An FDA for financial products

(breakingviews.com) -- FDA style regulation: Imagine this speech from a pharmaceutical marketing manager. "This new drug is designed to work well, but we haven't tried it out yet on real people. Of course, there could be terrible side effects, but wait and see. One thing's for sure, though. There's money in it for our company."

Regulators try to make sure drug makers don't work that way. But it's still pretty much standard practice in finance. During the credit boom, banks raced to create products with good margins but no clear economic purpose - and high risks for buyers and the whole financial world. Regulators mostly stood by idly.

It's time for a change. Tough standards for individual product certification should be part of the financial regulators' plan to establish a safer and sounder global banking system. The mantra in pharmaceutical regulation is "safe and effective". That's a good approach for finance too.

Safety in finance doesn't mean "no losses". Rather, high-risk products shouldn't get in the wrong hands. Regulators have long realized this. That's why small retail investors can't buy hedge funds. But many complex products - especially those that involve high leverage - are so unsafe that they should fail the risk-reward safety test for any investor.

Regulators should also look at group safety. One credit default swap isn't dangerous, but an uncontrolled CDS market that is bigger than the world's GDP is structurally unsafe.

Of course, banks and rating agencies have always done their own product safety tests for financial products. But they have consistently been too optimistic. Commercial considerations seem to have led the industry's in-house testers to underestimate the probability of - and danger from - extreme events. Regulators should be much tougher.

It isn't always easy to say what financial products are effective. Great claims were made about the ability of securitizations to spread risk more efficiently, but the benefits were vastly exaggerated. Similarly, credit insurance was supposed to give lenders more confidence, but many of the suppliers of this insurance - such as the monolines and American International Group - offered more supposed protection than they could afford.

A new Financial Product Safety Commission would have one advantage. All the basic financial products have already been proven effective by the test of time. Bonds, shares and old-fashioned banking and insurance did a good job at building a global industrial economy. Also, some newer securities in the futures and derivatives markets have probably been around long enough to be grandfathered in.

But the suite of existing products already does what finance is supposed to do - gather and allocate capital, amortize risks, provide fair returns. That leaves less room for helpful innovation. In finance, much of what is new is likely to be snake oil.

So regulators should be skeptical about claims that the latest proposed artifact of financial engineering has economic value - especially any financial widgets which are highly profitable for the producer or which allow buyers to put up less capital.

Financial regulators should borrow some tricks from their pharmaceutical peers. Animal trials are out - rats can't buy collateralized loan obligations. But new products should be tested on small groups of customers. And approval should always be tentative. Design flaws sometimes only emerge over time. If there are faults, the products should be scrapped or re-engineered with better safeguards. When it comes to stopping financial excess, it's better to be a little late than to wait for disaster.

--The above opinion is the personal view of Edward Hadas.