Sean Park Portrait
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I say profound things

More competition beats more regulation

As the “Occupy[anywhere bankers work]” movement gains momentum, renewed calls and support for more regulation of banks and other financial institutions grow. And yet.

Financial institutions are already highly regulated and one could argue that at best, this has not achieved the desired outcomes and at worst has actually contributed to some of the most egregious behaviors as the clever folks in financial institutions lost sight of the end game (ie the products and services and customers that lie at the heart of their raison d’etre) and focused increasing amount of energy and talent to working the system.

And not unlike Br’er Rabbit fighting with the Tar Baby, getting stuck and then pleading with Mr. Fox not to be thrown into the Briar Patch, the large incumbent banks pleading with the regulators not to write more rules may just be a brilliant case of misdirection.

but do please, Brer Fox, don’t fling me in dat brier-patch

Of course more regulations hurt the large financial institutions, but they hurt new entrants more. And competition is a whole lot scarier than regulation to incumbents. If you want to get a sense of this, you could do worse than reading Aaron Greenspan’s take on US payment regulations. And similar examples exist across the spectrum of financial services and across the globe.

The irony is that most financial regulations are born through the desire to protect the little guy from losses, and to some extent they achieve this on one (direct) level but following the law of unintended consequences, the result to often is to create an environment where far larger risks (and losses) are incurred at a systemic level. And who pays for that? Well as we all know now, increasingly it’s all of us (including of course, the little guy.) Via government subsidies, interventions, increasing costs to maintain ever larger and more complex regulatory regimes, all of which need to be paid for with higher taxes and more importantly slower economic growth. Here the bankers are right, all these new regulations make our current system less able to produce growth which of course hits the 99% hardest. But then the bankers stop before asking for a level regulatory playing field that would pour fuel on the smouldering fire of new, innovative, disruptive entrants. Please Lord deregulate me, but not just yet.

I’d like to coin a new phrase, “regulatory theater” inspired of course by Bruce Schneier‘s “security theater“:

Security theater is a term that describes security countermeasures intended to provide the feeling of improved security while doing little or nothing to actually improve security…Security theater gains importance both by satisfying and exploiting the gap between perceived risk and actual risk.

Regulators (and politicians) sensing the need to be seen to be doing something about the risk, fall into a trap of creating more and more regulations hoping to protect all of us from ourselves, only to create new (almost always) more dangerous and costly risks higher up in the system. Rinse and repeat. Until these risks reach the top of the pyramid and can no longer be shuffled and redistributed. At which time, they come tumbling down on all. This regulatory theater can be comforting in the short term but actually takes us further and further away from a sustainable solution to managing financial risks in our economies.

These risks exist and cannot be regulated away. Call it the 1st law of Financial Dynamics: the of conservation of risk. And I would postulate that pushed down to the base of our economic system, these risks would be easier and less costly to manage. With a more competitive and open system, with continuous renewal through many new entrants, the end users of financial services would get better (higher quality, lower cost) products and services with much lower risk of catastrophic systemic failures. Certainly – statistically – some of these new entrants would be managed incompently. Some would be frauds. People, customers would lose money. But the costs of dealing with these failures would pale in comparison to the multi-trillion dollar, economy-crushing losses that the existing system has allowed, nay encouraged to build up.

I’ll finish with an example, take UK retail banking. Concentrated, uncompetitive, legacy. No new entrants, no competition. Metro Bank, NBNK, Virgin/Northern Rock in my opinion are just shuffling deck chairs; better than nothing I would grant but essentially no real innovation, run in the same way with (mostly) the same assets, same people and same business models that previously existed. A token nod for the industry and the government to be able to say their is new competition (much as a dictator allows a hapless opponent to run in an election…) – window dressing. And even here, look at the hoops Metro Bank (who claim to be the “first new UK bank in 100 years”, QED…) had to go through to get a new banking license… If I were Cameron/Osbourne/Cable, the first thing I would do to start fixing the problem would be to create a new “entry” banking charter. Light touch. Basically just vet the founders and investors for fitness. Perhaps make them put up a certain minimum amount of the equity and/or guarantees as a percentage of their net worth. 90 days from application to charter. Nothing more. But restrict these new banks to say £50mn of assets until they have a 2 year track record (at which point they could apply for an increase in permissible assets and/or a full license.) Then oblige the large banks to open up their core banking infrastructure via APIs – analogous to obliging BT to make available their core telecom network to other operators.

