ben s bernanke : financial regulation and the invisible hand remarks by mr ben s bernanke, chairman of the board of governors of the us federal reserve system, at the new york university law school, new york, 11 april 2007. * * * market forces determine most outcomes in our economy, a fact that helps to explain much of our nation ’ s success in creating wealth. markets aggregate diffuse information more effectively and set prices more efficiently than any central planner possibly could. the result is powerful competitive incentives for businesses to produce, at the least cost, the goods and services that our citizens value most. writing in the eighteenth century, adam smith conceived of the free - market system as an “ invisible hand ” that harnesses the pursuit of private interest to promote the public good. smith ’ s conception remains relevant today, notwithstanding the enormous increase in economic complexity since the industrial revolution. although the market system is the principal source of america ’ s economic dynamism, economic theory and practice both suggest that targeted government regulation and intervention can sometimes benefit the economy. in the particular case of financial markets, for example, government regulation helps to promote general financial stability and to protect investors and consumers against fraud. of course, the benefits of regulation come with direct and indirect costs. direct costs include those arising from compliance with a thicket of complicated rules – costs that can add significantly to a firms ’ costs of production, leading to higher prices for consumers. indirect costs include reductions in innovation or competition that can result from overly restrictive regulations. therefore, before government decides to regulate in a particular situation, it must weigh the social costs and benefits of the contemplated intervention. in recent decades, public policy has been increasingly influenced by the insight that the market itself can often be used to achieve regulatory objectives. for example, in the area of environmental protection, the trading of emissions permits has been widely embraced as a cost - effective means of controlling pollution. that market - based approach is regulation by the invisible hand, as opposed to the very visible hand of direct government regulation and enforcement. the invisible - hand approach to regulation aims to align the incentives of market participants with the objectives of the regulator, thereby harnessing the same powerful forces that allow markets to work so efficiently. in the financial arena, as i will discuss, this approach often takes the form of creating incentives for market participants to monitor and control the risk - taking behavior of financial firms – that is, to exert market discipline – thereby reducing the need for direct oversight by

interaction between industry and regulators. this industrya€ “ regulator interaction must allow for feedback and information sharing throughout the innovation life cycle and incorporate regulatory feedback on innovation. there is more that can be done to accomplish this. while we should expand opportunities for regulators to provide clear, actionable, and timely feedback on innovation proposals, we should also consider developing regulatory " sandboxes, " those designed to allow some degree of testing and experimentation. we should also ensure our regulatory staff understands and appreciates the value of responsible new technologies, so they may contribute to crafting a sensible regulatory approach to financial innovation. the more that regulators understand innovation, the more comfortable they will be in accepting and promoting its adoption in the financial system. as part of this framework, we also must consider the broader financial system. the " regulatory perimeter " between regulated banks and other parts of the financial system is a permeable barrier, and not only can activities shift between the two - as we saw with the migration of mortgage servicing in the united states - but risk can shift between the two as well. as our financial system has grown and become more complex over time, it has also become much more interconnected. banks often have direct exposure to activities and risks that occur in other parts of the financial system. even when they do not have direct exposures, they may have indirect exposures to financial stability risks originating in other parts of the financial system. closing thoughts 7 / 8 bis - central bankers'speeches the most unfortunate approach to innovation would be to simply prohibit it, or to impose such onerous standards that effectively discourage innovation or prevent it from developing and flourishing. this approach would not only decrease the importance and relevance of the banking system, but it could also generate new financial stability risks as activity migrates to areas with lower regulatory standards and less transparency. broadly speaking, the regulatory framework should be dynamic, one that can and should accommodate new technology and services. where the same underlying activity presents the same risk, there is a strong case to be made for imposing the same type of regulation. but we must successfully balance the standards that protect households and businesses and prohibit criminal and other illicit financial activity with maintaining the safety and soundness of individual financial institutions and the stability of the broader financial system. we must also prioritize working on a whole - of - government approach to ensure we appropriately monitor and manage the risks of financial activity, no matter where those occur. as we continue to enhance our understanding, my hope is that we