Bernanke on Financial Innovation

♠ Posted by Emmanuel in at 5/16/2007 03:48:00 AM
Federal Reserve Chairman Ben Bernanke delivered a speech fit for an archetypal two-handed economist on the topic of financial innovation. Do these newfangled derivatives used by hedge funds and the like pose a threat to the health of the global financial system? On one hand you have sunny-side Ben singing stock neoliberal praises for financial innovation:
In addressing the challenges and the risks that financial innovation may create, we should also always keep in view the enormous economic benefits that flow from a healthy and innovative financial sector. The increasing sophistication and depth of financial markets promote economic growth by allocating capital where it can be most productive. And the dispersion of risk more broadly across the financial system has, thus far, increased the resilience of the system and the economy to shocks. 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.
Then Bernanke displays a more cautious side in advocating government's role:
Complexity, illiquidity, and embedded leverage also create challenges for policymakers with respect to the objectives of protecting investors and maintaining market integrity. If hedge funds and the large banks that are hedge funds' counterparties and creditors have difficulty assessing the risks associated with complex financial instruments, many investors will find gaining a sufficient understanding of the risks even more burdensome. Investors may also not appreciate the extent to which they may have multiple exposures to the same source of risk--for example, arising from effective exposures to the same hedge fund through funds of funds or from investments in different funds with similar trading strategies. Current restrictions on hedge fund investors, which limit direct investors to institutions or wealthy individuals, reflect the recognition of the difficulties that a retail investor would face in adequately assessing these types of risk. But as instruments and trading strategies become more complex and intertwined, even the most sophisticated investors will be challenged to make reliable judgments about their risk exposures. Likewise, complex and difficult-to-value financial instruments could be exploited as vehicles for profiting from insider trading or market manipulation, although, as history shows, simpler instruments can be used in this way as well. Policymakers must be confident of their ability to detect such market abuses when they occur.
Ultimately, Bernanke's suggestion is to emulate the British approach:
How best to respond to these daunting challenges? As I noted, there are powerful arguments against ad hoc instrument-specific or institution-specific regulation. The better alternative is a consistent, principles-based, and risk-focused approach that takes account of the benefits as well as the risks that accompany financial innovation.

Some commentators have sought to draw a sharp distinction between the approach to financial regulation in the United States and that in the United Kingdom. These observers have characterized the British approach as being principles-based and as using a "light touch"--the implication being that these two features somehow go together. In a speech in February of this year, Sir Callum McCarthy, the head of the United Kingdom's Financial Services Authority (FSA), took issue with this interpretation.1 Sir Callum confirmed that the FSA's approach is built on a framework of principles, although he noted that the FSA also has an 8,500-page rulebook to accompany the eleven principles it has laid out. But the FSA head rejected the view that their approach is "light touch." Rather, he said, it is risk-based, which means that regulatory resources and attention are devoted to firms, markets, or instruments in proportion to the perceived risks to the FSA's regulatory objectives.