I wouldn’t be surprised if within a year or two you had 30 or 40 new banks competing in various different ways, with many different (and differentiated) value propositions. And some would go bust. And some would be frauds. But even making the (ridiculous in my opinion) assumption that they all lost all of their customer’s money, and all of this money was insured by the government, we are talking about £2bn. Compare that to the direct losses of c. £23bn on RBS and Lloyd’s alone, not even considering the contingent losses and indirect costs born by the UK economy as a result of their predicament. Of course, I believe that many of these new banks would succeed and grow and any losses would be substantially smaller than £2bn. But none of these new banks would be too big to fail for a very long time (hopefully never) and although failure of even just one of them would attract headlines and aggrieved customers giving interviews on BBC1, especially if the cause of failure were to be fraud – it would behove us to put this into perspective. To not forget the difference between perceived and actual risk. To remember that huge failure even if diffuse and “no one individual could credibly be blamed” even if more psychologically comfortable, is actually much much more damaging than smaller point failures where cause and effect are more brutally obvious.

The world’s incumbent financial institutions are deeply mired in Christensen’s Innovator’s Dilemma, protected by regulatory barriers to entry that while not fundamentally altering the long-term calculus, have pushed back the day of reckoning only to make that day seem ever scarier. It might seem counter-intuitive, but I think we should be calling not for more regulation but for de-regulation of financial services (the real, robust, playing-field-leveling type and not the let-us-do-what-we-want-but-keep-out-any-competitors type). Competition is a far more robust route to salvation than regulation. Let a thousand flowers bloom.

  1. At 11:14 am on 18 Oct 11 James Moed said:

    Great post.

    I find that “regulation theater” also helps to paralyze public perceptions around what financial services should or shouldn't be allowed to do.. Reminds me of this article from the Times last year.. “A senior adviser to Elizabeth Warren, hired to help start the Consumer Financial Protection Bureau, is an investor in and, until recently, served as a director of a company that helps to arrange low-documentation loans for consumers with often-spotty credit histories.” His sin – he was a director at Prosper.… 

    Since today's system only acknowledges a very few categories of financial services, for the NYT, Prosper is no better than any other company targeting the subprime in traditional (abusive) ways.

    I applaud your proposal for regulatory schemes that are tailored to the scale and risk of different entrants. Hopefully, as regulators allow more services and business models to emerge, the press will also begin to change their mental models of which kind of companies are allowed to help people manage their money.

    Of course, as always, consumers are way ahead of the curve – already using loads of different (and gasp, unregulated!) tools to manage their money – like the millions of people loading up their Starbucks cards, or the families I've met whose family “savings” are in the form of Tesco Clubcard points. Now, these services don't call themselves “banks” or frame themselves as financial services. If they did, they'd be subject to a whole new set of consumer expectations – and scrutiny from the state and the press.

    Makes me wonder – all these FS startups calling themselves “_____ Bank.” Though they may have to deal with FS regulation in the background, would they be better off calling themselves something less “bank”-y? As long as you're winning consumers over with a better way to deal with money, why try to redefine the category? Eventually, once “a thousand flowers” have bloomed, people, the press, and the state will accept the full diversity of consumer financial services, and these companies can come out of the closet as “banks.”

  2. At 8:07 pm on 18 Oct 11 Chris Swan said:

    Possibly your best post yet – I love the definitions of 'regulatory theatre' and the '1st law of financial dynamics'.

    I'm not so sure about the opening up of core banking infrastructure via APIs. If you mean things like faster payments then fine, but there's a lot of horrible old COBOL running on mainframes still at the heart of things, and those turds have been sugar coated and deep fried too many times already.

    I had tea with a politician this afternoon and we talked about these ideas. I feel that besides the grass roots stuff from the 'occupy' movement there's appetite for change, but getting past regulatory capture won't be easy. His pet idea is that banks should self insure via contributions into a bail out fund operated as an insurance scheme (perhaps with some of the control framework we see with insurance in other fields). I wonder if this could be made to work for innovators/disruptors in parallel with the existing regime(s)?

  3. At 6:58 am on 20 Oct 11 parkparadigm said:

    Thanks James, you make a great point with respect to the lens through which the mainstream press views financial services.  As you know I think we are in the midst of seeing a fundamental new economic and societal paradigm emerge as we transition from the Industrial to the Information age and it is not surprising that the reporting of the (mainstream) press  follows rather than leads as they typically reflect the biases and worldviews of the incumbent power structures (even when doing so in good faith, ie not corrupted by them which also seems increasingly true.)

