Next month, shortly after the election, I will be attending a lunch at which Chris Dodd, best known as the co-author of the famous (or infamous) Dodd-Frank law will speak to a business group. One of the unintended (I think) consequences of the regulations that are still being determined as a result of that legislation is its negative impact on innovation and, ultimately, the quality of the choices and service that banks offer customers.

Compliance as a growth industry.

At some banks one of the few personnel growth areas is…the compliance department. Banks that allow zero hiring in revenue generating areas seem to have an open checkbook related to the compliance group, as the fear of regulatory action (often fueled by the internal compliance area itself) forces management to increase non-productive staff. That is not a good thing, as not only does that group fail to generate revenue but it also frequently slows down the revenue-generating abilities of all those it touches. Branch managers have more forms to fill, further keeping them from customers; relationship managers have more forms to fill, keeping them from customers … you get the idea. Some banks are even afraid to “audit” their compliance function to determine if some of the internal bureaucracy can be eliminated. Their concern is that a compliance consultant will suggest even more compliance requirements in a bid to feather its own nest, an arguably believable possibility.

One aspect of the impact of compliance is that the product development process at most banks has become increasingly cumbersome and today more resembles walking the gauntlet rather than a fast moving “skunk works.” Oftentimes, it appears designed to discourage creativity and dampen new ideas. Beyond the executive sponsor, the product approval process includes the involvement of a growing number of groups: compliance, legal, technology, operations, HR, finance, and so on. One bank I spoke with recently said that it could take up to a year to introduce a new product. Another very large bank said that they did not have the staffing and focus required to introduce any new products for at least the next six months. Why isn’t senior management outraged about this?

During a series of recent interviews, executives from two of the biggest U.S. banks used the exact same words in describing their current approach, stating their banks were pursuing a “back to basics” approach to their retail and commercial businesses. By this they meant that both banks were eliminating what they viewed as low priority products to focus on a few key areas. That sounds like good news, except that in each instance increasing compliance requirements, not a well designed strategy, propelled these changes. Line staff appears either unable or unwilling to fight this tsunami-like trend.

Too-big-to-fail banks are particularly focused on assuaging the OCC gods that increasingly determine their fates. Recent conversations with some of these banks indicate the degree to which they are concerned both about regulators and bad publicity, mentioning recent articles in which they were featured negatively. Indicative of the level of internal concerns, we just received notice from one such bank that all contractors, including consultants, had to undergo a background check prior to working there. The paranoia of the largest players provides some good news for regional and community banks that may be somewhat less a target for regulators.

Compliance excellence not compliance excuse.

Of course, excellence in compliance is of critical importance to banks, as is excellence in other important functions such as risk management and IT. But it cannot become an excuse for inaction. Today, too much of the innovation in banking is restricted to technology-based areas. Increasingly, non-banks rather than much larger and more powerful banks are bringing product innovations to consumer and business customers.

In many cases, compliance is harming the customer’s bank experience as well as making it more difficult for the customer to get things done: more forms, more time, more checks. Many of these hurdles are demanded by the government while others are similar to boat barnacles that require substantial effort to eliminate once they appear.

So, what should banks do? Smaller and mid-sized banks should hope that the bigger players continue to tie themselves up in knots. It is the gift that keeps giving. At the same time they need to question each and every additional requirement that compliance/legal tries to require: Why is this change necessary? Who dictated the change? Are competitors being forced to do the same thing? Pushing back is appropriate and should even be appreciated by a compliance group that is top rate.

The big banks have a different and more serious problem. For years now they have become piñatas for regulators and the press; that will not change no matter who becomes President. Only one very large bank I spoke with recently failed to complain about regulatory hoops. That bank basically sailed through the downturn, based upon its excellent risk management policies. In recent years, they maintained and grew their credibility with regulators. Most of the top ten banks are in the regulatory dog house and will remain in it until they not only meet all the compliance challenges but also demonstrate that they are looking out for the customer. It is no easy task to increase operating costs for compliance and related activities, reduce revenues due to governmentally imposed constrains and, oh yes, generate an attractive return. Compliance may be killing innovation, but it is one key factor that will ultimately fuel industry consolidation.