Regulations

Foreword

AML, KYC, MIFID, RegNMS, RegT, SEC, CFTC, FinCEN! Regulations and regulators! If you’ve ever worked in finance, you’ll know that the alphabet soup of regulations and regulators that need to be followed is long and overwhelming. Do we really need all of these?!

As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

Cost of regulations

If you’ve ever worked in a financial company, you’ll know that other than legal, there is a compliance department, whose job, it seems, is solely to make your life miserable. “Can I do this?”, “No”. “How about this?”, “Hell, no”. “What can I do?”, “I’ll get back to you in a month. Or year.”

And to rub salt into the wound, compliance folks do not come cheap. Every large bank spends millions to possibly even billions every single year for compliance related reasons, or, in cases where there is a compliance lapse, for fines. All of these costs are directly the result of regulations mandated by regulators. And like all costs to a business, all these are directly or indirectly paid for by clients.

Which means, yes, you are getting a lower interest rate from your savings account, in part, because some of the gains are taken by the bank to pay for compliance. You are paying a higher fee (either directly or via spreads) when you trade stocks, because the broker needs to take part of your profits to pay for their compliance. You are paying a higher mortgage rate, because, you guessed it! The mortgage company needs to pay for compliance.

Is it really worth it? What about a world without regulations?

Road to Alabama

Let’s say you are driving in a car, on the way to Alabama (1). This is the new world, a freer world, a world where there are no rules. Street signs? Nope. Traffic laws? No, siree. Speed limits? LOL. You get the idea.

How would you drive? On the right side of the road? Is the right side still the right side? There are no rules!

How fast would you drive? What if you drive too slowly for someone in a fancy car and they decide to just bump you off the road? Again, no rules!

How do you navigate a roundabout? Go straight through over the middle? Turn left? Or right? NO RULES!

Would you even dare to drive?

Confidence

Let’s say you have $100k, and you need to stick it somewhere. Somewhere safe, so not your mattress. What would you do?

Would you give the money to your next door neighbor Blair, and ask them (nicely) to take real good care of it and leave it at that?

Would you give the money to your local loan shark? After all, Cameron seems to be really good with money!

Would you put the money in the bank?

I’m guessing most people would say the bank, and the next question is… why?

Insurance

One of the reasons why folks tend to choose the bank for largish sums of money, is because of the FDIC insurance. If the bank goes under, or there is fraud and the money is lost, or pretty much anything else, the FDIC, an agency backed by the full might of the US Government, will make you whole. It may take a few days or even weeks for them to sort out the mess, but you can be sure that you’ll get your money back. In full.

Are you confident of getting your money back from your Blair? Or Cameron the loan shark? What if they just laugh in your face when you ask nicely to get your money back? Who you gonna call (2)?

Now, how does FDIC insurance works? Why would the FDIC subject itself to this? What if the banks just collectively decide to defraud the entire nation, take all the money and go live in the Bahamas with their slightly scandalous college room mates?

Well, that’s where regulations come in. The FDIC is playing a statistics game. They know that regulators regularly conduct checks on the balance sheets of banks, and that if anything goes wrong, certain folks at the banks are personally liable and may very well spend the rest of their days in jail. Now, bankers make a lot of money, especially if you are at the top of the food chain in a big bank. Like, a lot, a lot. But a lot of money is really only useful if you actually get to spend it freely — it’s really no fun spending money whilst in jail. So there is just that amount of incentives for bankers, and thus banks, to toe the line.

Yes, not all bankers and banks will toe the line. Some will think they can get away with it, and maybe they can! And some other banks are just unlucky and make bad bets. Like, who would have thought calls on AMC would go to 0? So some banks go under, and the FDIC pays out for those banks. But because the vast majority of banks don’t go under, collectively, the FDIC manages to stay afloat by collecting a small premium from every bank, and directing those premiums to bail out customers of the banks that do go under. Insurance, at work.

And the thing that gives the FDIC that confidence? The thing that allows this statistics game they play? Regulations. Regulations which detail what banks can and cannot do with your money. Regulations which mandate banks keep a minimum amount of liquidity (float), and regulators which conducts checks to make sure the banks are following the rules.

Confidence, again

Other than insurance (and also for insurance, because this is something FDIC, SIPC, other insurance companies depends on), is the fact that by putting down regulations, and setting out what a bank and broker can or cannot do with customer money, it dramatically reduces the surface area of shenanigans that bankers and brokers can do.

Yes, some of the more creative ones will still do stupid things. And some of the less scrupulous ones will just laugh at the regulations and do whatever anyway. But the vast majority of them will know where the line is, and while they will push ever so hard against the line, they will likely not actually cross it (by too much).

Because of that self policing, confidence in the economy and the financial system blooms. Businesses can operate, because they know that when they are approved for a loan, their interest rates won’t magically jump 20% tomorrow. Savers can bank, because they know the banks won’t bet it all on red in Vegas. Investors can leave their cash in their brokerage accounts, because they can be sure that the money is likely there, as opposed to being used to buy magic beans or to fund the CEO’s lavish lifestyle (3), and even if the money is lost, the SIPC will make them whole (4).

And this confidence in the system, this ability to know how others will act, and what to expect, these regulations, they allow the modern world to work.

All regulations are equal, but some regulations are more equal than others

That’s not to say that all regulations are good. While most of them come from a good place, a lot of regulations are reasonable, and many regulations are simply needed for the world to even work, there are, clearly, some regulations which were either poorly thought out, or designed with less than altruistic concerns.

Which is not great, certainly, but welcome to Earth, population 8billion (5), where humans fail, and there’s a lot of us around to fail. Get used to it.

The whole point of having ongoing lawmakers is because we know that laws and the rules borne of those laws are not always good or right, and very often become obsolete over time. And the whole point of democracy is so that lil’ ol’ us get at least a bit of a say in how and what the lawmakers do and legislate. If every law and rule was perfect and will always remain perfect, then there’s really no point to having an ongoing government, is there?

So yes, things break sometimes, but hopefully, over time the bad bits will get replaced with somewhat better bits.

But claiming that we should do away with all regulations, because of 1 or 2 bad ones, is simply naïve.

Footnotes

1. To bring granny a basket of fruits and cakes. In your red car. What else could it be?
2. Ghostbusters! The answer is, always, Ghostbusters! With the exclamation mark.
3. OK, fine, bank/brokerage CEOs get paid a lot of money. So maybe some of that. But not all of it.
4. Currently up to a maximum of $500k, of which at most $250k can be in cash.
5. Yea, that just happened, in the Philippines, apparently.