    We are tremendously exicited by the very recent “Cambrian explosion” of new entrants and business models in financial services (not the least because it validates our core investment thesis which looked a lot more tenuous when we first articulated it 5-6 years ago) but also because as you say, millions of people are already starting to use these new products, services and channels.  My fear however – which lies at the heart of my call to action in this post – is that if politicians and regulators don't start adapting their approach, as more and more of these services start reaching critical mass, the incumbents will line up behind their regulatory Maginot line and use the current anachronistic legal and regulatory framework to do everything they can to shut down the newcomers.  Even in this scenario, some will power through and have enough success, finance and “escape velocity” to become “legitimate” (think PayPal from the previous generation) but many others may fail to do so despite providing a great new service with no real regulatory risk if for no other reason than the inability to attract the disproportionately large follow-on funding needed to deal with the regulatory molasses.

    As long as these companies are small, more often than not even if they are breaking some arcane regulation or lack some meaningless operating licence, both the incumbents and enforcement authorities leave them alone.  It's only when they actually start to get some traction that the guns come out and try to nail them to the wall with an armory of technicalities.  The sad irony is that in many ways this looks not unlike a Kafka-esque / Soviet state or a Banana Republic where the bureaucracy is all powerful and substance and outcomes are a very distant priority compared to process and power.

  4. At 7:14 am on 20 Oct 11 parkparadigm said:

    Thanks Chris – re core banking, all I meant is that some of the core / foundational payments infrastructure (analogous to the wires/fibres in the ground) should be made available to all comers on a level basis.  ie Finance startups should not be expected (although are free to if they sense an opportunity) to have to build an alternative payments infrastructure.  Also – although I have a less strong view on this – particularly in the early stages  (perhaps the next 10 years or so – as a way of encouraging competition at the “presentation layer”, it might make sense to oblige the big banks to provide an api with a regulated tarif, to allow others to build services on top of a basic banking (current and savings account) platform.  Part of me however wonders why the hell the incumbent banks wouldn't do this off their own bat – the AWS's of banking I've been calling for for years.  (I know why they don't – classic innovators dilemma stuff and middle management push back but still…)

    As for self-insurance, while in the long term and in a highly heterogeneous distributed banking system that could work (lots of issues but for another post maybe), in the short term – especially in the UK – it would actually just be one more barrier to entry.  The incumbents while they would certainly squeal about it could afford to pony up (they can pay for anything because ultimately it's all underwritten by the taxpayer) whereas it would be a business case killing mechanism for new entrants.  At the risk of sounding too cynical, I'm sure that such a regime would be engineered as to price new “risky” entrants out of the market, and favour (via lower pricing) the incumbents.  The Briar Patch so to speak.  Further – in relation to the big incumbent banks, the problem with this suggestion (and it's brilliance!) is that it would lay bare the fact that if you insure/adjust for risks, they all become Russian car factories:  more value goes in than comes out.  Machines for losing money!

    So I'll stick to my view that what we need (as a society) is to take many many more small risks and lose this stupid notion that you can protect everyone all the time from everything.  Besides having manifestly and catastrophically failed to do just that, it's a toxic (almost Orwellian) worldview that in my opinion is a cancer on our very societies and cultures.

  5. At 9:58 pm on 10 Nov 11 Daen de Leon said:

    It's actually even worse than regulatory theatre: it's regulatory arbitrage.  You pointed out in a post over at Fred Destin's blog how that unpleasant cocktail of nerd and jock produced oodles of cash in the 80s and 90s (I know it all too well: I was a not-quite-trusting-the-system nerd at JP Morgan in London in the late 80s/early 90s).  Well, the same thing goes for the lawyers, who always find loopholes in regulation, because the some of best, brightest and highest paid lawyers don't work for government or in practice, they work for banks (read “Barbarians at the Gate” for an especially nauseating example of this symbiosis).  Trying to completely regulate the financial industry is like trying to hold water in your fist: the tighter you squeeze, the more you lose.  So I agree with you about over-regulation – fairness should win over comprehensiveness, and that should be the only regulation in place.  The one thing the lawyers can't cope with is a fair and level playing field.

  6. At 11:02 am on 03 Feb 12 The Park Paradigm - A Kodak Moment said:

    […] More competition beats more regulation ( […]

  7. At 9:08 am on 28 May 12 The Park Paradigm - A Damascene Conversion? said:

    […] too little competition (in the form of disruptive new entrants in particular): Of course more regulations hurt the large […]

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