Maybe we clamped down too hard on finance

Let’s talk today about compliance in the financial industry. This topic seems to come up a lot lately.
I hear complaints from brokers on the sell side, most of whom don’t have kind words to say about their main regulatory overseer, the Financial Industry Regulatory Authority — even though it’s supposedly in the pocket of the financial industry. I got an earful the other night from some folks I met near the New York Stock Exchange after the close. I hear about it as well from institutional investors on the buy side — as well as almost every guest I’ve had on the Masters in Business podcast series.
Their complaints are often very specific — there’s this rule and that rule and it’s almost impossible to figure out exactly what it is the regulators want us to do and not do.
But there’s also a bigger and more overarching complaint: The regulatory pendulum after the credit crisis has swung too far, in part as a result of the broad lack of trust in Wall Street among both the public and policy makers. This is stifling the creativity and initiative essential for the vibrant financial industry needed in a modern economy. If that’s the case, we should not only be worried, but pay attention to what people who work in the business are saying about this.
Conversations with people throughout the industry reveal several consistent themes:
The new compliance regimes consume an ever larger share of the resources in banking and finance. Compliance and legal departments have grown much more than other revenue-producing parts of financial companies; in some cases, these parts of financial firms have doubled or tripled in size while other divisions have been cut or eliminated. Organizational risk aversion has risen to the point where it is now counterproductive.
If you are reading this, then it is likely that the business you are in includes the rational assumption of risk in order to obtain a proportional reward.
That is the essence of finance, be it investing, trading, investment banking or underwriting. Capital is deployed with expectations of some anticipated rate of return and some possible risk of loss. This balance between risk and reward is crucial to the proper functioning of the financial system.
Ever since the financial crisis, all interested actors — investors, regulators, policy makers, corporate executives, bankers and brokers —have taken steps to avoid a repeat. It is parallel to Homeland Security’s attempt to prevent another huge terrorist attack on a par with 9/11. This maximalist posture solves some problems, but in the process it creates others.
Recall the 2003 global analyst research settlement, which firmly established (among other things) a so-called Chinese wall between research and banking. The idea was that analysts were supposed to write research reports that weren’t designed to woo companies seeking investment-banking services. Today, though, we have some version of that on steroids; risk aversion is what everyone thinks about first, and getting the lawyers involved is what everyone thinks about second.
Consider the decision-making process on matters of compliance, policy and potential litigation, then ask yourself what incentive legal counsel has approve any form of risk-taking? I say this in the context of statistical probability, where it is inevitable that some unknown percentage of decisions will eventually become problematic.
An appropriate balance between approval and denial of compliance reviews should let businesses take suitable risks in a measured and rational way, while staying on the right side of the regulation. It is a huge challenge to get the balance right, and an even bigger challenge to have staff execute on that sense of balance. When regulation tips this balance too far in one direction, as it seems to be doing now, you know there’s an issue.
I supported the Dodd-Frank Act, the Volcker rule and other new regulations of the financial industry because the credit crisis posed such a grave threat to the well-being of the U.S. and much of the rest of the world. Something clearly had to be done. But based on many of the complaints I’ve heard about regulation, I wonder if we fully understand the consequences of those reforms. We wanted a smaller, less-dynamic financial sector that took fewer risks, and it looks like we’re getting it. But there’s a price for that and we should be asking if it’s worth it.
Just as every general fights the last war, regulators are always addressing the problem that just occurred. But just as the next terrorist attack is unlikely to involve hijacked planes being crashed into buildings, the next financial crisis is unlikely to be caused by derivatives of securitized subprime mortgages.
We need to learn broader lessons from experiences. History teaches us that much of the time we draw the wrong conclusions from what just happened. We are a myopic species, and place too much emphasis on the most recent events. This cycle seems to be no
different.

— Bloomberg

Barry Ritholtz is a Bloomberg View columnist. He founded Ritholtz Wealth Management and was chief executive and director of equity research at FusionIQ, a quantitative research firm. He blogs at the Big Picture and is the author of “Bailout Nation: How Greed and Easy Money Corrupted Wall Street and Shook the World Economy”