The pace of regulation
I was recently reading the 2011 edition of an annual report on federal regulations in the US entitled: "Ten Thousand Commandments 2012," by Clyde Wayne Crews, Jr. The report combines estimates from credible government sources and academia to arrive at a $1.8 trillion cost of the US regulatory enterprise, and the expense to administer it. That amounts to over 1.5 times the total individual and corporate tax revenues collected by the IRS in 2011! The report goes on to compare yearly page totals for the Federal Register, which, as of 2011, was composed of over 80 thousand pages, nearly a third of which were devoted to final rules. Proposed rules are apparently growing faster than final rules and over the past 15 years over sixty thousand rules have been issued. Currently over 60 federal departments, agencies and commissions have over four thousand rules pending according to the report. In summary, the report was pretty sobering!
The purpose of regulation
Someone once quipped: "The purpose of regulations is to make companies do what they should be doing on their own." Specifically, companies should look out for their investors, customers, the environment, and social good in the communities in which they do business and for society at large. Yet we have felt the need to enact laws to compel them to live up to these responsibilities. Certainly it is unfortunate that we have been compelled to legislate in this fashion, and one must question from time to time whether or not newly enacted laws are really necessary, in whole or in part. If not, then what is needed to ensure that companies will "make the right choices" and "do the right things?" That responsibility rests with corporate executives and with their Boards as a primary line of defense. However, due to some glaring examples of corporate failures during the past dozen years that cost investors billions of dollars, Congress has passed legislation designed to provide investors, and the taxpayers, with assurance that:
1) necessary controls are in place,
2) their compliance will be monitored, and
3) all violators will be punished.
Some examples of regulations
The Sarbanes-Oxley Act of 2002 was intended to restore confidence in the securities markets in the wake of multi-billion dollar corporate scandals by spelling out responsibilities and enhancing requirements on Corporate Boards, executives, and public accounting firms in their reporting of corporate financial performance to the investment community and to their regulators. It created the Public Company Accounting Oversight Board, or PCAOB, to regulate and monitor firms that audit publicly held businesses. The act also addresses financial disclosure, obtaining a truly independent opinion, control strength evaluation, and governance.
The Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010 was intended to address imperfections and restore trust in the financial services industry in the wake of the great recession that began in 2008. It created the Office of Financial Research, the Financial Stability Oversight Board, and the Consumer Financial Protection Bureau, whose collective authority transcends identification, investigation and evaluation of any financial/economic systemic risks; investor protections relating to the regulation of securities, including credit default swaps, asset-backed instruments (ABS), and other derivatives; and aspects of bank supervision including consumer financial products and services regulatory compliance. Specifically, Title IX, Subtitle D requires due diligence relative to analyzing the assets underlying the security and it seeks to promote quality underwriting standards, but falls short of specifying what must actually be performed or defining what constitutes quality for a standard, in terms of its effectiveness or other criteria. A new and innovative approach for risk rating, pooling, monitoring and reporting loans that back securities sold to investors is described in chapter six of The Risk of Investment Products - From Product Innovation to Risk Compliance. Title XIV deals with mortgage reform, but does not specify the means by which mortgages are to be underwritten. These topics, and more, are addressed in the book Credit Risk Assessment -- The New Lending System for Borrowers, Lenders, and Investors.
There are varying opinions as to the effectiveness of these and other regulations, their cost burden on the taxpayers, and their impact on financial, and non-financial, institutions who struggle to compete in a time of shrinking margins and severe pressure to cut or contain costs despite rising operating expenses, of which regulatory compliance is an increasing component.
The case for innovation
In my opinion, what is needed is some real innovation, not merely process improvement on the same processes that have failed us in the past. Don't get me wrong, I favor evolution in preference to revolution 99.9% of the time, commonly referred to as the champion/challenger approach. But extraordinary occasions sometimes call for a fresh approach altogether, as opposed to the "same-old, same-old" with added bells, whistles and layered safeguards. Yes, what I am advocating is replacing a broken process, not heaping more regulations around it. But "Which processes do we replace?" and "With what do we replace them?" The answer must come from innovators, perhaps working as part of a team, who understand the business sufficiently to frame the problem, the latest technology in order to assess feasibility, and practical experience/subject matter knowledge in order to engineer, validate, and implement a solution.
