Leave hedge funds alone, Fed chairman says

At least until they crash -- then bail their big creditors out?

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Market Principles Should Top New Rules, Bernanke Says

From Reuters
Tuesday, May 15, 2007

http://www.reuters.com/article/governmentFilingsNews/idUSN1538553520070515

WASHINGTON -- Federal Reserve Board Chairman Ben Bernanke on Tuesday argued in favor of developing a British-style, principles-based approach to U.S. financial market regulation rather than new rules for each new financial instrument or institution.

In remarks prepared for delivery via satellite to a financial markets conference sponsored by the Atlanta Federal Reserve Bank in Sea Island, Georgia, Bernanke did not address Fed monetary policy or the U.S. economic outlook. The text of his address was made available in Washington.

He said the rapid growth of the credit derivatives market and the increasing prominence of hedge funds did not warrant specific regulation to address possible risks that they pose.

"I will argue that central banks and other regulators should resist the temptation to devise ad hoc rules for each new type of financial instrument or institution," Bernanke said. "Rather, we should strive to develop common, principles-based policy responses that can be applied consistently across the financial sector to meet clearly defined objectives."

Bernanke said development of a principles-based approach is consistent with recent U.S. guidance on hedge funds, which did not call for any new regulations to mitigate potential risks that the massive pools of capital pose to the financial system and economy.

Instead the guidance, developed by the U.S. Treasury Department, the Fed, the Securities and Exchange Commission, and other regulators, suggested that those risks would be kept in check by market discipline, due diligence by hedge fund creditors, counterparties, and pension funds, and with adequate disclosures to sophisticated investors.

Bernanke said the hedge fund guidance makes clear that regulators and supervisors should adopt a principles-based approach similar to that used by Britain's Financial Services Authority, with a regulatory focus on the areas with the biggest potential risks.

He said the guidance emphasizes that "risks to financial stability are best addressed by focusing our attention on the large institutions at the core of the financial system." These firms also happen to be the leading dealers in credit derivatives markets and the principal counterparties and creditors of hedge funds, he noted.

The application of rules is consistent with a principles-based approach, Bernanke said, noting that the FSA has an 8,500-page rulebook to support its 11 main regulatory principles. In fact, rules can provide clarity or a "safe haven" from legal and regulatory risks, but they "should implement principles rather than develop in an ad hoc manner," he added.

Bernanke said a narrowly focused approach to regulation could provide incentives for "regulatory arbitrage," driving investors to less-regulated financial instruments if rules are not applied consistently to instruments or institutions that pose risks for policy objectives.

He said the biggest objectives should be ensuring financial stability, investor protection and preserving the integrity of the market.

Rapid financial innovation has presented challenges to these objectives, particularly with the complexity of contemporary instruments and trading strategies, the potential for market illiquidity to magnify the riskiness of such instruments and the greater use of leverage that they often entail.

A principles-based approach would be better than ad-hoc rules for addressing such risks and taking into account financial innovations.

"To avoid moral hazard and let market discipline work, investors must be allowed to bear the consequences of the decisions they make and the risks they accept. But investors are entitled to the information they need to make decisions appropriate to their personal circumstances," Bernanke said.

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Join GATA
at the
World Gold, PGM, and Diamond Investment Conference
in Vancouver, British Columbia, Canada
Sunday and Monday, June 17 and 18, 2007

http://www.cambridgeconferences.com/ch_june2007.html

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