You are here: Home Knowledge Base Economy Balancing Risk Taking and Financial Regulation Solutions Consider establishing an institution with the power to approve or reject new financial products in accordance with their forecast systemic risks
Symposium 2009

Solution for Balancing Risk Taking and Financial Regulation

The Challenge

Many observers blame excessive risk taking and inadequate regulation as the core causes of the current global financial crisis that we have been witnessing.

Many observers blame excessive risk taking and inadequate regulation as the core causes of the current global financial crisis that we have been witnessing.

Consider establishing an institution with the power to approve or reject new financial products in accordance with their forecast systemic risks

The purpose of the institution is to assess, detect, and prevent adverse economic effects of financial products. The originators of new financial products would be required to submit the relevant information about expected benefits and adverse side-effects, of new financial products and these products could be launched only with the institution’s approval.

These tasks could be conducted by an existing body (such as a central bank) or a new establishment. The institution would collect information about these products, analyse the systemic risks that they may generate, and submit the systemically relevant institutions that offer these products to the relevant stress tests.

The onus of proof concerning the safety of a new financial product would lie with the originator. In these respects, the institution would serve an analogous function to the US Food and Drug Administration and the European Medicines Agency working with the national competent medicines authorities.

The activities of the institution are meant to ensure that new financial products are not toxic and do not have perverse effects on the economy. With the benefit of this work, the solvency of systemically relevant financial institutions should become straightforward to assess. In this area, this work would effectively replace that of the rating agencies.

Clearly, the practical success of the institution would depend on its ability to find an appropriate path between the dangers of allowing excessively risky projects and of preventing useful financial innovation. Inevitably, the FVA will make both Type I errors (rejecting new financial products that generate a net gain to society) and Type II errors (accepting new financial products that generate a net loss to society). The important policy decision is to define the rules of the institution so that the size of each of these errors is minimized and the balance between them is clearly in the public interest.

    Implemen- tations

    Implementation
    Symposium 2009

    New control mechanism in EU financial markets

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