Let me illustrate with a concrete example. Consider an innovation for consumer loan underwriting that exhibits eight important properties that render it:
1) transparent so that the borrower, lender and investor all have an identical view and full disclosure on how every loan is rated
2) grounded in accepted principles that have stood the test of time in practice, such as the Five C’s of Credit (character, capacity, capital, collateral, and conditions) for qualifying a request for credit
3) adaptive so that repayment odds for a loan is based on up-to-the-minute results, rather than a historical development sample that is several years old
4) accurate, because the system becomes more predictive over time as experience accumulates, not less so, especially over economic cycles when static credit scorecards diminish in effectiveness as witnessed in the last recession
5) systematic, based upon a statistical model that objectively applies ratings that are based upon the best judgment and science
6) comprehensive because it considers a 360 degree view of the transaction relative to the borrower, any collateral, and the conditions of the transaction and of the current and future market states which could adversely impact the financial position of the borrower, the value of the collateral, and/or the affordability of the loan
7) simple due to the straightforward classification of a loan transaction through transparent qualification definitions, rather than attempting to assign oftentimes counterintuitive amounts of points to individual characteristics that exhibit very complex correlation patterns
8) validated using both statistics and common sense, and is not subject to violations of critical theoretical and distributional assumptions incumbent on today's prevailing models (e.g. equal variance, normality, etc.)
9) inclusive of broader segments of consumers whose access to credit may be hampered by their lack of a credit bureau record, insufficient history of being in debt for purchase of costly durable goods, or infrequent usage of credit in preference to routine cash transactions for small purchases. In some cultures people are taught to borrow only when needed, and to repay what is owed as quickly as possible. This type of behavior is either not captured (cash obligations and related payments are not typically captured and reported to credit bureaus or lenders) or is unrewarded in our current consumer credit culture and system.
I can't speak for you, but my gut tells me that such a means of granting loans would be far more effective and efficient and would require far less regulation that the current fragmented and complicated lending systems which have evolved over the past five decades or so. Why? Well, for the reasons I just cited, plus the fact that far fewer loans would be granted to borrowers who cannot afford them, and also loans would be made more available and priced more reasonably to creditworthy applicants who may, or may not, fall within the mainstream of consumer finance.
Barriers to innovation
Sound simple? Why should there be any resistance to changing the lending process as described in the previous example? The answer to that question is threefold.
1) First is resistance to change. People tend to confuse new and unfamiliar with complicated, because they have to exert the mental energy to take on and fully understand an entirely different perspective or solution approach. People would rather live with a problem that is partially solved than adopt a complete solution they do not understand.
2) Second is fear of the unknown, especially relative to performance. There may be concern that a new idea may sound good, but it may not work as advertised. How can that fear be addressed? Typically, ideas are first proven in the lab, thoroughly vetted amongst experienced practitioners and academics, and then they are pilot or market tested to see how well they perform and how acceptable they are to consumers.
3) Third, and perhaps most significant, is the cost of change. Companies only undertake voluntary change in cases where the value to be derived represents a significant enough return to warrant making the change. The expression “Is the juice worth the squeeze?” comes to mind. This may be impossible to intuit, and that is where a pilot, or market test, would come into play. But to perform a pilot, you would need to have built the system, and so it becomes a “chicken-and-egg” situation. Fore risk adverse companies, the profit motive will prove insufficient to overcome the uncertainty associated with a new approach that can have far reaching consequences.
Fallout of failure to innovate
There are less obvious consequences than lack of effectiveness and efficiency associated with out-of-date business processes and practices. Certainly they put a drag on a company's profitability. Still, many companies opt to take a calculated risk that delaying the cost of modernization will not cause any near term harm. In banking, where risk management and information technology play such a vital role, that sort of thinking can prove fatal to the enterprise and very costly to taxpayers, as we witnessed in 2008.
Failure of companies to innovate when it is required to improve and maintain their business processes and practices may result in a shift of an even higher cost burden to the taxpayers through the enactment of regulations that attempt to more rigorously monitor and control flawed or outdated business practices.
What is the answer, if you believe that innovation is preferable to adding to the regulatory burden? Perhaps what is needed is an innovation council, composed of representatives from the government, industry, and academia, to develop and assess innovative ideas and technological advances in order to ensure that industry practices and business processes stay current. This type of model has been explored extensively over the past dozen years (refer to: The Triple Helix of University-Industry-Government Relations (February 2012), by Loet Leydesdorff).
Apologies for harping on lending, but that is an area of particular familiarity for me. My points are intended to be broad in scope, and not industry-specific. It is clearly in the best interest of every business to serve and protect its customers and to inspire the trust of shareholders, its Board, its primary regulator(s), legislators, elected officials, and the public at large. Laws and regulations provide and essential safeguard to society.
However, there is a need to strike a balance, and also a need and a responsibility to get to root cause(s) of problems in order to avoid:
1) missing the mark,
2) promoting overkill, or
3) generating unintended consequences.
Not an easy task, but I believe that especially when confronted with a problem of epic proportions, we may be well served to ignore for the moment our sizable investment in the status quo, and spend some quality time pondering alternatives, defining how a successful outcome would perform, and crafting a vision of the means to achieve success.
I’d like to hear what you think. Please post a comment with your preference for more innovation or more regulation!!