The Weakest Link

Without the right regulatory framework the, seemingly, strongest player is likely to become the weakest link in our global economy.

In my last post, Implementing Regulation for Success, I indicated that we need a new approach, if we are to sort out the present mess in the financial services sector. Let's be honest: the business of regulation is intrinsically difficult, but it is devilishly difficult when money, power and reputations are at stake and all those ingredients are present in the financial sector.

John Kenneth Galbraith, one of the great economic historians of the 20th century, observed that, "The regulation of economic activity is without doubt the most inelegant and unrewarding of public endeavors. Almost everyone is opposed to it in principle; its justification always relies on the unprepossessing case for the lesser evil."

I agree with the first part of this proposition, but not the second – I think we can do better than arguing for a lesser evil. Research, experience and judgment combine to tell me that regulation is unavoidable and that an increasingly globalised web of regulation is desirable, to accompany our increasingly globalised way of living and ways of doing business. Also, because the responsibility to regulate rests with nation states, the success or failure of global regulation is dependent on the success or failure of its weakest link, its weakest component and that, in a globalised economy, no country or business can make itself invulnerable to shocks to the system that are big enough to affect a significant element or component of that system. As recent events illustrate, the weakest element can be the largest economy in the world, the lone superpower. This should not surprise us.

It is more likely to be the largest economy in the world that puts us all in a perilous situation than a lesser power, such as Mexico, Argentina or even the United Kingdom, because our dependence on the former is likely to be much greater than on the latter. Also, the track record of regulation in the USA is not great. Americans have a strong belief in the power of the market, tend to resent government interference and worship entrepreneurs and risk-takers. This is not a good set of indicators when assessing the capacity of a nation to get the balance right between freedom and restriction, which is what is needed to have effective regulation.

Looking forward a decade or two, any global accord on how to manage the financial system must take into account the share of risk presented to the system by larger economies, especially those that have a poor track record or inadequate regulatory infrastructure. We do this in our businesses, when we consider with whom to partner and whom to avoid, or when we make decisions about how much insurance to take out, and how much should be set aside to deal with unforeseen contingencies. But we don't do it in international relations, where nation-states indulge each other with the fiction that each state is independent and sovereign. While the concept of sovereignty makes sense in a legal setting, allowing us to keep our own laws and customs, it makes no sense when we turn to the movement of money across borders.

Here each state depends on all others – much as consumers of water depend on the good behavior of all others who are upstream from the point at which they tap the river.

Big land users upstream present a much greater risk than individual users, because of their intrinsically greater capacity to pollute. This reality is recognised in law, by placing a burden of responsibility on land users upstream to protect the supply of water of those downstream, whoever they may be. We need a similar approach in the financial services industry. We need to acknowledge explicitly the collective responsibility of nation-states and of large corporations to keep the flow of money clean and unadulterated, within and across borders.

We also need to apportion the responsibility for mitigating risk to the global financial system to those that have the greatest capacity to do harm to that system. Capacity to do harm should be determined by assessing the significance of an economy within the system (scale); the level of competence of that economy in managing its affairs, its creatures (corporations) and its impact on others, through action or omission; and its political and social stability.

By my rough calculations, this means that our focus should be primarily on the USA, China, India, Russia, and Brazil, with secondary attention paid to the European Union (EU) and Japan.

In the case of the last two, we should actually watch that their natural tendency to over-regulate does not win out, remembering that death from either fever or sclerosis is an equally final and equally unpleasant event. Using this model, the straws blowing in the wind suggest that the next bubble with global impact is most likely to arise in China.

I will explain why in my next post.

Patrick Callioni is a former senior public servant, with the Queensland and Australian Governments, and is now the Managing Director of consulting company, Enterprise Intelligence Pty Ltd, which specialises in helping business to do business with government and vice-versa. www.enterpriseintelligence.net.au His book Compliance Regulation and Financial Services is available at Amazon