"How to Prevent a Financial Overdose"

 Gretchen Morgenson at NYT:

THE Food and Drug Administration vets new drugs before they reach the market. But imagine if there were a Wall Street version of the F.D.A. — an agency that examined new financial instruments and ensured that they were safe and benefited society, not just bankers.

How different our economy might look today, given the damage done by complex instruments during the financial crisis.

And yet, four years after the collapse of Bear Stearns, regulation of these products remains a battleground. As federal officials struggle to write rules required by the Dodd-Frank law, some in Congress are trying to circumvent them. Last week, for instance, the House Financial Services Committee approved a bill that would let big financial institutions with foreign subsidiaries conduct trades that evade rules intended to make the vast market in derivatives more transparent. 

Which brings us back to the F.D.A. Against the discouraging backdrop in financial oversight, two professors at the University of Chicago have raised an intriguing idea. In a paper published in February, Eric A. Posner, a law professor, and E. Glen Weyl, an assistant professor in economics, argue that regulators should approach financial products the way the F.D.A. approaches new drugs.

The potential dangers of financial instruments, they argue, “seem at least as extreme as the dangers of medicines.” 

They contend that new instruments should be approved by a “financial products agency” that would test them for social utility. Ideally, products deemed too costly to society over all — those that serve only to increase speculation, for example — would be rejected, the two professors say...

It is a refreshing rejoinder to the mantra on Wall Street — and in some circles in Washington — that financial innovation is always good and regulation is always bad. Bankers often argue that complex financial products are among America’s great inventions. 

But given that exotic instruments played a central role in the credit crisis, it is worth questioning the costs and benefits of such financial innovations. The paper by Mr. Posner and Mr. Weyl provides a basis for what could be a productive dialogue. 

“We tried an experiment with a very radical form of deregulation that has very little basis in sound economic science,” Mr. Weyl said in an interview last week. “What we’re advocating is to do the best we can to put the genie back in the bottle.” 

FIRST, their paper says, we should distinguish between financial markets — where institutions lend money, trade securities and make investments — and the real economy, where people trade goods and services. 

“It is tempting to think that if the real economy should be largely unregulated (as it is), then the financial markets should be as well,” the professors wrote. But that view, they went on, is wrong.

Instead, they advocate testing new financial products for social benefits. For example, financial instruments could be judged by whether they help people hedge risks — which is generally beneficial — or whether they simply allow gambling, which can be costly. 

The instruments could also be measured for how they affect capital allocation, and whether they might add useful information to the marketplace. 

The professors note certain instruments that they say have added little to society. Among them are credit default swaps, which were devised in the 1990s and became enormously popular. 

The paper concludes that credit default swaps have considerable drawbacks. Those who use swaps to hedge their debt holdings, for example, assume the risks of dealing with counterparties. Swaps also contribute little to the appropriate allocation of capital, the professors say, because investors use them to take positions on debt that is already outstanding. And the paper dismisses the notion that such swaps provide significant information to the market about the safety of underlying debt. 

Imagining a credit default swap being brought before a financial protection agency, Mr. Posner and Mr. Weyl wrote: “We would expect the F.P.A. to treat it skeptically.” ...

The professors also question the central tenet of the nation’s financial regulatory framework — that full disclosure provides enough protection for investors. 

“My major concern about Dodd-Frank is that the basic philosophy behind it is to improve disclosure, the traditional way of addressing market failures in a way that is thought to be helpful but not too intrusive,” Mr. Posner said last week. 

But disclosure alone isn’t enough in the pharmaceutical industry, he said, and the same view should be applied to finance. 

“In pharmaceuticals, we could allow a company to sell whatever it wants as long as it tells people the product might work but also might cause your head to fall off,” Mr. Posner said. “We don’t do that because people will ignore the information, so we draw the line and say, ‘You can’t buy that product.’ ” ...

THE proposal by Mr. Posner and Mr. Weyl is unlikely to get off the ground anytime soon. But if their ideas open a discussion about measuring the social costs of our financial products, that alone would be a step forward.