One positive fallout of the financial crisis of 2007-201? is our realization that financial products can be as complex and dangerous as drugs. This realization has led to innovative ideas and experimentation with new laws, regulations, and institutions around the world.
In India, the government has announced the establishment of the Financial Stability and Development Council (FSDC) to address inter-regulatory coordination issues and provide macro-prudential supervision.
In the United States, the Dodd-Frank Wall Street Reform and Consumer Protection Act, and new initiatives to monitor the safety of financial products, could alter the architecture of finance.
Several proponents of these new ideas have openly used the analogy with drugs. It has been argued that if, in 2007, the US had a Financial Products Safety Commission akin to its Food and Drugs Administration, the market would not have been flooded with “teaser” mortgages that entangled millions of households in chains of predatory credit.
What is especially sophisticated about the new ideas cropping up in the US, Europe, India, China and elsewhere is the recognition that, as with drugs and toys, it is impossible to say in advance which financial products we should allow and which we should not, because we cannot conceive of all the products that can and will come to market.
Hence, the need for a judgmental body that can look at a new product and form an opinion about its desirability.
Indeed, there is a worrying aspect to the new plans: they must tread a narrow path between reckless freedom for financial institutions, which contributed to the recent global financial crisis, and over-caution, which can suffocate innovation and create inefficiencies.
Consider a teaser loan, which initially charges low or even no interest, with much higher rates kicking in at a later date. To be sure, this is a dangerous product, and it did cause many families to fall into an unsustainable debt trap.
But such loans can be of great value to sophisticated firms and households that may have good reason to believe that their future earnings will be higher than their current earnings. Such entities would be able to make investments that would not be possible otherwise.
This is just one example. It is impossible to anticipate the numerous financial products that human ingenuity can create, and that can be dangerous to use but of great value to some.
The risk created by many of the regulatory measures under consideration in today’s crisis-scarred world is that they may end up over-regulating our markets to the point of blocking the emergence of valuable new products.
But there is a way out of this conundrum. In creating new financial regulations, we need to take the medical analogy one step further – by creating the equivalent of the prescription.
Instead of banning or freely allowing all dangerous products, we need to identify products that are valuable to some customers but not all – call them “prescription financial products” – and create a body of registered finance professionals (RFPs) who are empowered to certify the purchase of these products by individuals.
For example, you are planning to buy a house. Your local bank offers you what is certified to be a teaser loan – a prescription product. You can take such a loan provided that an RFP approves such a contract.
In brief, just as we do not ban steroids because they are dangerous, but require that buyers have a valid prescription, we should institutionalize caution in how financial products can be used – and by whom. This option could vastly shorten the list of products that will need to be banned outright.
We should, however, avoid the medical convention whereby each product is either over-the-counter or prescription, regardless of who is buying the product.
In order to keep the system lean, there should be a provision for exempting some individuals and firms – those sophisticated enough to handle their own affairs, or well off enough to deal with financial failure – from the requirement of an RFP’s approval before buying a prescription financial product.
The reason I argue for this provision is my positive experience in India, having recently moved here from the US. A few months ago, I went to meet the owner of our local drugstore.
Without encumbering him with any prescription, I told him somewhat sheepishly that I was going on an extended foreign trip and wanted to keep a precautionary strip of antibiotic tablets with me.
He looked me up and down, sized me up, and then said, “Since you are going for so long, I would suggest you keep two strips.”
Kaushik Basu is Chief Economic Adviser, Ministry of Finance, Government of India
Copyright: Project Syndicate, 2010.