, for organisations to collapse. As many commentators are starting to note, the danger of this is the asymmetrical nature of risks and rewards.

Paul Volcker, ex-chairman of the US Federal Reserve, says: 'There are enormous rewards for successful trades and for loan originators. The mantra of aligning incentives seems to be lost in the failure to impose symmetrical losses - or frequently any loss at all - when failures ensue.'

In addition to great riches for success, failure is often rewarded by generous pay-offs and smooth transitions to new jobs. Therefore, if there is a requirement for regulation, it may put an end to pay-offs for poor performance. If people knew they could lose everything, a new sense of caution might balance the lure of the new sports car. This is how markets work.

As a further measure, we need to ensure that performance measures reflect long-term performance. This applies to today's profits, while providing the capacity to generate higher profits tomorrow and considering the risks in pursuing both. Wider society benefits significantly from a well-functioning financial system and we cannot allow this system to fail.

However, protection should be focused on the public and not on individual institutions. There would be fewer crises in the long term if financial organisations considered appropriate levels of risk. Nationalisation is therefore not necessarily a bad response. After all, the argument in favour of tax-funded intervention is societal benefit. While markets are good for regulating complex interactions, other mechanisms must be used if they fail.

Safe and sound

To ensure safer financial systems, organisations must possess the following:

• Strong principles in order to capture hard-earned wisdom
• Leaders who protect these principles against short-term greed
• A sense of owning these principles throughout each firm
• Symmetrical consequences for risks taken, and
• Have a sense of protection for society, not for individual businesses.

Box-ticking challenge

To assess your exposure to potential difficulties, start by asking the following questions:

• Do people at all levels within your organisation speak their mind about concerns and risk?
• If so, are their concerns addressed?
• Do your senior team members engage in meaningful, enthusiastic debate?
• Who are your organisation's heroes and, as far as colleagues are concerned, how are they being rewarded?
• Do performance measures cover results, risk and capacity?
• What three key principles capture how your organisation has learned to generate long-term value?

Graeme Yell is financial services sector leader at Hay Group.