After the crisis: Should law firms self-impose capital adequacy standards?

Should law firms take inspiration from the banking sector, and self-impose capital adequacy standards? A rather trite and self-satisfied answer would be that the banking sector has largely created its own crises over decades (and centuries), that its problems are varied but largely specific to the sector, and that law firms have nothing to gain by emulating the approach of banks.

An alternative response, and perhaps more realistic and humble, would be to acknowledge that law firms are subject to competitive and financial pressures unlike any they have previously experienced, and their instinct for self-preservation should cause them to embrace best practice wherever it may be found. As such, partners should require and empower a self-regulatory regime of the highest standards.

Regulatory reach

The banking sector has no choice about capital adequacy and is subject to the progressive constraints of the Basel agreements in their various iterations. Taking the point a little further, the question could be posed about the role of the Solicitors Regulation Authority (SRA) as regulator in England and Wales and whether some form of fixed rules should apply to law firms.

Admittedly, problems with law firms do not present the same potentially cataclysmic consequences as failure in the banking sector. Nevertheless, the SRA's main duty as regulator is to protect clients, and financial failure of a law firm presents the greatest risk to clients (excepting malpractice or defalcation).

As it happens, the SRA has pretty far-reaching powers and, increasingly, the will to intervene where it perceives that problems are building. However, the current regulatory regime is clearly a work in progress; the SRA is still working out how to reliably identify the key issues and make interventions (formal or informal)
in a sufficiently timely manner to avoid serious problems.

The SRA's current focus, whatever its remit and intentions may be, is necessarily much more on resolving current crises than avoiding future problems. But, whatever the intent of the SRA, law firms should look out for themselves. In future, capital adequacy standards would be essential as a comfort and protection to owners, clients and other external stakeholders alike. So, what should these standards be?

Capital adequacy regime

'Capital adequacy' is possibly too narrow a concept, as is the objective is not merely to ensure that the firm can meet its financial commitments at any given moment but also to allow it to survive and thrive in future. Capital adequacy benchmarks are only really beneficial within the context of a sensible financial strategy, which itself should be aligned and
integral to the competitive strategy
and culture of the firm.

In considering what the scope of a capital adequacy regime (whether self-imposed or super-imposed) should be, it is instructive to look at the Basel III framework, which is in the course of implementation via the European Commission's Capital Requirements Directive IV (CDR IV). It is, of course, extremely detailed and complex but, in essence, the framework covers the following.