Walter Mattli and Ngaire Woods

Yet another financial scandal has hit the headlines this week, in the shape of Bernard Madoff’s

alleged $50bn swindle. His investment scheme ensnared banks including HSBC and the Royal Bank of Scotland, costing them hundreds of millions. The current crisis has taught us, in the words of Mario Draghi, head of the Financial Stability Forum, that we need a financial system that operates with less leverage, has stronger oversight, and is more transparent so risks can be better managed. His views represent a growing consensus. Missing from the consensus is an explanation as to why regulators were so feeble in the face of an ever more risky and aggressive sector.

The bankers, earning millions, persuaded regulators earning thousands to opt for a “light touch” which allowed them to take more risks. The explosion of new instruments, off-balance sheet activities and fancy risk models made regulation ever more difficult.

What is needed is a hefty global regulatory framework. Three elements are crucial. First, there have to be robust and enforceable rules at an international level: recent events have made it clear that all countries, not just those with big financial sectors, stand to lose from a crisis in the industry. Second, oversight has to be made more powerful and effective: global institutions need to monitor and report on national regulators, pressing them to apply regulatory standards and resist lobbying to “lighten up”. One obvious contender for this role is the IMF, which already runs a financial sector assessment programme.

Participation is voluntary: the US, for instance, refused assessments until July 2008. The assessments need to be made compulsory, and focused on whether regulators are implementing globally agreed standards. Furthermore, the results need to be published.

Robust monitoring will also require some non-governmental “watching the watchdog” bodies, like those that have emerged in the environmental sector. These might be financed by public grants or fees paid by firms. Indeed, this would be in the interests of responsibly-run banks who have lost out as the confidence crisis engulfed the industry.

A third element necessary for effective regulation is an international court or tribunal: this would further focus national regulators on their duties. A specialised judicial institution would be charged with assisting the enforcement of global rules in banking and finance, reviewing the actions of global regulators and decisions of national administrative bodies charged with implementing the new global rules, adjudicating disputes, and offering uniform authoritative interpretations of the rules.

To be effective, the judicial institution would need compulsory jurisdiction: governments would not be able to wriggle out of a case. Who could bring cases? A government could, using its own information as well as that provided by International Monetary Fund assessments and other watchdogs. Such a government might be concerned about the way in which foreign financial services companies were being regulated in their home countries. If the international court found the foreign country’s rules deviated from global regulation, it could permit the suing government to suspend national treatment of such firms from that inadequately regulated country, or to apply special reserves standards.