Does Overregulation Lead to Underperformance?

Some years ago I was privileged to attend a meeting in the ornate Board of Governor’s room at the Federal Reserve in Washington, D.C. The occasion was a meeting of a delegation of senior bankers of the largest banks in California with a Fed governor who was primarily responsible for bank regulation at the Fed.

It was a largely formal meeting with very little give-and-take, as those meeting tend to be. However, the Fed governor made a very strong statement that still resonates with me these many years later. The governor made it very clear that the Fed and its staff saw their main regulatory purpose as “saving the bankers from themselves.” In other words, banks could not be trusted to act prudently on their own and needed a strong enforcer of strong rules to safeguard the U.S. banking system.

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Harold Reichwald

Since that meeting, much has transpired in the banking world including a move to de-regulation followed some years later by the so-called Great Recession and the inevitable strong and sharp turn to legislation and re-regulation.

Since that time, the regulations have grown and in so many ways the business of banking and other financial institutions has become harder and more difficult to manage with consistent profitability. While the regulatory authorities would argue that the heavy regulatory environment, both on paper and in practice, has made the financial world safer, inevitably the business of banking is adversely affected and innovation suffers. Here are some examples:

• Overregulation (including heavy-handed bank examinations) stifles creativity and diminishes the attractiveness of the industry as a career choice, which leaves the banks with an ever-diminishing pool of young talent with which to plan and adjust for the future in an increasingly complex business environment.

• A regulatory emphasis on de-risking makes boards of directors and senior managers skittish about innovative strategic planning, forcing them to choose potentially new business models and meeting demands for more capital, notwithstanding that in an era of rapid technological change new but prudent strategies are necessary to meet market challenges.

• Overregulation increases the cost of doing business without any demonstrable positive effect on bank profitability because of the need for additional staffing, training, and upgrading of information technology structures and procedures.

• The threat of regulatory penalties and “penalty box” orders for perceived infractions of the regulations and the adverse effect they have on the ability of a bank to expand and grow, makes managers more apt to want to plan merely to the examination process and not to prudent marketplace opportunities.

• The difficulties in getting past all the burdensome regulatory hurdles in establishing new banks ultimately reduces the vigor of competition, which in itself leads to lassitude, making the business of banking less attractive and more utility-like.

• Boards of directors are unsure how to meet their traditional fiduciary duties given the heavy presence of the regulatory agencies as very significant, if not primary, stakeholders in their institutions, which, in turn, dampens investor interest.

There was a time when no self-respecting bank CEO or board member would let a regulator tell him how to run her or his bank. Those days are long gone, which is not to say that given the importance of banking to our economy there should be no regulations, just that they should be prudent and reasonable. However, unless the regulators lessen their collective hold on the “tiller,” banks and other regulated financial institutions run the risk of losing their place of importance in the U.S. economy, for which all of us will suffer.

Harold Reichwald is a partner in the Los Angeles office of Manatt, Phelps & Phillips, LLP.