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Bernanke: Innovation Needs Regulation

Federal Reserve Chairman Ben Bernanke said Friday that financial innovation is good for the economy but must be accompanied by proper regulation.

New financial products, such as subprime mortgages and structured investment vehicles, have become symbols of the economic crisis. The challenge for the government is to come up with regulations that protect consumers without stifling innovation, the Fed chief said.

"As we have seen all too clearly during the past two years, innovation that is inappropriately implemented can be positively harmful," Bernanke said in a speech to a Fed conference. "It would be unwise to try to stop financial innovation, but we must be more alert to its risks and the need to manage those risks properly."

The central bank already is moving in that direction. The Fed and other regulators last year put forward credit card rules that were seen as the biggest clampdown in decades, seeking to protect consumers from companies that arbitrarily raise interest rates or don't give borrowers adequate time to pay their bills. But those rules don't take effect until next year.

The central bank also approved new regulations aimed at curbing abuses on home mortgages. They bar lenders from making loans without proof of a borrower's income and would require lenders to make sure risky borrowers set aside money to pay for taxes and insurance.

However, critics complained that federal regulators have moved too slowly and not done enough in the face of heavy lobbying from financial services firms. On the housing front, critics contend that a more vigilant Fed might have prevented the worst abuses during the boom when borrowers got homes they clearly could not afford, often under terms they did not fully understand.

In his speech, Bernanke said regulators need to watch closely to ensure that complex financial products and services are explained in ways that consumers can understand.

Structured investment vehicles and securities tied to subprime mortgages are among the complex products that contributed to the financial crisis and credit crunch.

SIVs are funds that borrow money by issuing short-term securities at a low interest rate and then lend that money by purchasing long-term securities at higher interest. Investors can profit from the difference, but SIVs began to struggle as demand dried up for short-term bonds during the credit crisis. The value of SIV holdings fell sharply, forcing banks such as Citigroup Inc. that operated the off-balance sheet funds, to provide them with financial support.

High-interest, subprime mortgages made to borrowers with poor credit records exploded in popularity until the housing boom started to burst. The mortgages were packaged into securities snapped up by investors worldwide. Lenders stopped worrying about the creditworthiness of borrowers and offered them ever-riskier mortgages. Many were made by commission-driven mortgage brokers, who had nothing to lose if the loan went bad.

Despite the financial crisis, Bernanke said he did not believe anyone would want to return to the highly regulated financial industry of the 1970s because today's wide range of financial products has expanded access to credit and reduced borrowing costs.

"We should not attempt to impose restrictions on credit providers that are so onerous that they prevent the development of new products and services in the future," he said.

The Obama administration has unveiled a broad outline for overhauling the nation's financial rule book and key leaders in Congress have pledged to take up the proposals later this year.

"The challenge faced by regulators is to strike the right balance: to strive for the highest standards of consumer protection without eliminating the beneficial effects of responsible innovation on consumer choice and access to credit," Bernanke said.