8th March 2012
Britain's high street banks can never claim they were not told. Consumer groups and the media continually warned borrowers for a decade that payment protection insurance was a bad idea – an uneven balance where they paid big premiums for cover of little or no value.
The banks ignored this, claiming the insurance gave "peace of mind". Now the same banks face a bill running into £8 to £10 billion in compensation for mis-selling PPI.
Vetting new products
The new Financial Conduct Authority which will take over controlling retail finance in 2013 from the Financial Services Authority has proposed a degree of pre-vetting to prevent products that could be harmful from sale. Financial firms including high street banks say this will stifle innovation and competition.
But if they don't like that, they will positively hate a new proposal by two University of Chicago academics which calls for Big Finance to be treated like Big Pharma.
Eric Posner and Glen Weyl want financial products to be pre-tested before they are allowed to go on sale in the same way that pharmaceutical firms have to test new drugs (including variants of existing medicines) for long periods – often a decade – before they can be prescribed. Big Pharma remembers Thalidomide, a drug which caused serious birth deformities when given to pregnant women. The compensation bill was enormous.
Other industries must also test products to an externally applied standard before selling them – cars and electronics are examples.
The Chicago duo wants financial products to be tested by equivalent organisations to those that licence medicines to root out harmful schemes. Their present proposal is aimed at "limiting speculation on derivatives" but could easily be extended to consumer plans, many of which are built around futures, options and other derivatives. It is the very opposite to the "light touch regulation" that banks and other businesses claim is necessary for success. They say the banks should show products are useful for the wider society they should serve rather than exist for the delight and entertainment of traders.
Speculation no, hedging yes
The authors attempt to draw a line between speculation and hedging (or insurance against an unforeseen event such as a crop failure). It is not always an easy demarcation. Marine insurance is usually seen as having a social utility. But it was not that long ago that "tonners" enabled anyone to take a bet on a ship reaching port safely. You could have gambled on the equivalent of a cruise liner. You can't because you now have to show an "insurable interest" – as an owner. Life insurance has been abused in the UK as a tax avoidance tool. It too must now pass an "insurable interest" screen otherwise anyone could take out cover on anyone else.
New regulatory agency
The idea is to set up a regulatory agency to screen new products before it can be marketed. Tests could include social utility or, for retail plans, the balance between seller and buyer. So what role does the product play in the allocation of capital or what does it do to create "positive informational externalities" (revealing information about underlying events which could not otherwise be discovered).
The agency would have criteria that would need to be met – a form of screening that would be quicker and cheaper than the long drawn out drug approval process. But it would still be more costly and slower than the current unregulated product introduction. The process would be transparent.
The analogy with medicine is because most consumers, including the sophisticated, do not understand the mechanisms of financial plans or of pharmaceuticals. The authors suggest that "the dangers of financial products seem at least as extreme as the dangers of medicines" with individuals and society at risk.
Products could be licensed only for certain groups just like drugs may be permitted only for men or only for animal use.
The banks won't buy it
Banks are, despite their innovative products, inherently conservative. They will not like any constraint on their present freedoms. Critics of pre-vetting say:
Light touch regulation for Big Pharma?
Turning the academics' argument on its head would lead to Big Pharma having the same product fre
edom and light touch regulation as Big Finance. Go back far enough, and pharmacies sold untested drugs, opium, and cosmetics with metals and other dangerous materials. And go back far enough and pharmaceuticals lobbied against regulation using many of the same arguments as the banks' defenders.
Insurable interest test
The academics conclude: "One of our goals is to establish a more sophisticated version of the insurable interest rule that will block speculation while permitting socially valuable hedging." They point out that regulators already exist in most jurisdictions. Now they want them to protect by pre-vetting products.
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