Stopping the Financial Products Agency Before It Gets Legs

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The Consumer Financial Protection Bureau is just getting started with its war on credit availability for low-income families. But already a new idea for a financial markets regulator is beginning to emerge: a "Financial Products Agency" (FPA) modeled on the role of the Food and Drug Administration (FDA).

In her New York Times column this past weekend, financial writer Gretchen Morgenson put the FPA idea in the public square, making a case for a new agency that is the brainchild of the deservedly respected economic and legal minds, Eric Posner and Glen Weyl. Similar to the way the FDA tests pharmaceuticals before they hit the market, this FPA would test new financial products for "social benefit" before approving them.

Morgenson's book with Josh Rosner on the financial crisis, Reckless Endangerment, is one of the best accounts available and is a must read for every economics and finance student. Her columns are often refreshing and compelling. But the idea that a financial products agency would be beneficial is wrong for at least three reasons:

First, having an FDA-like regulator for financial products would stunt markets and stifle innovation.

There is a growing drug shortage problem in America, particularly with cancer medicines. According to the FDA's own internal estimates, it takes between 8.5 and 17 years on average to get a new drug approved. The costs associated with this process run in the neighborhood of a few billion dollars. And for many pharmaceutical companies the investment is just not worth the risk of failing to get an expensive drug to market. The high costs mean that for the drugs that do get approved, the prices are very high such that Americans find themselves seeking cheaper drugs from Mexico and Canada.

It is not a stretch to envision a similar scenario playing out in the financial sector if an FPA were to be let loose on U.S. markets. Only, in this case, the finance firms would be heading to Europe and Asia instead of our neighbors to the north and south to conduct business.

Posner and Weyl acknowledge this in the paper they wrote proposing the FPA, but they argue that it is a fair trade off to have less systemic risk in U.S. markets. The problem is that neither they nor Morgenson make a compelling case that an FPA would make us all that much safer. Consider that even with all those resources going into drug testing, there are still regular complications with medicines and harmful food products that appear on supermarket and pharmacy shelves. An FPA would likely have similar results, bringing us to the next point.

Second, an FPA would not have stopped the financial crisis from happening.

"Imagine if there were a Wall Street version of the F.D.A.," Morgenson writes in her column, "How different our economy might look today, given the damage done by complex instruments during the financial crisis." Not all that different, actually.

Let us assume for a moment that this FPA existed in 2004. Subprime debt was piling up like injured New York Knicks, yet there was there was little understanding of the risk that was building up in the system. If Michael Burry wanted to buy a credit default swap from Deutsche Bank, there is little chance the FPA would have done much to stop the transaction. We can't just assume that having an FPA would mean regulators might have somehow gained 20/20 hindsight or have had Michael Lewis's The Big Short magically as a reference guide.

Around that time regulators like then-Federal Reserve Chairman Alan Greenspan and Fed Board Governor Ben Bernanke were well aware of the housing bubble, but they either didn't think the risks were that big, or did not think it was appropriate to step in. With rising housing prices (which regulators never thought would go down) masking the risks of subprime debt by preventing defaults, it's hard to believe that regulators at this FPA would have done much to stop the risky financial products some assume caused the financial crisis.

The problem is not a lack of rules but the absence of the right rules.

If we learned anything from the crisis, shouldn't a key lesson be that a lot of rules without regulators smart enough or inspired enough to enforce them just leaves with meaningless protections and a false sense of security?

Third, the premise for the idea of an FPA is based on the persistent myth that derivatives contracts themselves were significant contributors to the financial crisis.

We doubt this will solve the debate, but here is the reality: derivatives are innocuous vessels, even the most risky of contracts. Blaming them is like blaming money for the crisis. Derivatives contracts became a problem because the underlying assets they were being created with were misunderstood and financial institutions,like AIG did not properly hedge its risk. Even if an FPA had stopped subprime CDS bets, there still would have been billions in subprime debt. A much better way to prevent the crisis would have been to ban homeownership and force everyone to rent.

More seriously, the challenge the American financial system faces today is not the continued existence of risky financial products, but rather the improperly aligned incentives that exist with mega financial institutions. All financial reform has done so far is make big banks bigger and more dangerous. An FPA won't solve that problem and would waste resources better spent pushing U.S. markets back from the moral hazard cliff on which they now rest.

Ultimately, the entire concept of regulating or restricting financial products because they have limited social utility - as the FPA would be designed to do - is simply nonsensical. Just because something has limited social utility does not mean it should be restricted. Going by this logic we should just go ahead and ban all reality television. (Wait, maybe that's not the best example.)


Anthony Randazzo ( is director of economic research at Reason Foundation where Victor Nava is a research assistant.   

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