Getting Bank Regulation Back On The Right Track (And Not The Left One)

The question posed at the start of a recent Harvard Business Review article epitomizes what’s wrong with the current government’s approach toward regulating the financial services industry:

With better regulation can we tame the financial markets so they’ll once again perform the social functions that are their responsibility?

My take: It is no more the financial service industry’s responsibility to perform “social functions” than it is Stop N Shop’s or Safeway’s responsibility to feed the masses, or GM’s or Ford’s responsibility to provide means of transportation to people so they can get where they want or need to go. The only “responsibility” financial services firms (even not-for-profit credit unions) have is to deliver profits to their owners.

That’s not to say that you can’t do well by doing good. But we shouldn’t confuse the ends with the means.

The author of the HBR article goes on to say that key to the banks’ success were “their compensation systems, designed to incentivize employees.”  The author claims that these compensation systems “put the larger economy into free fall and destroyed public confidence.”

My take: The huge paychecks that Wall Street and banks have paid out have certainly contributed to the negative publicity that these firms have received. But the statement that the compensation systems put the economy into a free fall is so far from reality that it wouldn’t warrant consideration if hadn’t been issued by a respectable economist.

The reality is that every company in every industry rewards and incents employees for short-term results. How else can you do it? “We sucked wind this year, Ron, but here’s a $500k bonus in the hope that the actions you took this year will produce benefits in 2012 or 2013.” Dream on.

The problem isn’t that we don’t have enough regulation. It’s that we have too much bad regulation, specifically, regulation that isn’t designed properly.

When an industry produces “excess” profits, opportunities are created for new entrants who are able and willing to come into the market and accept lower levels of profit (because their cost structure is lower, or because they’re willing to accept lower current profits with the expectation that they will increase margins later on).

But financial services regulations have created barriers to entry, protecting current players’ margins.

In response, the Democrats’ regulatory stance has been to create regulations that punish the incumbents by reducing fees (and therefore margins), instead of regulation that would help foster competition that would lower those margins, create new wealth, and benefit both consumers and providers.

The examples of wrong-headed regulation can be seen in a number of places.

Take a look at Jeff Marsico’s blog post on deposit regulations, for example, and the perverse and unintended consequences produced. Jeff writes:

Regulators [have] myopically focused on interest expense, to the exclusion of all other costs and offsetting revenue. But to write-off business models that utilize a higher percentage of “hot money” because of higher interest expense denies customers of having choices, limits competition, and further turns the banking model into one homogenized glob.”

Or take a look at what Tom Brown wrote, on, about Gene Ludwig’s (former Controller of the Currency) comments at a recent conference. According to Tom, Ludwig said that:

While regulatory changes are indeed needed, Congress and regulators, in their haste to ‘do something’, aren’t likely to adopt the best solutions. The likely result: more costs to banks and, at the margin, less lending to creditworthy borrowers.”

Another boneheaded idea: Principal forgiveness for the unemployed. If this isn’t an invitation to fraud and rule-skirting, nothing is. Again, from Tom Brown, who quotes from a letter someone wrote to a bank CEO:

Principal forgiveness is an affront to every responsible, non-delinquent borrower in your book of assets…you are rewarding those who bit off more than they could chew, while those who did not take on excess leverage, or who kept their income-to-debt ratios manageable, see no benefit, even as their home equity values have declined.”

At the core of Obama’s regulatory efforts is a fundamentally flawed view of the purpose of regulation.

In a capitalist environment and society, the purpose of regulation should be to ensure the alignment of competing interests and incentives.

Think about that. You might view regulations as something that forces players to do something, or prohibits players from doing something. But a good regulation ensures the alignment of conflicting interests and establishes a win/win situation — or to be more precise, a “win a little less, win a little more” situation, but not a win/lose one.

But Washington’s current approach to regulation is rooted in win/lose, namely: wealth redistribution. This is true whether we’re talking about financial services, health care, or any other area.  It’s fundamentally a win-lose proposition. It isn’t tenable, and it isn’t sustainable.

We need regulation that aligns interests, and creates a win/win situation, for providers and consumers of financial services. We’re not getting it.

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