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.

Towards the end of the 20th century, derivatives provided a lucrative and liquid market that was allowed to operate with a large amount of freedom. In 2000 this freedom was even legislatively enforced and the derivatives market seemed to have secured a relatively free niche in the financial industry. Although the 2008 crisis was caused by the Fed, regulators needed scapegoats. The derivatives industry became one of these scapegoats. The industry experienced intense regulatory requirements, and their freedom was diminished greatly almost overnight. Ever since then, the derivatives market has been only a shadow of what it once was. Huge regulatory costs have shaken up an industry that was once profitable. The industry is fully comprehended, and heavily scrutinized by a government that clearly favors traditional banking. The derivatives industry is a clear example of this second tier of financial firms in relation to regulation, as they are too new to be trusted, yet old enough to be severely regulated. Perhaps they will graduate into the same tier as banks and become a governmental favorite in the future, but that is a question of lobbying and political economy that will only sort itself out over decades.

Banks have become a favorite servant and the derivatives market has paid the price for its past freedom, but the private credit market is still one step ahead of regulatory control. The primary means through which they are regulated is Federal regulation of bank’s exposure to private credit. Shadow lenders receive much higher returns than banks, and are able to help businesses and consumers who could otherwise not receive access to credit. One price that banks pay for their safety is the inability to serve a truly wide range of customers. Private credit fills this gap, and has allowed many of the most influential start-ups to thrive. The varied business models of the alternative credit sphere cannot yet be cleanly categorized and put into regulatory boxes. As long as it stays so confusing to regulators, it will be able to innovate and give access to financial products previously unheard of. The beauty of the third category is the ability to try things that may or may not work. While control of private credit is tightening, both in the US and abroad, its role in the third category will allow it to serve people and reap fair rewards in the near future.