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.


John

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?

Michael Peters

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.

John

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.

Mitch

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.

Kir

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.

JBP

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.

Olga Bauma

I have yet to see one remark about what I think was the real problem of the 2008 melt down. I still don't believe it was the banks' fault. I had first hand experience of whose fault it was. It was the fault of the real estate agents, not the banks. Here is what happens. A homeowner wants to sell a house. The real estate agent who we believe to be an authority comes in and appraises your house. They tend to under - appraise by a few thousand dollars, because they know homeowners haven't really got a clue how it works and they know the homeowner will add to the amount they appraise for because they want to stick the buyer with the commission, even though it is the homeowners tab. Then in the same breath they agent tells the homeowner that they will get a 6% commission. So, for example, the agent says your house is worth $ 100,000,- . The home owner figures out that well 6% of that amount is $ 6,000,- and if they bought their house just a few years before that, for maybe $90,000,- then they want to make a bit of money to recoup their expenses and interest they paid on their loan, so they put the house up for $10,000 to $20,000 more than the $100,000 which is what the agents appraisal was. The real estate agent says:"Great lets do that". Because that adds a little to their commission, and they don't really care how long your house is on the market. It's really no skin off their back. The real estate agents have a lottery system. This week its Harry's turn to sell a house, so we're bringing all prospective buyers to Harry's houses first. So now we have a house which may in actuality be only worth $95,000 for sale for $120,000. So now they find a buyer, they may haggle a little bit but eventually the house still sold for more than it was appraised for. Meanwhile the buyer gets his loan, which maybe more than he can afford, and the city appraiser comes in and appraises the house within $ 500.- of the selling price. Helps the city with upping the property taxes for the next year, and isn't really a deal breaker for the seller or the buyer. The only one snickering is the real estate agent, because he/she is the only one who remembers that he/she originally appraised the house for $20,000,- , and some, less. Really I still can't believe that nobody ever looked into that yet.

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Ryan

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.

Kentucky Packrat

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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Pete

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

Mike

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

Travis

The products were the problem because they obfuscated the assets backing them.

Airman Spry Shark

New drugs shouldn't even be treated like new drugs currently are. Rather than years-to-decades of testing for binary approval, new drugs (and, perhaps, new financial instruments) should be taxed based on their potential harm (essentially a stochastic Pigovian tax). Completely novel NMEs would be highly taxed; as their effects & interactions become better understood, the tax would be lowered proportionately to their benignity. The revenue would support a fund to compensate those harmed by drugs released under this system (thus reducing the incentive for drug companies to cover up problems, as they wouldn't be financially liable).

rehajm

As the last crisis demonstrated, collective legislative action is sorely lacking in expertise and is insatiable in it's appetite for social engineering via financial markets. Given this, there's no reason to conclude an additional FDA-style layer of government would do anything constructive in preventing the next crisis. Good government comes from clearly defined rule of law- not from the collective discretion of political appointees.

Torsten

Why not go a step further and require that following “FDA” approval of the new financial instrument, prospective customers need a “prescription?”

Lindsay

I think the idea of treating new financial instruments like new drugs is well thought-out. Many of the high-risk financial products which contributed to the financial crisis were extremely complex instruments which professionals in the industry even struggled to understand. The absence of any regulatory agency like this made it even more difficult to gauge the utility of such an instrument. It would make complete sense if this financial version of the FDA were created and reverted back to the insurable interest doctrine which was successfully utilized in the past for assessing and controlling speculative financial devices.

Jim

One concern I have is that the in the case of the FDA there is a more concrete public opinion about the standards for health, but how would financial products be judged? The article describes that, “The agency would approve financial products if and only if they satisfy a test for social utility”. I find the wording “social utility” to be extremely vague and therefore the basis for my doubt in this kind of system. A quote I once read comes to mind “Ask advice to 5 economists and you will get 5 answers—6 if one is from Harvard”. Assuming this agency would be well informed in economic theory, is it not unreasonable to think there would be considerable difficulty in reaching decisions about new financial products’ merit? Or even existing ones?