Chicago Professors Argue That Governmental Approval Should Be Required For Wall Street’s Exotic Financial Products


Wall Street is peddling snake oil ? new financial products that are the equivalent of bottles of medicine with labels like “Dr. Bartlett’s Beneficent Balm ? Boon to Mankind” ? and they should be regulated as such, according to University of Chicago professors Eric A. Posner and E. Glen Weyl. The FDA protects consumers from poison sold as medicine and we should do something similar for financial products that “seem at least as extreme as the dangers of medicines,” they argue. (See “How to Prevent a Financial Overdose,” by Gretchen Morgenson, New York Times).

In a paper published by the professors, they are quoted as saying: “It is not the main purpose of our proposal to protect consumers and other unsophisticated investors from shady practices or their own ignorance. Our goal is rather to deter financial speculation because it is welfare-reducing and contributes to systemic risk.”

They recommend the creation of a “financial products agency” that would test financial products for social utility, just as drugs must be shown to be safe and effective. For example, financial instruments could be judged by their effectiveness in hedging risks and rejected if they would serve only to increase speculation and systemic risk. They might also be judged by whether they allocate capital and provide useful information to the market.

Credit default swaps, for instance, may lessen default risk but they substitute counterparty risk, and they do little to allocate capital because the underlying debt is already outstanding, say the professors. Credit default swaps played a major role in the credit crisis of 2008-2009.

Disclosure of risks (the main focus of the U.S. securities laws, including Dodd-Frank) is not enough to get a drug approved by the FDA and it should not be enough to get dangerous financial products past the yet-to-be-created FPA (Financial Products Agency), according to the professors.

Ms. Morgenson concludes: “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.”

Page Perry is an Atlanta-based law firm with over 170 years of collective experience maintaining integrity in the investment markets and protecting investor rights.