Inspire Bank Regulators with a Drug Experience

Monday, September 19, 2011 7:00 PM

How to prevent the next debacle in financial markets? The debate continues but little substantive action has been taken to prevent a systemic relapse. In an abject failure of leadership, governments and politicians have so far simply missed their historic opportunity to impose reforms, bowing to the banks whose businesses they seem not to understand, and whose lobbying continues unchecked.

Great to ringfence commercial banking, but what about the bank businesses outside the barrier, the ones that triggered collapse? How should those activities be patrolled? Maybe regulators should look at another industry for inspiration.

How about drugs? The legal ones, that is.

Finance and pharmaceuticals have lots in common. Hotbeds of innovation and magnets to creative minds, both industries have played major roles in the economies of developed nations. Like global investment banks, big pharma companies engage in highly sensitive undertakings requiring management of complex global networks that interface with clients and authorities at all levels of governments. Banks interconnect across their networks with financial systems; pharma companies with healthcare infrastructures.

Similarities, yes, and striking differences. After all, few people question the social utility of the pharmaceutical companies, competing as they do to develop new products that improve lives for rich and poor. While the world reeled from its economic meltdown, devastating lives and livelihoods everywhere, we all made it through another year protected from plague and without a major systemic mishap related to effects of dangerous medicines.

What is it about finance and pharmaceuticals, then, that has led to such wildly divergent fates of volatility and excess, on the one hand, and stability and responsibility on the other?

Well, for one thing, regulation.

The research that goes into the creation of a new drug requires extensive investment and rigorous, even onerous review before approval by an organization like the US Food and Drug Administration. This requirement for approval applies not only to consumer products but also to drugs and therapies prescribed by doctors and hospitals. These are the institutional buyers, if you will: qualified, intensively trained and savvy in their fields.

In finance, investment banks devise new products and then determine themselves that their contractual inventions comply with law and are suitable for clients. Without centrally regulated approval processes, financial instruments launch and transact in a marketplace that has no corollary in the legal drug industry. There, away from the exchanges and their readily available prices, take place the biggest trades, the ones that proved most toxic in the financial crisis.

Financial products are structured and customized, often with minor variations that make them unique or nonstandard. Their nuanced complexity creates the value, goes the argument, with reams of documentation to protect synthetic intellectual property. As a byproduct of this, the markets these instruments trade in are predestined to be illiquid and opaque, cluttered with innumerable, inscrutable products. Add these ingredients together, stir well and wait patiently for the next meltdown.

Bankers hasten to note how heavily regulated they are, bemoaning rules they claim hinder competitiveness. But measured against their counterparts in pharmaceuticals, many bank businesses are self-regulated. In pharma, new products are approved - or not - by an independent regulator. In finance, banks’ in-house counsel review new products before compliance departments rubber stamp them to trade.

What if the process for bringing a financial product to market resembled the launch of a drug?  A central tenet of such a regime would be that trading in new financial products could not occur until approved by an appropriate regulatory body.

That government agency would insist on seeing risk analyses and side effects. It would consider the distribution plans for new deals to assess their safety and suitability against any possible toxicity. Officials would insist, as they do with drugs, that any new product exhibits demonstrable benefits relative to others already approved, lest the marketplace saturate and become needlessly complex.

The same regulator would maintain central databases of product information and well-documented systems and processes for product approval. That standardization would lend itself to more transparent pricing and liquidity, not to mention central clearing to mitigate the counterparty risk that featured so ominously in AIG and Lehman, among others.

Would a regulated product approval process stifle innovation in finance? Maybe, but the fundamental questions are the same as for pharmaceuticals. What is the optimal process? What room should be granted for experimentation? What risks should be allowed for a greater good?

There may even be other benefits to such a regulatory regime. Investment banks run lucrative businesses (like Delta One) to “optimize” their clients’ taxation. Would these be allowed, given many banks’ recent dependence on taxpayer money? Would bailed out banks be approved to conduct business offshore or through “special purpose vehicles” that benefit from existing outside specific tax and regulatory regimes? Vigilant overseers might raise the alarm if approval were on the critical path to market, but it isn’t.

Consider the fallout if a major pharmaceutical company conducted themselves that way, intentionally exploiting loopholes to distribute drugs inappropriately. “Sure, we now know a side effect of this treatment is to shut down metabolism in healthy teens, but technically it was legal to manufacture in Singapore and distribute from the Channel Islands.”

Although the intention of instituting a formal approval processes for financial products would be to ensure ongoing financial stability, one could reasonably expect side effects. Reduced financial sector volatility? Yes. Reduced bank profitability? Sometimes. Compensation?

Legislating product approval processes would narrow the compensation gap between banking industry professionals and their counterparts in pharmaceutical and other industries. But when we consider our future financial freedom and the environment in which we raise impressionable children, is that side effect so adverse?

Probably not. Applying the correct regulatory oversight would eliminate the “career arbitrage” that has led a generation of talent to eschew more productive fields for the rich rewards of investment banking. Time to fix that.

Here’s hoping the politicians forgo the next round of bank lobbyists’ drinks to consider how profound are the effects of even subtlest policy. If they want to stabilize the financial system and lay the foundations for a real recovery, the path ahead invites deliberate steps.