There's a rule or regulation that says you can't allow longer than the absolute minimum layover time?

Regarding the reason for compensation... it's partly designed so your airline doesn't leave you stranded with no options. If your flight is delayed 'x' number of hours, the last minute walk-up fare on another carrier can be prohibitive. The compensation will go part way to off-setting that fare difference.

Your crew doesn't get sleep and decides to delay the flight. Great from a safety perspective. But the passenger still needs to get to their destination. Entirely a separate issue.