Financial guidance from FDA

NEW AND UNTESTED products have an infamous history. The German dream of hydrogen zeppelins, and dozens of lives, burned up over New Jersey in the Hindenburg disaster. The craze for radium water quickly decayed as radiation poisoning took the lives of the cure's chief evangelists. Yet, as the world has painfully discovered over the last months, it would be hard for any of these to match the destructive scope of cutting-edge financial derivatives.

Collateralized Debt Obligations, Collateralized Mortgage Obligations, Credit Default Swaps, volatility and correlation swaps, and other exotic derivatives have, to some extent, expanded the ways investors can hedge their risk, allowing productive risk taking and entrepreneurship.

They have brought the sorts of benefits expected of any new technology. At the same time, though, they have engendered many of the problems that have brought the global financial system to the brink of collapse. Banks have passed on dodgy loans in bundles to unrelated investors without many questions asked.

Mutual fund investors have ended up holding supposedly safe tranches of mortgage pools that collapsed as soon as house prices fell. Investment banks have raced to demonstrate their sophistication by buying up assets they do not understand and cannot control.

What can be done to control the spread of these "financial weapons of mass destruction"?

A long-established agency of the federal government deals daily with the regulation of complex, confusing, and innovative products, and may provide guidance: the Food and Drug Administration. Its pre-approval process for prescription drugs makes sense because of several features of the pharmaceutical industry, most of which are shared by the financial sector.

The hazards of many consumers using untested medication are severe, but perhaps no more so than those posed by toxic financial instruments. The epidemiological effects of misuse of antibiotics or other medications are troubling, but the systemic risks of financial contagion are at least as serious. The enormous incentives drug companies have to market their cures would certainly be corrosive in the absence of an independent arbiter, but financial innovators certainly stand to gain as much from propagating their inventions, regardless of their social value. Most important, new financial products, just like medicines, are very difficult to understand without concerted, focused, expert, and independent analysis. Such analysis is a public good and will not be supplied by a free market.

Only a prospective system, based on pre-approval, will allow the foresight to prevent a new crisis.

Such a system should be global, or surrounded by clear borders, to prevent nonparticipating nations from becoming havens for illicit activity. It should be adversarial, forcing innovators to justify in a transparent way the contribution their products will make to the health of the financial system in the face of an appointed devil's advocate. It should be relatively cheap, making use of available economic data. It should be arbitrated by a group of independent specialists. It would probably require some system of intellectual property for financial innovators to protect them during the process.

And, crucially, it should implement its decisions flexibly. Blanket approvals or prohibitions may be appropriate, at least for a period of time, to protect individual investors from shifty mutual fund managers and corrupt or incompetent rating agencies. But a sensible process would allow more flexibility to banks. For example, during pre-approval, a capital requirement for holding innovative assets, based on pessimistic assessments of worst-case scenarios, could be set, and lowered only as investors and regulators gained experience with the product.

National and world leaders should make a pre-approval process for financial innovation a centerpiece of the new global financial infrastructure they will create in the coming year. The details of such a system will undoubtedly be complex. But with rising unemployment on Wall Street and the world focused on reforming global finance, the talent needed to design and implement such a system is more available than ever.

Glen Weyl is a junior fellow in the Harvard Society of Fellows at Harvard University. He is also a post-doctoral fellow in Harvard's Department of Economics.