Will over-regulation strangle financial services?

As the financial industry braces itself for an inevitable increase in regulation following credit-crunch government bailouts, we should not overlook the serious negative impact of over-regulation and micro-management on business performance and employee productivity.

The Barings, Enron and MCI WorldCom debacles, among others, have led to a large increase in regulatory workload and focus on compliance but this appears to have done nothing to prevent the latest round of problems.

In a fast moving and innovative industry a backward looking, rules based regulatory regime is unlikely to anticipate the next round of risks.

In our work with major multinationals around the world (many but not all in financial services), we have identified a consistent drift towards higher levels of central control.

In our survey of 1,300 managers, 34% thought their company already had too much central control, and 43% felt that the direction was towards more central control.

We believe that this is a response to increased business complexity – operating large, complex, fast moving organizations with people in multiple locations, cultures and timezones, makes it hard for managers to understand their operations and to know and trust their people. In this environment managers often react by tightening approvals, reporting and other mechanisms of control in order to get back their feeling of "having their finger on the pulse". Unfortunately, this is counterproductive because in a complex environment central control is ineffective.

Why? Because central control is slow – if we wait until problems are escalated or uncovered by central controls then we are inevitably too late. Real control is exercised fast and close to the action. We learned this in manufacturing quality control in the 1980s and achieved huge improvements in product quality and cost. Yet in management, we are heading in the opposite direction.

Central control is more expensive – by introducing delay and getting more people involved, we make solving the problem more expensive and ensure that things go wrong for longer.

Central control also creates employee dissatisfaction – nobody likes being controlled and a typical reaction is to tick the boxes but not feel committed to the results.

If you can afford your control mechanisms to be slow, expensive, ineffective and demotivating then central control is a good choice. Otherwise, recognize that real control is fast and close to the action.

Unfortunately, the instinct of politicians and regulators is often the opposite. Many come from a legal or political background and consider writing rules to be the solution. They represent an outdated paradigm of control that is just not effective in managing and controlling large complex organizations.

If they learn from previous experiences, they will realize that all the effort and cost of Sarbanes-Oxley and other regulatory approaches did little or nothing to prevent these latest problems and will realize that this traditional approach no longer works.

I fear they will not learn, and that the industry will be subjected to more counterproductive bureaucracy, form filling, meetings, approvals and checks – and that none of these will prevent future problems.

The financial services world may have lost the moral authority and financial independence needed to resist regulation but it must come up with some ideas of its own to replace rules based compliance with a new way of managing for more complex environments.

Here are my suggestions based on our consulting work with over 300 major multinationals and in delivering over 100,000 participant days of training in how to manage and exercise control in complex organizations.

• Look outside the industry for new ideas. Specifically, groups considering new regulatory regimes should include those with experience of modern manufacturing quality assurance techniques which offer insights into effective, fast control.
• Resist the temptation to gold-plate externally imposed regulation. You will have no choice but to be compliant but compliance is not control.
• Any effective solution requires distributed control – make sure that people close to the action have the skills, information and authority to make the right decisions locally.
• Consider escalation of decisions as a control failure. Whenever a problem requires escalation it is a signal that you have not given people the knowledge, skills or confidence to make decisions for themselves – it is a sign of a capability gap.
• Focus on building judgement skills rather than mechanical compliance. In a fast moving environment, last year's rules will not help.
• Create clearer individual accountabilities and responsibilities. Unclear and shared collective control is not as effective.
• Reward should include a longer term balance of risk and return
• If you can't understand it, you can't manage it. Either distribute control to the people who do understand it, or you cannot afford to play that game.

In financial services, we know that risk and reward are linked. Higher investment risks tend to correlate with higher rewards and lower risks attract lower returns. If we drive out the risk, we drive out the returns and may also drive out the creative people and undermine the motivation of the ones that remain.

To those of us struggling with the consequences of the credit crunch and its impact on the wider economy this may seem of little consequence right now, but in the longer term we all need a motivated, creative and confident financial services industry to enable a successful economy.

In order to achieve this we need a regulatory environment that encourages fast, decentralized control, not an outdated, centralized, rules-based approach.