Back when I was deeply involved in telecommunications regulations, my eyes were opened to the reality of how government intervention in the form of regulations can easily result in unintended outcomes. The reason this occurs is because, generally speaking, the government becomes just one more "market force" among a multitude of others, and the industry adapts to it like any other. That adaptation will always be one that ultimately promotes the objective of any corporation: to make money for its owners. In other words, a company will test a new regulatory regime to find the attributes that can be turned to the company's advantage. Frankly, to expect anything different is naive. Coming up with effective regulation -- that which achieves the intended outcome -- isn't easy.
The first thing to understand about regulation is that the government's capacity to enforce regulations is finite: there do not exist infinite resources to pursue ideal outcomes from regulatory compliance. This is true even if the regulations are crafted with a deep understanding of the targetted industry, which is often absent. Politicians and bureaucrats in the public sphere often fail to grasp the fine details of motivations of, and tools available to private corporations. Worse, regulations (or their removal) that are driven by ideology often go awry.
Now let's get specific: regulatory cost is approximately proportional to the number of companies regulated. What this means is that fewer companies in a sector can be much cheaper to regulate than many small ones, where the sector's size is equivalent. If the government is serious about regulatory compliance, they will benefit from making it difficult for additional companies to enter businesses that fall within those regulations. If they do allow entry, the available resources will have to be spread more thinly, resulting in poorer enforcement. In the present era, governments of all persuasions are biased toward reduced spending on regulations. This explains why many industries are now 'self regulating' -- an oxymoron if there ever was one.
When it comes to banking, the government has strong motivations to keep the sector functioning smoothly. Like it or not, the modern economy is so closely tied to the banks that a weakness in one frequently engenders a weakness in the other. Intense regulation of the financial sector is made easier by having fewer banks, building high barriers to entry, and not allowing banks to enter a variety of financial businesses. The last restriction has been gradually eased over the years, allowing banks to offer insurance products, mutual funds and investor services. Other financial services like investment banking remain mostly in the domain of non-bank companies. In contrast, this separation does not exist for most of the United States' largest banks. (There are other factors which lead to differences between the two countries' banks, but those are outside the scope of this article.)
For Canadians, the price of our banks' financial health has been less bank competition, and high service fees. As I've mentioned before this isn't necessarily bad for us since we can choose to invest in the banks and share in their profits. The challenge for the government is how far to let bank profits rise before public pressure makes it politically advantageous to take remedial steps. Again, regulations cost money and further entrench government in the banks' operations. It is now becoming particularly galling for many Canadians since we pretty much have no choice but to use bank services for the majority of the goods and services we purchase, and this also goes for the merchants on the other side of the transactions. Further still, the government prefers to have transactions done this way since it makes it more difficult for people to avoid paying taxes on their purchases, sales and investments. It will be interesting to see if the Conservative government will step in to more-stringently regulate bank fees, which is not what they would prefer to do if they can avoid it by getting the banks to adopt voluntary measures.
To move onto my second point, how can regulations can be written to achieve separations among financial businesses. I lightly touched upon this a few paragraphs earlier, but it deserves closer scrutiny. These separations are a blunt weapon in the hands of government and often have consequences far from the ones intended. Here are three of the most popularly-implemented separations regulations in increasing order of strength.
- Co-marketing: Now that RRSP season is upon us, if you visit your bank to make a contribution you will almost certainly be presented with the option (or even pressured) to shift some or all of those dollars to mutual funds operated by the bank's investment business. This is an example of co-marketing, where an agent for one line of business attempts to generate sales for another. The other business does not have to be within the same corporation; it can be one the bank is representing and is remunerated via a finder's fee or other commission. A particularly egregious example during the dot-com era was when stock analysts (buy side) often became shills for the same bank's investment banking arm (sell side) by highly rating stock issues and then promoting those to their retail customers as good investments based on those inflated ratings.
- Accounting: Accounting separations allows for regulated business lines to be operated within a single corporation if they maintain a separate set of books for each. If you've never encountered this idea before it may at first seem puzzling, yet it can sometimes work when the regulators have adequate oversight. In the case of the dot-com problem described above, the investment bankers, analysts and retail investor managers only reported a profit-loss account of their combined operations. For example, there was no indication on the books when an analyst received a bonus derived from the underwriting fee after having given a high rating to a poor investment product; only the overall revenue and expenses were shown. With accounting separation, schemes like this can be prevented by making the compensation visible: any flow of money between the investment banking business to the analyst and retail investment management operation(s) will show up on the books. The books can then be used to regulate the corporation's operations to prevent these conflicts of interest, thus protecting the bank's customers.
- Structural: In its weakest form, structural separations would take the previously-described accounting silos and place them into separate corporate subsidiaries. At its strongest, the businesses would be fully separated by dividing the corporation's lines of business into fully independent companies, each with its own share capital, assets and liabilities. The broken-up corporation loses the benefits of scale and business line synergies, while the government's enforcement costs are lower than for accounting separations and the risk of compromises to the so-called Chinese walls they require. For the bank's customers it's a trade-off: they no longer have a one-stop shop for all their financial needs, but they do benefit from a lower amount of potential conflicts against their best interests.
Structural separations are effective but very controversial. The business sector hates them because they imperil their ability to compete, especially on the global stage where their competitors are often not so constrained. Governments are wary of the approach since it alienates the business sector (and may even imperil politicians' futures) while being a bit difficult to explain to the electorate. It takes a lot of political capital and a strong stomach to go through with this in an industry with the prominence, strength and necessity as that of banking and finance.
Let's now look at some of what Obama had to say about this in his speech last week:
"...to benefit from taxpayer-insured deposits, while making speculative investments..."Clearly, he understands the problem. So what does he propose to do about it?
"In recent years, too many financial firms have put taxpayer money at risk by operating hedge funds and private equity funds and making riskier investments to reap a quick reward.
And these firms have taken these risks while benefiting from special financial privileges that are reserved only for banks."
"...this kind of trading often puts banks in direct conflict with their customers' interests."
"Banks will no longer be allowed to own, invest or sponsor hedge funds, private equity funds or proprietary trading operations for their own profit unrelated to serving their customers."Part of the uncertainty following his speech was due to the lack of detail with respect to how he intends to regulate the banks, in particular whether the government will pursue accounting or structural separations. Even so, the banks are already preparing to game the forthcoming regulatory changes. My guess is that he will initially push for structural separations -- simpler and lower cost to the government -- but that Congress will push back. I have too little insight into US politics to guess at the outcome. Perhaps there will be a compromise with higher-cost accounting separations similar to what was done after the lessons learned from the dot-com bust.
Either way the US conversation is unlikely to impact Canadian banking. It has been suggested that there will be financial industry refugees fleeing for the freer regulatory environment in Canada, but I doubt it. These people know very well that the current regulatory regime in Canada is weak only because of the social contract between government and the banks. Once that contract is broken the government will have to act, and the result could very well be stricter than the one that will eventually be implemented in the US because of our relative comfort with the idea of government intervention. Beyond more debates about bank fees, Canadian banking will most likely remain stable, conservative and highly profitable.
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