The Handcuffed Banker

Originally Published In:

American Banker (3/22/2013)

To the detriment of consumers, innovations in banking tend to be conservative, late, and incremental, despite top talent and plenty of ideas. Is regulation backfiring?

It's now about as hard to innovate in banking as it is with cars.

The problem is not a dearth of ideas: just about anybody you speak with nowadays seems to have a great idea for how to structure mortgages or loans or executive compensation in a way that they think will prevent anything like the modern crisis from happening again. And the problem is not a lack of talent: good salaries continue to attract the world's top programmers and developers to work in various aspects of banking, from IT to research to trading to compliance to operations.

The problem is regulation.

Consider how hard it is to get approval to tweet even something innocuous if you are a banker. Now imagine trying to get approval for a new retail product, especially in the current environment.

Individuals and companies still try, but the only ideas that seem to have any hope of getting approval internally, and ultimately from regulators, are those that are humble, bureaucratic, and, frankly, kind of lame.

Bear in mind that not every new idea needs to get approved by a regulator, at least not directly. But if an internal review determines that the innovation may ultimately be frowned upon by regulators, it would be a poor business decision to proceed. Indeed, it is possible that the threat of additional regulation is an even greater barrier to banking innovation than the already large corpus of existing regulation.

So what happens in an environment like this, when innovators are exposed to a potentially negative regulatory review at some unknown point in the future? We have two ways of knowing what will happen: theory and history.

In theory, we can look to financial models themselves, specifically options pricing. The kinds of innovative ideas that are likely to raise regulatory eyebrows are the most successful. If a regulator sees a bank making a lot of money on some newfangled product, they may have questions, and if they don't, the innovator's competitors will keep complaining until they do. So innovators are in a way writing a kind of call option: their profits are capped at some arbitrary limit they do not know in advance.

In general, when investors are short options, they are short volatility, meaning, they lose more money when the idea is volatile or risky, even if the "risk" is that it may be wildly successful. Thus, innovations will tend to be of the tweaking variety, making slight, unobjectionable improvements: streamlining a website, introducing mobile apps, gradually introducing features like remote check deposits from scans or photos, enabling person-to-person payments, adding the ability to open new accounts via phone, and the like. In the broad scheme of things, these are unexciting innovations. But in modern banking, these win awards.

The important guidelines to innovation in a regulated environment are, first, to let people do things that they already can do in an easier way, and, second, to limit the amounts and frequencies that people can do those things in the easier way. The second part is important to keep regulators and competitors from shouting that the new tools suddenly aid money launderers or criminals or terrorists. Checks deposited through your mobile phone and person-to-person payments have an upper limit, both per day and per check or payment, and they can still take several days to clear. Thank you, government regulations. Imagine if we had similar kinds of "reasonable" limits on emails. After all, only enemies of the state need to make lots of transfers or send lots of messages.

In history, we can look at other overly regulated industries, such as car manufacturing. When regulation threatens to rear its ugly head, that mere threat precludes untold numbers of innovations, ones we don't even know that might have existed. How many years ago would we have had self-driving or even self-flying cars if there were not mountains of regulations stifling automobile innovation? How many accidents would be averted, how many lives saved, how many manhours of travel made more productive or at least more relaxing? Hopefully some of those innovations may still come about, but we have already lost decades.

In banking, we have the same problem. How would we even know what innovations are missing?

Perhaps without regulations, we would have been able to bet on various and arbitrary world outcomes, including political, military, and other outcomes, and markets would be able to shift risk from those who wish to divest it to those who wish to hold it, at prices mutually agreeable to both. But regulators view that as gambling.

Perhaps we would have been able to have truly anonymous and private digital currencies, allowing the benefits of cash transactions to go from local to global. But regulators are already preparing to brand that as money laundering.

We may never know what we are missing. And the few heroic innovators who persist in the face of these barriers, and somehow push through useful innovations despite the challenges, will only succeed in making us wonder why; why did we have to wait so long for something so obviously valuable? Why didn't we have all of the even admittedly small mobile banking innovations five years ago?

The answer, of course, is the regulators, the self-appointed saviors nobody ordered and whom nobody can fire. They say they are here to protect us. They say we are better off than we were before. But it is a theoretical and historical fact that under the rule of regulators, we are definitely much worse off than we could have been. Because of them, innovation on Wall Street is now about the same as in Detroit.

Philip Maymin is an Assistant Professor of Finance and Risk Engineering at NYU-Polytechnic Institute.