ben s bernanke : regulation and financial innovation remarks by mr ben s bernanke, chairman of the board of governors of the us federal reserve system, to the federal reserve bank of atlanta's 2007 financial markets conference, sea island, georgia ( via satellite ), 15 may 2007. * * * good morning. i'm pleased to be able to join you for this year's financial markets conference, albeit from afar. last year the focus was on hedge funds, and the main theme of this year's gathering is credit derivatives. this pairing makes eminent sense, in that 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. both of these developments have also been the subject of public policy debates, including calls for increased regulation. in my remarks today i will address, from the 30, 000 - foot level, the challenges that financial innovation poses for public policy and the nature of the appropriate regulatory response. 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. 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. 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. clear thinking is therefore essential. in developing a regulatory framework, we need to be explicit both about what the public policy objectives of regulation are and about how, if at all, fresh developments threaten to undermine those objectives. we should also take into account the role that the market itself can play in controlling risks to public objectives ; as i noted last month, market discipline can be an important element in a well - functioning regulatory scheme. and as i have already observed this morning, any regulatory changes should fulfill the test of consistency, across both institutions and instruments. ensuring a consistent approach in thinking

capacity and is not overly reliant on unstable short - term funding. yet, even if the risk of financial system disruption does not seem high, it well remain true that if the economy weakens, some businesses may default on this debt, potentially leading to a contraction in investment, a slow - down in hiring, and possibly to an unusual tightening in financial conditions. these concerns highlight how cyclical factors influencing monetary policy borrowers may overlap with financial stability considerations. how monetary policy can influence financial stability let me begin by laying out how monetary policy can influence financial stability. monetary policy, operating primarily through adjustments in the level of short - term interest rates, has powerful effects on the entire financial system. a more accommodative monetary policy lowers interest rates across the maturity spectrum. the textbook result is that mortgage rates and corporate borrowing rates, among others, decline ; equity prices rise ; and the dollar exchange rate depreciates. in other words, financial conditions broadly ease, spurring households to buy more and businesses to invest and hire, thereby supporting economic growth and price stability. 2 monetary policy, however, if too accommodative, may lead to a buildup of financial vulnerabilities. these incentives arrive through a number of channels. for instance, low interest rates reduce 1 / 4 bis central bankers'speeches the cost of borrowing, and so may prompt businesses and households to overborrow. low rates may lead to a speculative bubble by compressing risk premiums for assets — such as equity, corporate bonds, and housing — and potentially leading investors to extrapolate price gains into the future in a bout of irrational exuberance. low rates may also squeeze the profitability of financial intermediaries through narrow interest margins and other factors. in turn, these intermediaries as well as investors that had promised fixed nominal rates of return — such as insurance companies and pension funds — may “ reach for yield, ” or take on more credit or duration risk in their portfolios in order to maintain high returns. taken to extremes, this story often does not end well. periods of excessive leverage, rapid credit growth, or buoyant credit market sentiment increase the risk to economic growth. 3 these dynamics point to the possibility that accommodative monetary policy, while necessary to support activity during the early stages of an economic expansion, may also increase vulnerabilities in the financial system, especially if maintained for too long. these vulnerabilities weaken