Should Financial Products Be Regulated Like Drugs?

Photograph by Michael Paras/Getty Images

What if a bank had to get government approval before deploying a new financial instrument its engineers had devised in their labs? Would that curb the proliferation of risky derivatives in markets, reducing the prospect of the world facing another financial Armageddon as in 2008?

The answer, in the opinion of law professor Eric Posner, is yes. Posner and his University of Chicago colleague, economist Glen Weyl, have written a new paper arguing that Wall Street needs the equivalent of the Food and Drug Administration—an agency that would review new financial instruments to determine whether they serve a useful market purpose. Those that don’t pass muster don’t make it to market. In the paper, they write: ”Speculation is a zero-sum activity, which, in the aggregate, harms the people who engage in it and which can also produce negative third-party effects, for example, by increasing systemic risk in the economy.”

The Posner-Weyl paper likens financial products to prescription drugs: They can do abundant good, but used improperly, they can be deadly. Sound familiar? For all their intended (theoretical) benefits, complex products such as naked credit default swaps and synthetic CDOs have left a trail of financial ruin around the world. While credit default swaps function essentially as insurance against bad loans, naked CDS contracts allow people to place bets on debt they don’t own. During the crisis, this turned small defaults into tsunamis. By packing together millions of different mortgages and then slicing them into smaller pieces, CDOs made junky mortgages look like triple-A gold, thereby spreading risk throughout the system.

Posner argues that one of the primary reasons for the crisis is that too many people simply did not understand the products they were using, products that Warren Buffett in 2002 called “financial weapons of mass destruction.” By this line of thinking, if the folks at AIG Financial Products, for example, had truly grasped the nature of naked credit default swaps, they certainly wouldn’t have sold billions of dollars of credit protection through them, leading to the firm’s near collapse in 2008. Same thing goes for all the people who bought synthetic CDOs that were built to fail from the likes of Goldman Sachs and Magnetar, a Chicago hedge fund. Had many customers truly understood what they were buying, they probably would not have.

Posner and Weyl argue that through the near-constant innovation of new, complex financial instruments, Wall Street has strayed too far from its core purpose of capital allocation. “We’ve reached a point where these instruments are just being used to gamble, which has no social value,” Posner says in an interview. “There is a lot more speculation going on than legitimate hedging right now.” The difference between the two, he says, is that hedging reduces the amount of risk in the market, while speculation via derivatives increases it. “The problem arises with these complicated derivatives, which merely transfer risk to counterparties, thereby increasing the amount of risk that’s in the system,” says Posner.

So how would this hypothetical financial FDA work? Posner envisions a system whereby banks would submit for approval new instruments they’d invented. The agency, which Posner thinks would best be housed within the new Consumer Financial Protection Bureau, would then evaluate their usefulness and determine what, if any, legitimate uses exist. “Some drugs aren’t allowed to be marketed, because they carry no benefits. The same test should be applied to financial products,” Posner says. “If there’s no legitimate hedging purpose, then it wouldn’t be allowed.”

Instruments in current use would be grandfathered in, although Posner doesn’t think very highly of any of the derivatives developed over the past 20 years. In his opinion, the last truly beneficial financial products were life insurance, created in the 19th century, and mutual funds, from the middle part of the 20th century. All the rest have had no real benefit to society.

Posner says that a lot of academics haven’t shined to this review proposal, and he understands why. ”There are lots of questions as to the logistics of how something like this would work,” he says. “You have to wonder if we really want another level of bureaucracy.” (As Steven Levitt noted on the Freakonomics blog, the University of Chicago isn’t exactly known for being proregulation.)

But Posner says his and Weyl’s proposal is more akin to the “moderate regulation” that Cass Sunstein, the Obama administration’s regulatory czar, is attempting to implement. Sunstein, a Harvard law professor, is perhaps best known for his “Libertarian paternalism” theories on finding ways to “nudge” people into behavior that is of more benefit to themselves and to society, without eliminating freedom of choice.

“We would want this agency to be conservative and cautious,” says Posner. “It wouldn’t be that difficult to determine whether a product has useful purposes beyond merely speculation. Finance people have been able to game this system for more than a decade, and the whole idea is to find ways to discourage them from doing so.”

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