The best way to regulate a world of increasingly complex financial instruments is to pursue broad principles without stifling innovation, U.S. Federal Reserve Chairman Ben Bernanke said last week.
Bernanke said that in responding to the challenges of rapidly evolving financial markets, regulators need to keep in mind the economic advantages that hedge funds and investments such as credit derivatives provide by helping to diversify risks.
“We should always keep in view the enormous economic benefits that flow from a healthy and innovative financial sector,” he said in remarks prepared for a financial markets conference in Sea Island, Georgia.
In his speech, Bernanke specifically addressed the growth of credit derivatives, financial instruments that derive their value from the bond market.
Big Concerns
Billionaire investor Warren Buffett has warned of the risks of such investments, calling them “financial weapons of mass destruction.” Recently, concerns have been raised about one segment of this market, investments backed by subprime mortgages, because of a sharp rise in mortgage defaults.
Bernanke cautioned against over-regulation of specific problems, saying that it was important to allow financial markets the room to innovate.
He made a similar argument in a speech last month concerning hedge funds, saying that a market-based approach was the best way to regulate the trillion-dollar hedge fund industry.
“The increasing sophistication and depth of financial markets promote economic growth by allocating capital where it can be most productive,” Bernanke said in the speech last week, copies of which were distributed in Washington.
“When proposing or implementing regulation, we must seek to preserve the benefits of financial innovation even as we address the risks that may accompany that innovation,” he said.
General Rules
Bernanke did not specify any area where he thought increased regulation was necessary. Rather, he laid out certain principles that regulators should follow in considering new rules.
“We should strive to implement a regulatory regime that is principles-based, risk-focused and consistently applied,” he said.
Bernanke’s comments were delivered by satellite to the conference, which was sponsored by the Federal Reserve Bank of Atlanta.
In his remarks, he reminded the group that at last year’s conference he had cautioned against adoption of a proposal that would have sought to better regulate hedge funds by developing a database of the holdings of various hedge funds.
He said he still held the view that creating such a database would be extremely difficult given how quickly hedge funds can change their holdings.
He also said the effort by regulators to create such an information base would give investors in hedge funds a false sense of security that regulators had been able to reduce the risks they were facing.
Bernanke is a member of the President’s Working Group, formed after the 1987 stock market crash to provide recommendations on ways to improve market regulation. That group recently concluded that what the hedge fund industry needed was increased vigilance on the part of investors rather than new government rules.
Critics, however, contend that large hedge fund failures, such as the collapse last fall of Amaranth Advisors, point to the need for tighter government regulations.
In his speech, Bernanke said it was appropriate for the conference to have focused on hedge funds last year and to be examining credit derivatives this year.
“The increasing prominence of hedge funds and the growth of the market for credit derivatives are both aspects of the remarkable wave of financial innovation that we have seen in recent years,” he said.
Bernanke said that it was important for the Fed and other regulators to resist the calls to develop rules that are too specific.
“We should strive to develop common, principles-based policy responses that can be applied consistently across the financial sector to meet clearly defined objectives,” he said.
