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The Regulation Nation

Our Financial Innovation Dilemma

TL:DR

The Silicon Valley Bank liquidity crisis has revived debates about financial regulation. While necessary for consumer protection and financial stability, overregulation can hinder innovation and competition.

A balanced approach, like in the tech and healthcare sectors, fosters innovation without compromising consumer safety. The key to success is smart regulation, such as the UK’s Financial Conduct Authority’s regulatory sandbox, which encourages fintech startups to test their services while protecting consumers. Collaboration between regulators and innovators is essential for striking the right balance and ensuring a resilient financial future.


Picture a high-stakes game of tug-of-war, with financial innovation and regulation pulling from opposite ends. The winner? Well, it depends on how much rope we (the electorate) are willing to give. As the current Silicon Valley Bank (SVB) liquidity crisis rears its ugly head, cries for more financial regulation have grow louder on both sides of the isle; Republicans are calling out regulators for not enforcing existing standards, the Democrats are calling for harder regulations to be reimplemented (after Trump era rollbacks), and the Biden administration is urging congress to make it easier to directly punish executives of banks that fail. In reality, they are probably all somewhat right, but before we start heaping on the red tape & pointing fingers, let’s ponder the effects of overregulation on innovation, competition, and public well-being in the financial sector; because if one team ends up with too much of the rope, we all get hanged in the process.

The Good, the Bad, and the Regulatory

First off, let’s admit a fact: financial regulations are vital for consumer protection, financial stability, and averting crises (apologies to my libertarian friends). However, an overzealous approach to regulation can backfire. Overregulation may restrict competition, hinder innovation, and give rise to unintended consequences, ultimately reducing the availability of credit for small businesses and local communities. In America, we often turn to regulation as a knee jerk reaction to fill the void of distrust created by our adversarial relationship with big banks. A 2020 research paper from Lake Research Partners showed that 91% of American voters believe in regulating banks, with 74% in favor of even tougher regulation than currently exists; and anyone who has watched the past 20 years of financial history unfold could be inclined to agree with the American voters surveyed in the paper. But what many of those voters miss is the cause and effect of their feelings. More regulation leads to a safer financial ecosystem, sure; but it also leads to less choice, as cost to stay in business increases, or the capital needed to start a financial company moves beyond a point where such an investment is worth it. This knock on effect is often referred to as “the unintended consequence of regulation” (not the most catchy name, but it gets the point across).

One of the most famous “unintended consequences of regulation” flagships is the landmark Great Recession era legislation: The Dodd-Frank Wall Street Reform and Consumer Protection Act. Passed in 2010 with the aim of stabilizing the financial sector, the act increased the average cost of regulatory compliance across the board. However, the changes disproportionately affected small banks (with assets below $1 billion), increasing their compliance costs by an average of 21% between 2010 and 2014 (per a 2016 study by the Federal Reserve Bank of Minneapolis). As a result, a number of small banks went out of business or sold out to larger institutions, resulting in a 14% reduction in community banks from 2010 to 2017.

In the startup space, overregulation has often completely suffocated new ideas before they even make it into our hands. Startups have historically struggled with high-entry costs & outdated rules not designed for their business models. Robinhood famously had to get enough investor funding to make it through the SEC Broker Dealer application process; and in the Crypto space, companies constantly run into SEC guidelines around custody (who holds the assets), that are structurally unable to cope with innovations in self-custody, leaving crypto startups out a sea with no framework to lean on. Both Robinhood and large crypto companies like Coinbase & Uniswap have made it through with only minor bruising, but it makes you wonder, how many of them didn’t?

In the European Union, they have experienced similar problems, such as the revised Payment Services Directive (PSD2), which came into effect in 2018. While it aimed to create a more integrated, competitive, and innovative European payments market, strong customer authentication (SCA) standards have created hurdles for emerging payment service providers. A 2019 study by CMS and Legal found that 66% of respondents saw SCA as a barrier to market entry for new payment services.

