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.


Ken Arromdee

New drugs are regulated, but new regimens aren't. A doctor can prescribe a drug off-label, or prescribe a combination of drugs without getting the particular combination approved. Is a "new financial instrument" more like a new drug or a new regimen?

John

Hmmm .... At least we have an admission by some economic gurus that Las Vegas style finance is damaging - but, I think the Designer of the economic model described in Deuteronomy and Leviticus told us so a few millennia ago...

Amanda

I don't agree with the idea, for the following reasons

1. The idea of doing this for drugs is different than with financial tools, so its justification is not completely convincing. For instance, drugs are a type of good with literally life threatening implications almost instantly. Financial tools-took time to be threatening and aren't a product to be sold. For that matter, its not clear how we would know the threat, i.e. can we agree on asset bubbles?

2. The cost (major inefficiencies and waste) seem obviously large, but the benefit-its very uncertain.

3. Our Dodd-Frank legislation has not really taken to play, we've worked to pass it and should make use of its tools and new bodies before added FDA-like regulations.

Amanda

Aseel Houmsse

I find this post interesting mainly for the fact that it gives a glimpse into the structure of large organizations. To the general public, the FDA may seem like a very stable and good-willed association, but this post just goes to show that in every large movement, there are obstacles.

Daniel Mccumllam

Obviously, I have that found of new financial instruments can be treated like new drugs. I can see that Chicago economists arguing for more regulation rather than less. Thanks for published! @ Felix Investments

Billy Burtson

In my opinion, i think that this idea should be implemented. Although it probably can't be done at the moment, due to economic hard times, eventually it would help people out. I have done research before and i know that several people have gotten rich by selling fake drugs, and tehre are still people doing it to this day.

Steve Florman

Nothing, with the possible exception of new politicians, should be subjected to the same process as new drugs. Not only is that process inefficient and riden with politics, it also probably kills a number of people every year by keeping new medicines off the market. There are prbably better ways to accomplish testing new drugs for safety than they way we currently use.

New investment vehicles, on the other hand - how do you know they're "risky" until they blow up? Everyone loved mortgage derivatives until they suddenly became big losers. The fact is, unlike a pharmaceutical, the risk was always there. It just took the right market conditions to bring out the collapse. Try getting a government agency to figure that out in advance, or for that matter, even after it happens.

Arturo Jastrow

This regulations try to solve the problem of market efficiency. But behavioral economics complete the history. And I think the question here is: are regulators going to be as irrational as the rest of us?