The Case for Treating Big Finance Like Big Pharma

A pair of University of Chicago law professors say the federal government needs to regulate new financial products the same way it tests new drugs for safety
Roadside Attractions

Jeremy Irons captured a new Wall Street's moral ambiguity in the 2011 film "Margin Call" when his fictional chief executive lectured his investment bank staff on the three ways to make money.

"Be smarter. Be first. Or cheat. I don't cheat, and while we have a lot of smart people in this organization, it's a hell of a lot easier just to be first."

That moment is central to a distinctly non-fictional proposal by two University of Chicago law professors which will cause dyspepsia among their famous free market colleagues at the university and the well-heeled leaders of Chicago's booming and path-setting exchanges, where many of the most important financial products of the past 20 years have been born, including derivatives.

They want to dramatically re-regulate new financial products, including sophisticated derivatives, that they assert "facilitate gambling and regulatory arbitrage, both of which are socially wasteful activities."

In sum, authors Eric Posner and E. Glen Weyl want to return to the 1990s, when those same exchanges, and much of the financial world, were far more closely regulated. Their article's title underscores their policy urging: "A Proposal for Limiting Speculation on Derivatives: An FDA for Financial Innovation."

"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 pair writes. "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?"

The professors open by arguing that financial products are "socially beneficial" when they help us insure or hedge against risk. When they're used for speculation and regulatory arbitrage, they're "socially detrimental." That's because the "difference between hedging and speculation is that hedging enables people to reduce the risk they face whereas speculation increases it."

The most vivid recent example of what they deem socially destructive speculation involves the investments in derivatives that played an important role in the financial crisis of 2008. "The costs of speculation are now widely recognized, and it is clear that speculation was facilitated by the financial innovations of the last thirty years."

The authors fully concede the many benefits of financial innovations, notably when it comes to hedging and insurance, as well as allocating capital. But financial markets also produce speculation, exposing speculators to risk without fully compensating them, and "informational racing," with a vivid example being the high-speed trading in which hedge funds make big bets to procure information a split second earlier than rivals, just like Jeremy Irons' firm in "Margin Call."

That informational racing is what the authors deem one of several basic problems with a lack of regulation. There are two others.

One is regulatory or tax arbitrage, where a bank uses derivatives to heighten its exposure to risk beyond what's allowed by law, with regulators often largely ignorant about those derivatives and thus not given to stop them.

The other is what they deem useless gambling or speculation. Two traders wager on whether a derivative is higher or lower than their market price; a bet that the academics feel doesn't add anything of value to the real economy.

"There are products that appear to have no social value," they write, including naked credit default swaps (CDSs) which were once illegal in most jurisdictions until regulatory restrictions were lifted in 2005 and they inspired a boom industry. They then played a role in the instability of the financial markets in the credit crisis.

So they urge either a new agency with the power to screen new financial products or taking an existing agency, such as the new Consumer Financial Protection Bureau, and give it the authority.

The reason they allude to the Food and Drug Administration in their article's title is that they do see the review of new pharmaceuticals as an apt analogy for what they're seeking. They also suggest an analogy to the power of both the Department of Justice and the Federal Trade Commission to review proposed corporate mergers.

But why do they focus so intently on medicines and not look at the many products which don't face such stringent controls, be they televisions or computers?

In their view, "Economic theory teaches us that finance is much like medicine. Individuals' optimal investment portfolios differ between individuals relatively little, except in ways that can be readily observed and described based on a small number of individual characteristics."

"These characteristics include risk-preferences, age, industry in which one is employed, and where one lives. On the other hand, optimal financial planning is a complicated computational problem that is at the frontiers of both economic theory and computer science. The vast majority of the well-off seek advice about the allocation of their financial assets, but rarely do so about other life decisions."

The authors know they'll engender dismissive rebukes. There will be those who scoff at the FDA analogy, arguing that the agency is too bureaucratic and impedes innovation. They will ask whether the free market will do things better than regulators and why transparency about the nature of products will get you where you want to go.

Disclosure is simply insufficient and won't stop firms from investing huge resources to develop products that "facilitate gambling and regulatory arbitrage," argue Weyl and Posner, who is the son of Richard Posner, one of America's most influential federal judges and academics.

They admit that there is a tough problem in defining just what is a "financial product" for the purposes of a regulatory review. Should the inventor of the very first CDS have been forced to gain government approval? They say yes.

They also find the frequent criticism of insufficient expertise within regulatory agencies, presumably because they can't attract enough top talent, to be overdrawn. And they deem exaggerated the anticipated complaint that firms won't invest in financial innovation if they fear their products will be stuck in a review process for long periods of time.

"Any proposal to introduce new regulations will be controversial because of legitimate concerns that regulation interferes with the efficient allocation of resources and is vulnerable to capture by interest groups," they conclude.

"In the current, highly polarized political environment, it is easy to predict that many people will regard our proposal as an excessively radical reform, one that is inconsistent with free market traditions in the Unites States. It is therefore important to emphasize that or proposal in large part revives an old regulatory system that served the United States well until it was dismantled in the 1990s."

And, as they note, every state has an insurance agency with the power to regulate financial instruments with insurance-like elements, as is often the case with financial products. At the federal level, the Commodities Futures Trading Commission and the Securities and Exchange Commission do have jurisdiction over financial products.

"Our goal is simply to provide them with the right powers and guidance so that they can regulate these products effectively."

Well, they are intrepid. That's why one might respond just as President Obama did Tuesday at his press conference when asked about criticisms leveled his way by Mitt Romney. He dodged the query and referenced Romney's big test that evening in "Super Tuesday's" Republican primaries.

"Good luck," he said.