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When things go wrong, we tend to blame the regulators. We certainly did in the initial aftermath of the credit crunch, with the Bank of England, the FSA and the Treasury all coming under fire.

We also saw some fancy political footwork as each of the targets sought to pass the blame along.

Could tighter or better regulation have prevented the credit crunch, however, or could it prevent a similar thing happening again?

That is the heart of the problem – it is not the same thing happening again that we need to worry about, but the next, entirely different problem.

Gaps in the effect of regulation 

Like generals always trying to fight the last war, regulation is perfectly designed to solve the last crisis. 

Regulation works badly in a complex environment, and there are few environments more complex than modern financial services. Regulation also works badly in the face of rapid change, again a fact of life in the finance industry.

With these forces in play, there are always gaps in the effect of regulation: the stronger we tighten our grasp, the more value slips out between our fingers.

Rules and regulations are little more than a form of incentive – the negative incentive of punishment for transgression.

In the City, therefore, they also have to contend with a further challenge – the massive incentives provided by bonus schemes.

Which is more real to a trader, this year’s bonus, and a new Aston Martin, or the abstract threat of future investigations?

Short of draconian measures, there is little hope of a regulatory framework competing to shape behaviour. How could regulation have stopped Jerome Kerviel, for example, who was driven only to ‘be the best’?

Ethical and practical principles 

Regulation has its place, and good regulation is one of the attractions of the City, but tighter or more complicated regulation is not the solution to maintaining a healthy and safe financial system. The right approach contains two strands.

Firstly, principles – both ethical and practical – need to come to the fore, guiding behaviour by capturing the wisdom of the organisation while creating room for discretion.

Secondly, individuals and firms must bear the full consequences of their actions, good and bad – at that point we can leave it up to them to follow the wisdom contained in their principles or not. The solutions therefore lie in leadership and reward.

Whenever we seek to influence behaviour through punishment and rewards we get transactional compliance with the letter of the law.

Yet, while immense ingenuity is devoted to working around regulations, and finding new loopholes, people almost automatically comply with the customs and assumptions of the culture they work within.

We have no problem with seeking new tax shelters for our income, but would never question whether this quarter’s profits are an adequate measure of our success.

Partnership models of governance 

It is the role of senior leadership to decide, communicate and enforce enduring principles, which capture their long experience and which take precedence over short term demands.

This involves sacrifices and the strength to stand up to powerful stakeholders when the opportunity for a quick buck conflicts with what they know to be right.

Too often, the lessons of the past are forgotten with the assumption that the rules have changed.

We saw this with the dot com bubble, when it seemed the laws of economics had been overturned - reality intruded with a bang eventually - and again in the management of sub-prime risk.

One institution which has kept its eye on the long game is Goldman Sachs. Partnership or quasi-partnership models of governance are particularly effective for creating a – literal - sense of ownership of the principles of the organisation. Owners act differently to employees.

Culture of dialogue and debate 

We have also noticed in our work on organisation design, that a culture of dialogue and debate between equals acts as an effective antidote to the atmosphere of unspoken complicity in bad decisions. 

Often, when a crisis is unpicked, it turns out that most people knew something was wrong but were afraid to speak out.

Dialogue allows people to test and articulate their unformed instincts and find that they are not alone.

There are few organisations that successfully create this climate – and hard driving superstar CEOs are the death knell of dialogue.

Small wonder that recent research from Hay Group into the performance of 120 senior leadership teams found that less than a quarter were fully effective.

Embedding principles in an organisation is a different challenge to strategy implementation. It involves an older skill set: telling compelling stories about the past, establishing clear role models and creating rituals and celebrations to add power and weight to the principles.

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