Opinion and Economic Analysis

HICKS: UL model could fix financial regulation morass

June 2, 2012

Hardly anyone who has an opinion on the matter believes our country has struck the right balance in regulatory oversight of our financial industry. Oftentimes, that would be good news, since widely shared disappointment is frequently the hallmark of successful compromise.

We need a compromise that preserves innovation and mitigates the tendency for the sort of moral hazard that fueled the last recession.

Sadly, I think we have settled on exactly the wrong set of regulations. Emerging financial rules strangle innovation while doing nothing to prevent the sort of publicly insured financial meltdown that still burdens our economy.

So why is that, and what should we do?

Changes to financial regulations largely have been focused on expanding the reach of new and existing regulatory agencies, but these smart, engaged public servants are outgunned. The starting salary for a newly minted analyst at a top Wall Street firm is competitive with that of the secretary of the U.S. Treasury.

Relying on educated, dedicated men and women to choose public service at half the going salary is hardly a long-term strategy for success. No matter how hard we try, federal regulators are not going to have a sufficient grasp of the intricacies of new financial instruments. The best they can do is put brakes on the entirety of financial markets—something that risks simply slowing the economy without reducing risk.

On the flip side, we still insure lost loans and guarantee large banks from stupendous losses. This promotes risky behavior in a regulatory environment that makes insufficient distinction between a $32,000 savings account and a $32 million private equity fund. I propose a radical change.

The complex nature of financial instruments makes them much like a prescription drug or electrical appliance. The quality and associated risks cannot readily be judged by even highly educated persons outside that narrow field.

Assessing efficacy in prescription drugs is done by scientific researchers, but financial instruments are more like electrical appliances. The efficacy is easy to judge (does the toaster work or does the instrument make money?), but what really matters is the risk involved.

Here we ought to use the Underwriter’s Laboratory model. Founded in 1894, Underwriters Laboratory is a not-for-profit that has rendered the most potentially dangerous item in our homes (electrical current) nearly benign through rigorous third-party testing. And as a private agency, it can pay market wages for the research talent it requires.

A financial Underwriters Laboratory could function the same way. New financial services and products (like those toxic assets) would have to meet standards set by a not-for-profit regulator before they could be traded by FDIC-insured financial organizations. The cost of the testing would be borne by financial firms, not taxpayers, and the FDIC would still have a final say.

I know this is not a perfect plan, but it is better than what we have now.•

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Hicks is director of the Center for Business and Economic Research at Ball State University. His column appears weekly. He can be reached at cber@bsu.edu.
 

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