Friday, April 30, 2010

My Problem with Part of the Proposed Financial Reform

I'm not sure if it's in the current version of the reform bill or not, but one proposal for financial reform was a sort of FDA for financial instruments. It would review new instruments and determine whether they were valuable innovations or excessively complex and unnecessary--possibly even fraudulent--tricks that will lead to further financial disaster. So, for example, if a company offers some fancy new kind of derivative, the review board would have to approve it before issuance.

I have two problems with this (they're closely related to each other, but I think they're different enough to call them separate arguments). The first is well-summarized here with an example:

For example, before 1996, certain initial public offerings of stocks were subject to merit review in certain states, where the state decided if a security is a "bad" investment and thus not appropriate to be offered to its citizens. In fact, this is exactly what happened to Apple Computer when it first went public in 1980. Massachusetts prohibited the offering of Apple shares because they were "too risky," and Apple did not even bother to offer its shares in Illinois due to strict state laws on new issues. What if federal bureaucrats had had the power to impose their judgment on a "risky" financial product (such as an IPO) on a nationwide scale, or every state followed Massachusetts' lead?
That's taken directly from Marginal Revolution, which quoted it from Paul Atkins.  This is a great example of my first problem with this kind of reform: Financial instruments are really just contracts, and every one is new and different. New financial instruments are created all the time, with new and different terms. Every new financial instrument is a new contract. Can a review board really review and approve all of them in anything resembling a timely fashion? The only way I can imagine that they could do so would be to restrict financial instruments to a set of standardized forms. Issuers are allowed to change a few things--the interest rate, the time period, etc.--without needing approval. Changing anything else would require approval.

Yet this would almost certainly leave some value-increasing exchanges foregone. There must be some value in allowing new and different financial instruments that don't follow strict forms; they can't all be schemes and frauds. Arnold Kling would probably argue that we can do without the complexity and do fine with simple forms, but I'm no more comfortable with that than I am with governments deciding if an innovator like Apple should be able to issue stock.

My second problem with this kind of reform has to do with the FDA. Economists (particularly Robert Higgs) have long suspected that the FDA tends to be too reluctant to approve new drugs. The reasons for this are straightforward: The incentive to approve new drugs is low, and the incentive to deny them is high. If a drug is approved, and someone gets sick as a result, the public and Congress are going to blame the FDA. If a drug is approved, and it works wonders without getting anyone sick, then no one is going to sing the praises of the FDA. Furthermore, the people who could have been saved by a drug that is not approved are usually not a vocal interest group (a notable exception being HIV/AIDS victims), and their suffering is not visible to most of the public. As a result, the FDA tends to require drugs be tested for a long time before approval.

I would expect the same problem to occur with financial instruments. The regulatory approval body would have an incentive to reject most instruments, or at least subject them to lengthy reviews that delay their implementation (leaving many potential users of these instruments without them for some time).

To add my usual caveat, I'm not an expert in finance or macro, and my opinion on this subject is not as valuable as the opinion of such an expert would be.

No comments: