One of the key lessons of the recent financial crisis, and the greatest challenge facing post-crisis regulatory reforms, is the need to control and reduce systemic risk associated with financial innovation, complexity, and the growing interconnectedness of global financial markets. The centerpiece of the U.S. reform effort, the Dodd-Frank Act explicitly targets systemic risk in the financial sector through a variety of measures, including enhanced disclosure of market data, greater standardization and central clearing of derivatives, higher minimum capital standards for financial institutions, and even controversial attempts to restrict trading activities of insured banks and their affiliates.
Despite its sweeping reach, however, the Dodd-Frank Act fails to articulate a unifying vision – a philosophy, if you will – of systemic risk regulation in today’s financial marketplace. Mandating numerous regulatory “fixes” to specific problems exposed during the last crisis, the new statute does not offer an answer to the fundamental question: what does it really mean to regulate private participants and transactions in financial markets with the ultimate goal of protecting the national (and global) economy and citizenry – the public – from the next systemic crisis? How should we manage the inevitable trade-offs involved in that regulatory enterprise?
In two recent companion-articles, I explore one possible answer to this critical question and outline the rough contours of a highly unorthodox regulatory scheme for systemic risk prevention: mandatory pre-market government licensing of complex financial instruments (including derivatives, asset-backed securities, and other structured products).
The defining feature of the proposed regime is that it explicitly aims to reduce and control the amount and types of risk before such risk is introduced into the financial system. In that sense, mandatory pre-approval of financial products represents a true gatekeeping mechanism, a form of ex ante regulation that targets directly and proactively the levels of risk, leverage, and complexity in the financial system.
The general principle of pre-market product approval is not new. The main real-life experiments with product approval regulation include licensing of pharmaceutical drugs by the U.S. Food and Drug Administration, chemicals regulation in the European Union, and a system of mandatory pre-approval of commodity futures contracts administered by the Commodity Futures Trading Commission from 1974 to 2000. Complex and controversial as they may be, these examples offer valuable insights into whether – and, more importantly, how – a similar regime can potentially operate as a model of systemic risk regulation in financial markets.
However, shifting the focus of the product approval scheme from primarily consumer-safety and market-manipulation issues toward broader systemic stability concerns—such as socially unproductive levels of complexity, leverage, speculation, regulatory arbitrage, and interconnectedness in financial markets—complicates the task of designing it. A rigorous product approval regime can inadvertently slow down the development and marketing of potentially beneficial financial instruments and impede socially useful financial innovation. To avoid or minimize this danger, it is critical to structure the new regime to target, primarily and explicitly, what I call strategic complexity in financial markets: constant introduction of new complex financial instruments into the market, regardless of actual demand or true economic need for such instruments.
To operationalize this regulatory objective, I propose a process for product approval, which would require financial institutions to make an affirmative showing that each complex financial product they intend to market meets three statutory tests: (1) an “economic purpose” test, which would place the burden of proving commercial utility of each proposed financial instrument on the financial institutions seeking approval; (2) an “institutional capacity” test, which would require a review of the applicant firm’s ability to manage the risks and monitor the market dynamics of the proposed product effectively; and (3) a broad “systemic effects” test, which would require a finding that approval of the proposed product does not pose an unacceptable risk of increasing systemic vulnerability and otherwise does not raise significant public policy concerns.
Framed around this dynamic three-part test, the proposed regime does not necessarily prohibit any financial activities. It merely imposes the duty to provide information necessary for evaluating potential risks and benefits of a specific financial product on the party that has the best access to such information and the greatest incentives not to disclose it voluntarily. Yet, by altering underlying presumptions and shifting the burden of proof in this way, the proposed regulatory scheme is likely to have profound effects on the fundamental dynamics of our financial markets.
Of course, implementing such an ambitious and novel regulatory scheme in practice is bound to generate criticism and raise many difficult questions, both politically and as a matter of regulatory design. To many, the very idea may appear unrealistic or misguided. Nevertheless, it is vital to put this reform option on the table for a full and open-minded discussion. Implementation challenges notwithstanding, mandatory product approval offers a potentially effective method of advancing the public interest in more robust systemic risk prevention, as well as enhancing the efficient operation of financial markets. It deserves our attention and a thorough analysis.