Should Bank Regulators Do FDA-Style Product Vetting?

Forget, for a moment, about heightened capital requirements or formal designations for financial firms deemed "too big to fail."

Reader Brett Blake has alerted BankThink to an alternative proposal from law professor Saule T. Omarova aimed at reducing systemic risk in global financial markets: Require pre-approval for complex financial products.

Omarova's proposal, outlined in a paper published by the Washington University Law Review, is aimed at complex financial instruments such as asset-backed securities and derivatives. Under her plan, these and other structured (i.e. not retail) products would have to pass three tests to earn regulatory approval. Financial firms would need to demonstrate (1) the product had economic value; (2) they could manage associated risks effectively; and (3) the products wouldn't increase the vulnerability of the overall financial system.  

The implication, ultimately, is that such a system bests existing reforms because it would address excessive risks in volatile markets head-on. (The fact that the Office of the Comptroller of the Currency just voted to delay implementation of Dodd-Frank's swaps "push-out" rule certainly supports the notion that the law has yet to influence the markets Omarova is most concerned with.) 

"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," Omarova writes on Columbia Law School's Blue Sky Blog on corporations and capital markets. "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. "

Omarova notes that the concept of mandatory product approval has a track record in other industries. The Food and Drug Administration, as one example, requires new drugs and complex medical devices "be proven safe and effective before companies can put them on the market."  But it certainly represents a departure for financial institutions, which have become accustomed to receiving detailed guidance from regulators on financial products after they've been introduced to the marketplace.  

Would requiring pre-market approval for financial products curb systemic risk? What unintended consequences, if any, might result from implementing such a proposal? Leave a comment below.

Jeanine Skowronski is the deputy editor of BankThink. You can contact her at Jeanine.skowronski@sourcemedia.com or follow her at Twitter @JeanineSko.