At some point we have to ask ourselves, are these rules worth losing the innovation for? Is there a better way to do this?

A Tale of Two Industries: Comparing Finance to Other Sectors

Comparing the financial sector to industries like technology or healthcare underscores the advantages of a balanced regulatory approach. In the US, tech start-ups experienced a 47% increase between 2007 and 2016, driven in part by a regulatory environment that has promoted internet freedom and very low compliance hurdles. Conversely, the financial sector has lagged, with fintech start-ups encountering severe regulatory barriers to entry. The PwC Global Fintech Report 2017 found that 48% of financial services companies surveyed considered regulatory uncertainty as one of the top challenges for the fintech sector.

However, regulation doesn’t have to stifle innovation. The healthcare sector, despite its stringent regulations quite literally designed to stop human injury & death, has seen significant innovations in the last five years alone: gene-therapies, advances in medical devices & prosthetics, as well as tech-centric personalized medicine (like glucose monitors). Although innovations this startling would make any financial industry compliance officer’s heads spin, this progress is really quite common in healthcare, and can be attributed to collaborative efforts between regulators and industry players to accommodate new technologies.

For example, the U.S. Food and Drug Administration (FDA) launched the Digital Health Innovation Action Plan in 2017 to foster innovation in digital health technologies, including telemedicine, through clearer guidance and efficient oversight. Additionally, the FDA’s 2018 ‘Framework for FDA’s Real-World Evidence Program’ aims to support the development of new treatments and diagnostics using real-world data, demonstrating the agency’s adaptability to advancements in personalized medicine.

These programmes mean that the American public can benefit from a faster turn around on regulation (by their own choice), while still maintaining strong protections on established players with the financial chops to navigate the more complex regulatory environment for a scaled business.

Striking a Balance: The Road to Smart Regulation

Collaboration between regulators and innovators is crucial to find the right balance between regulation and innovation. Adaptive regulations that protect consumers while fostering progress are key, and more importantly, very possible. The UK’s Financial Conduct Authority (FCA), for example, has taken a step in this direction by introducing a “regulatory sandbox” in 2016. This initiative enables fintech start-ups to test their services in a controlled environment, promoting innovation without compromising consumer protection. It is actually one of the key drivers behind the wave of banking fintech companies that flourished in the UK during the 2010s.

Another example is the way in which governments around the world have embraced crypto technologies, exploring opportunities for it to help fix capital access for certain populations, and help weed out corruption. In El Salvador, for example, Bitcoin is already considered to be legal tender by the government; and in Slovenia, the government explicitly told regulatory agencies to work on understanding crypto and present a framework in a bid to help industries to adopt the technology where possible.

In the US, although behind, some innovation / regulation balance has been achieved. The Office of the Comptroller of the Currency’s (OCC) proposed fintech charter in the US. The charter aims to provide a national licensing framework for fintech companies, reducing the need to navigate a patchwork of state-level regulations. While the charter has faced legal challenges, its intention is to create a more level playing field for fintech innovators.

All of these moves are a step in the right direction, aiming to allow for innovation to flourish, but maintain protections where needed for the general public.

Balancing the Books: where is the middle ground?

In the delicate dance of financial progress, striking the perfect balance between regulation and innovation is the key to success. Overregulation can smother the very advancements that could reshape the financial sector for the better. As we grapple with the banking liquidity crisis and face increasing calls for regulation, we must remain mindful of the potential effects on innovation, competition, and public welfare.

By drawing inspiration from other industries and calling for a collaborative approach between regulators and innovators — not just one or the other — we can create an environment where financial progress thrives alongside consumer protection. Let’s challenge ourselves to untangle the red tape and ensure that the financial sector remains nimble and adaptive. Let us not so easily run to partisan calls for “no regulation” or “nothing but regulation,” but instead take a thoughtful approach to what regulation is there for, and how it can best be used, and progressively applied. Ultimately we must strive to pave the way for a more prosperous and resilient financial future, and not let current crisis-driven emotions stall the progress that we all so deeply rely on.

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