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Scoring investment risk

June 29, 2009

The Bank for International Settlements is thinking the right way in calling for a global standard of ranking financial instruments based on their risk and suitability for different kinds of investors.

The BIS Annual Report argues that financial instruments, markets and institutions all require reform if a truly robust system is to emerge. For instruments, it means a mechanism that rates their safety, limits their availability and provides warnings about their suitability and risks.

One way to do that would be to require investment houses to slap a Surgeon General cigarette-style warning on every exotic security that gets peddled to retail investors.  This warning would be attached to every piece of marketing material for a financial product, disclosed by brokers everytime they pitched the security and prominently displayed on every investor account statement.

For instance, the warning on a structured note could read something like this: “Even though this security is marketed as principal protected, you could still lose everything if the bank that issued it goes bust. Additionally, structured notes generate fat fees for the both the issuing bank and the bank that sells them. In many cases, an investor could achive the same asset exposure by buying a basket of stocks, commodities etc. on his or her own.”

Let’s hope this idea from BIS is adopted by the SEC and the new consumer financial protection agency the Obama administration wants to create.

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