3 Regulatory Categories in Financial Innovation

As regulation seeks to enclose the rapidly expanding financial services sector, the freedom found in innovation proves that success for customer and business alike can be found best far from restrictive regulations. While regulation often inherently favors the businesses that already exist, regulators also try to keep up with recent business trends to prevent fraud, unethical practices, and most importantly, maintain control. While these distinctions are true in many spheres, the financial services industry has three categories when it comes to regulation: traditional businesses that are competitively served by high regulation and also regulated so heavily that they are unable to be agile, newer types of businesses that are understood just enough to be regulated with a clumsy touch, and finally, businesses on the cutting edge that are able to avoid the same level of targeted regulation, and thus experience far more freedom. We will examine traditional banking, the derivatives market, and the private credit market to examine how regulatory incentives divide companies into these three groups.

Big banks have unique relationships with the Federal government, as they are simultaneously reliably protected by the Fed but also aggressively regulated. One can think of the relationship as similar to that between private equity firms and the companies they buy. The profit of the firms is decided by the success of their company portfolio so they take an extremely involved role in their development. Just as private equity seems to limit creativity and company pivots, the Federal government makes it very difficult for banks to innovate or do anything that could have potential risk. While banks are still able to innovate, they have to face detailed reporting and reserve requirements that would not be extrinsically necessary if they were truly self-sufficient. The government safety net has taken away the motivation for survival, and regulation must push banks to do what would be natural in a free banking system. The big banks are the favorites of the government yet they don’t earn this role without acquiescing to numerous Federal demands. It is an extremely close relationship that damages both banks and the development of the financial sector.…