Financial Regulation Of Derivatives Could Be Handled Like Drug Approvals, Experts Say

Are exotic financial derivatives as risky as untested prescription drugs? Two University of Chicago economists say possibly. As noted by economist Steve Levitt in his Freakonomics blog, professors Eric Posner and Glen Weyl proposed
in a recent white paper the creation of a regulatory body that could prescreen financial products -- like the subprime-asset stuffed securities that nearly brought down the U.S. economy -- before they’re sold to other banks or investors. In other words, an FDA for CDOs.

"A large part of what contributed to the financial crisis were innovative financial products that introduced a large amount of risk to the system and concentrated it in the hands of people who were least able to understand them," Weyl told The Huffington Post. "What we're proposing is something similar to the role the FDA plays in the approval of new medicine."

Weyl and Posner said that their proposal would entail the creation of a new regulatory arm, perhaps an offshoot of the Commodity Futures Trading Commission or the Consumer Financial Protection Bureau -- comprised of financial experts who would evaluate each new product for potential systemic risk. So every new collateralized debt obligation would get their vetting before being unleashed to the public.

"Imagine an investment bank comes up with a new derivative," Posner told HuffPost. "[Under our proposal], before they can actually sell that derivative, they'd have to go to an agency and get its permission. And the agency at thus point would say, 'Give us all the information that you use to decide if this is a good way to make money.'"

Part of what shook the foundations of the U.S. financial system during the crisis was the massive trade in complex financial instruments backed by faulty mortgages that even the banks themselves didn’t fully understand.

But what about those products whose risks can't be totally foreseen in the long run? "One can't know all the long-term implications of a new financial instrument," Weyl conceded. But, he said, something has to be done to protect the economy from dangerous financial products. "The next crisis will not be from CDOs. I think people have basically figured out the story of those. The problem is, there’s a constant innovation to stay one step ahead of what people understand. You have to fight the next war."

Comments

[walstir]

12:52 PM on 02/15/2012

Derivatives are a zero sum game. If you believe that Greece will default and I do not and we use derivatives to take opposite positions on the outcome; then one of us will be proved to be smart/lucky and the other stupid/unlucky. There isn’t a risk of loss - there is a certainty of loss for one party. Risk cannot be eliminated - risk is what derivatives are all about. The issue with derivatives is whether the player who loses is going to be able to cover his losses.

[J T K]

05:58 AM on 02/15/2012

Just what we need, another bureaucracy.