Banking Reform: Do We Need More Regulation Or Just Better Regulation?

by: Steve Picarillo

It has been five years since the height of the financial crisis, yet bankers and regulators have still not agreed on the future of banking and how to truly fix the financial industry.

While there are many issues outstanding, and some have been resolved, the ultimate question must be answered. Is more regulation needed, or just better regulation? The answer is likely the latter, with one stipulation: bankers and regulators must agree to improve cooperation. Increased cooperation and transparency is as important, if not more important, than the level of regulation. Looking across the globe, it is apparent that both regulation and transparency have been uneven. This adds complexity to an already challenging task.

True, in the past five years, many issues have been resolved, but there is much more to do and the progress has been uneven, at best. Some banks have made significant progress in reducing their debt stacks; however, the global economy's exposure to the financial sector remains large, at about 60% of the world's annual economic output. As such, the importance of banking to the global economy has (arguably) increased, if that is conceivable.

This is, to a certain extent, due to the many banks turning to the capital markets to operate, moving away from traditional banking activities. As seen during the financial crisis, there is a potential danger to an over reliance on the markets instead of depositors' money to fund lending and other activities. Many banks across the globe were severely damaged and at the brink of collapse after the credit markets seized up in 2007, forcing many government to enact bailouts. The banks are almost too many to list, especially across the Atlantic. In the time since the crisis, many banks have improved on their loan to deposit ratios, but deposits are limited to a finite supply and depositors are often fickle.

There is no argument that banking and banking products continue to increase in complexity and the task of regulating this industry is equally as complex. However, it is more important that the bankers and the regulators get it right, so as distasteful as it may sound to many, a slow and cautious approach to regulation is needed to ensure the best outcome and reduce the risk of over-regulation.

The past five years set the foundation; now it's time to sit down and get together to rebuild and improve the industry and regulation to regain confidence in both.

Without confidence, it is likely that the nascent economic recovery in the US will stall and the "R" word will once again be the topic of discussions. Confidence increases banks' willingness to lend and businesses' to expand - which, after all, is a recovery. The stock market, which returned to pre-crisis levels, needs to be reassured that financial institutions will act prudently and will not to allow the mistakes of the past to come back in another form.

Better regulation will likely lead to improved profits at banks, while more regulation will lower profitability, at least in the short term. To restore profits, banks will pursue more significant business changes. In some businesses, a portion of the higher regulatory costs may successfully be passed on to customers. Banks will need to continue to investigate price elasticity, and act accordingly. Clearly, bank restructuring and separating non-banking businesses will continue, as banks continue adjust their product and services mix, while reviewing their geographical and legal structure.

As a result, banks will need to take a sharp pencil to costs, with the first cuts being employees. Banks continue to announce major restructures across the globe, with pink-slips going out en masse, negatively impacting employment statistics.

While new regulations will likely result in a safer banking system, equity investors will need to adjust their expectations in terms of receiving lower returns on their investment. On the other hand, fixed income investors will continue to enjoy higher returns, as new bonds are issued at higher yields, given the need to hold additional capital and the "not to big to fail" discussions continue to make capital raising expensive.

Indeed its a bit of a catch-22: regulators' attempts to fix one problem may trigger others, if they go too far. We are already seeing the result of regulation: increased costs for banks, weaker employment, less lending, lower returns, all of which do not bode well for a strong economic recovery. Overregulation will likely intensify these results. Conversely, smarter regulation will likely lead to a quicker return to the new-normal for banks and investors.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.