Bernanke: Light regulation of hedge funds works well

NEW YORK (Reuters) - Light regulation of hedge funds has worked well so far and seems appropriate given the benefits they provide to the financial system, Federal Reserve Chairman Ben Bernanke said on Wednesday.

Speaking at New York University Law School, Bernanke said it might be possible to apply more sophisticated risk-management techniques but stressed that the purpose of the big funds is to take risks.

"Thus far, the market-based approach to the regulation of hedge funds seems to have worked well," he said.

"Market discipline does not prevent hedge funds from taking risks, suffering losses, or even failing -- nor should it," the central bank chief said. "If hedge funds did not take risks, their social benefits -- the provision of market liquidity, improved risk-sharing, and support for financial and economic innovation, among others -- would largely disappear."

Hedge funds are investment pools that are aimed primarily at wealthy investors and institutions, and have grown hugely in recent years. Bernanke used the figure $1.4 trillion for the amount of capital they control though there are no hard and fast estimates.

RISK PERCEPTION GROWS

Bernanke said the regulatory oversight that was applied to them was "relatively light" and acknowledged that their growing market share has raised concerns about possible systemic risk.

"The failure of a highly leveraged fund holding large, concentrated positions could involve the forced liquidation of those positions, possibly at fire-sale prices, thereby imposing heavy losses on counterparties," Bernanke said.

"In the worst scenarios, these counterparty losses could lead to further defaults or threaten systemically important institutions," he added.

In a question-and-answer session afterward, Bernanke said he saw no sign China and Japan were moving toward divesting their large holdings of U.S. Treasury and other securities, acquired in the course of trade with the United States and, in China's case, while managing its yuan currency's value.

But he said China was unlikely to want to keep acquiring U.S. assets indefinitely -- its current holdings are estimated at over $1 trillion -- and said Beijing needs to allow market forces a freer hand.

FREER POLICY HAND

"It would be very much in their interest to increase the flexibility of their exchange rate," he said, in part because it would give Chinese authorities more ability to set their own monetary policy.

Bernanke said regulators should try to ensure the counterparties in hedge fund deals, primarily very large commercial and investment banks, take all steps possible to guard themselves from the risks they are taking. In that way, the broader financial system also will be protected.

His speech was timely, coming ahead of a Friday meeting where hedge funds' activities are expected to be discussed by finance ministers from Group of Seven nations -- the United States, Britain, Canada, France, Germany, Italy and Japan.

Bernanke said he thought that regulation that relies on the "invisible hand" of market-based incentives is an effective complement to direct government regulation. The Bush administration generally has argued that markets are able to provide the discipline needed for hedge funds to operate safely.