Financial products should undergo registration like medicines to curb investor access until safety is proven, the Bank for International Settlements said on Monday.
Policymakers were alarmed at how opaque and complex securitized products collapsed in value as the credit crunch began unfolding from mid-2007, despite being highly rated. This sparked huge writedowns by banks that shattered investor confidence.
In a scheme analogous to the hierarchy controlling the availability of pharmaceuticals, the safest securities would, like non-prescription medicines, be available for purchase by everyone, the BIS, which acts as a forum for the world's central banks, said in its annual report.
Next would be financial instruments available only to those with an authorization, like prescription drugs; another level down would be securities available only in limited amounts to pre-screened individuals and institutions, like drugs in experimental trials, the BIS said.
Finally, at the lowest level would be securities that are deemed illegal.
A new instrument would be rated or an existing one moved to a higher safety category only after successful tests.
Such a registration and certification system creates transparency and enhances safety ... This will mean that issuers bear increased responsibility for the risk assessment of their products, the BIS said.
Access to some products is already restricted in some countries, such as to hedge funds, while the Netherlands, Greece and other states impose restrictions on how big a mortgage a consumer can have on a property.
Critics say an all-encompassing financial product classification system would stifle innovation and it should be up to customers to decide.
Our hope is that people will take this up and evaluate whether or not it's worth pursuing, BIS chief economist, Stephen Cecchetti, told a news conference.
There has to be some mechanism for the evaluation of suitability and riskiness of instruments, especially as they become more widely traded, Cecchetti said.
EU financial rules already require banks and brokers to ensure some clients meet a suitability test but attitudes are changing even among the more traditionally liberal regulators.
Britain's Financial Services Authority is mulling whether it should regulate retail and wholesale products, a shift from its past stance that a properly run firm won't offer risky products.
And the Obama administration has proposed a new consumer protection agency to regulate products but the banking industry, sensing a potential threat to profits, is fighting back hard.
DERIVATIVES, RISK CHARGE
Policymakers are tightening financial rules in a process spearheaded globally by the Group of 20 industrialised and emerging market countries.
The BIS endorses many of the pledges the G20 made in April such as the need to monitor all parts of the financial market, particularly system-wide risks, to limit tendencies to amplify rather than counter the prevailing trend, and to insist on the clearing of off-exchange traded derivatives.
Policy interventions should combine outright bans with regulations that bump up the cost of risky activities, it said.
The BIS goes a step further than the G20 by suggesting shifting off-exchange traded instruments onto exchanges. The primary advantage of taking this step is that it ensures price transparency with less reliance on market-makers, the BIS said.
It proposed a bespoke systemic capital charge on each bank to reflect the risk it posed to the wider financial system as well as a minimum leverage ratio, another regulatory tool other policymakers have aired.
The BIS also backed calls for all financial institutions to have a bankruptcy contingency plan.
The G20 wants banks to build up buffers of capital during good times for tapping when markets turn sour, thereby lessening the likelihood of more taxpayer funded bailouts.
The BIS cautioned that one difficulty was knowing when banks should start building up a buffer, which would make lending more costly, and when reserves can be tapped to promote lending.
Yet another problem with implementing a countercyclical charge is that it is not 'one size fits all', the BIS said.
Central bankers also needed to adopt a more activist stance to booms in both credit and asset prices.
The issue is how monetary policymakers should expand their frameworks to make room for property prices, equity prices and amounts of debt outstanding, the BIS said.