Should New Financial Instruments Be Treated Like New Drugs?

My colleague Glen Weyl and Eric Posner at the University of Chicago Law School, argue in a recent white paper, that new financial products should be subject to regulatory approval analogous to that for new drugs by the Food and Drug Administration. Here is the abstract:

The financial crisis of 2008 was caused in part by speculative investment in sophisticated derivatives. In enacting the Dodd-Frank Act, Congress sought to address the problem of speculative investment, but merely transferred that authority to various agencies, which have not yet found a solution. Most discussions center on enhanced disclosure and the use of exchanges and clearinghouses. However, we argue that disclosure rules do not address the real problem, which is that financial firms invest enormous resources to develop financial products that facilitate gambling and regulatory arbitrage, both of which are socially wasteful activities. We propose that when investors invent new financial products, they be forbidden to market them until they receive approval from a government agency designed along the lines of the FDA, which screens pharmaceutical innovations. The agency would approve financial products if and only if they satisfy a test for social utility. The test centers around a simple market analysis: is the product likely to be used more often for hedging or speculation? Other factors may be addressed if the answer is ambiguous. This approach would revive and make quantitatively precise the common-law insurable interest doctrine, which helped control financial speculation before deregulation in the 1990s.

It is not every day you see Chicago economists arguing for more regulation rather than less!

It is worth nothing that Glen is not a newcomer to arguing the dangers of speculation.  He was one of the few economists who had his eye on the ball, thinking about these risks well before the financial crisis.  Back in the fall of 2007, he told me about this interesting paper he had written pointing out the social costs of arbitrage.  At the time his concerns about the dangers of financial innovation were not much in vogue.  How times have changed!   Now lots of economists (two examples here and here) are pursuing the same line of thinking as Glen.

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  1. John says:

    I am in favor of the idea, but I just don’t have faith in a government run branch to regulate this correctly/effectively without a very strong chance of corruption. Am I wrong to think this?

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    • Michael Peters says:

      How corrupt is the FDA? There’s a ton of money on the line there too. And while we may hear about something every now it does successfully regulate a lot of food and drugs.

      Also, what makes you think that a privately run regulating entity would be less corrupt? If there’s a lot of money at stake, I’d say the odds of there being corruption have almost nothing to do with whether it’s government or the private sector.

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      • John says:

        I see what your saying and mostly agree with it. But the FDA was lobbied to the point where they no longer regulate an entire section of the Health industry (i.e. anything you find at a GNC store). Yes, it is effective for the most part (that we know of). We don’t know what is shelved because of politics which have potentially saved thousands of lives but instead a drug like Viagra was pushed through ($).

        The more I read about the financial collapse the more it is evidently clear that if the private sector is completely deregulated then there is no doubt that doom is eminent.

        Could this be any worse of a process than how CDOs were invented? Probably not…but would they have gotten through this hypothetical agency anyays? Probably, yes.

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      • Jason says:

        The FDA is extremely corrupt. It’s run by pharmaceutical executives for one thing. Just like the EPA is run by oil executives and the Treasury is run by bank executives. Regulation is the problem not the solution. Big corporations want strict regulations and lobby for them on a constant basis. It seems counter intuitive but the reason is obvious, the more regulated an industry is, the tougher it is for smaller businesses to compete. Large corporations however, can easily afford to hire their lawyers and lobbyist goons to get around the rules and penalties. Corporate America as a corrupt negative force cannot exist without big government and vice versa. They work for the benefit of each other and will continue to grow until people wake up and stop listening to the mainstream media. And explain to me, how is the FDA successful? FDA approved drugs are the 4th leading cause of death in the United States. That does not include prescription drug abuse, ONLY deaths from proper drug use as instructed by a doctor. And guess what, the statistic came from the FDA’s own website.

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  2. Mitch says:

    Would the regulators be smart and independent enough to do these analyses?

    Also, it’s hard to see any of the major products that have blown up in the last few years (ARS, CDS, CDOs) not passing these tests. When used properly, these products can and do create value.

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  3. Kir says:

    The idea sounds good, until you subject it to “Would this have done any good at all in the last 4 recessions?”

    The answer is pretty clearly no, since from the perspective of a few years ago, they were quite valuable inventions.

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  4. JBP says:

    This assumes that the agency is in a better position to determine social utility than the market. Given that several regulations and government programs contributed significantly to the economic downturn, I think this needs to be looked at closer before we accept this proposition. Otherwise, its stealing first base.

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  5. Olga Bauma says:

    Hidden due to low comment rating. Click here to see.

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    • Ryan says:

      If investment banks didn’t have an insatiable appetite for overly risky mortgages to bet on/against then the real estate agents could have never made those loans.

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    • DaveyNC says:

      Real estate agents were, at most, third parties to these transactions. Hardly in a position to set the stage for global financial collapse. They were just playing the hand dealt them by the Greenspan Fed.

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      • Olga Bauma says:

        Real Estate agents are the first point of contact for any housebuyer, and they are the ones who give the first appraisal

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    • aepxc says:

      The fact that the crisis started from housing is just a detail. Given the direction of financial innovation over the past 20 years, if it was not housing it would have been pork bellies, and if not pork bellies, then tulip bulbs.

      One of the biggest flaws in the financial system today is that trading has become more of an abstract game, where the nature of the thing traded is mostly ancillary. Such an approach can never lead to an accurate modelling or efficient allocation of anything…

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    • Meg Greer says:

      Olga, you need to listen to the Planet Money/NPR/This American Life production, The Great Big Pool of Money, to understand the meltdown. The real estate agents were just doing what Greece has done, taking “free” money and spending it.

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      • Olga Bauma says:

        I’m not sure if any of you are paying attention of what you are writing. The real estate aren’t taking free money. They have nothing to do with what kind of loan the homeowner opts to buy. It’s the homeowners who go for loans they can’t afford. How hard is it to understand that the bank is providing a goods and service, and people are opting for goods and services they can’t afford, and then blame the banks instead of themselves. That is what brought the housing melt down, and had a lot to do with the whole melt down.

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  6. Kentucky Packrat says:

    As Mitch says, most of the paper generated (especially credit swaps) do have useful value. Denninger (among others) has been yelling about how they’re sold, not the fact that they exist. The exotic crap only exists to take money or risk off book, and when you take stuff off-book, you’re just wanting to commit fraud.

    Require that any futures-like object (CDS, ARS,etc.) meet the same margin and reserve requirements required on the standard exchanges, and require mark-to-margin valuations on the paper owners. I can write a 1 billion USD CDS against Greece now without any margins or reserves, and Citibank et. al. can take that paper on face value to counter risk on Greek debt. A stiff wind comes along, and I collapse under the weight of the CDS paper, and Citibank requires a bailout. Again.

    Force mark to market, and force the current paper back onto balance sheets. We’ll have a lot of explosions, but a lot of this paper would start evaporating.

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  7. Pete says:

    Glen Weyl is a rock star. Probably the brightest young economist out there.

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  8. Mike says:

    Were the products really the problem? It seemed to me like there were two problems:
    1) The assets backing the products
    2) The volume of products sold

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