UPDATE 2-Fed's Bernanke: Market principles top new rules

(Adds remarks by Minehan, changes dateline, previous WASHINGTON)

SEA ISLAND, Ga. May 15 (Reuters) - Federal Reserve Chairman Ben Bernanke on Tuesday argued in favor of developing a British-style, principles-based approach to U.S. financial market regulation rather than new rules for each new financial instrument or institution.

In remarks delivered via satellite to a financial markets conference sponsored by the Atlanta Federal Reserve, Bernanke did not address Fed monetary policy or the U.S. economic outlook.

He said the rapid growth of the credit derivatives market and the increasing prominence of hedge funds did not warrant specific regulation to address possible risks.

"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," Bernanke said. "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."

His colleague Cathy Minehan, who is president of the Federal Reserve Bank of Boston, noted that credit derivatives had helped stabilize the financial system.

But she warned that the market had evolved during a period of extended stability, and had yet to show how it would perform when conditions got rocky.

"They have yet to be tested in any real environment of financial shock. To me, that suggests that concerns about how their underlying risks will play in such circumstances are warranted," she told the Sea Island conference.

"What happens when things get tough? Do ...users in these instruments really understand their inherent risks? Do they understand how embedded leverage in these products can come back to bite?" she said.

A similar point was made by International Monetary Fund Managing Director Rodrigo Rato.

"The rapid growth in complex credit risk transfer instruments and the relative lack of transparency of these transactions have also prompted concerns about risks migrating from the banking sector," Rato told a conference in Dubai.

"They reinforce the need for supervisors to cooperate across sectors to better understand the associated risks."

HEDGE FUNDS

Bernanke said development of a principles-based approach is consistent with recent U.S. guidance on hedge funds, which did not call for any new regulations to mitigate potential risks that the massive pools of capital pose to the financial system and economy.

Instead the guidance, developed by the U.S. Treasury Department, the Fed, the Securities and Exchange Commission and other regulators, suggested that those risks would be kept in check by market discipline, due diligence by hedge fund creditors, counterparties and pension funds, and with adequate disclosures.

Bernanke said the hedge fund guidance makes clear that regulators and supervisors should adopt a principles-based approach similar to that used by Britain's Financial Services Authority.

He said the guidance emphasizes that "risks to financial stability are best addressed by focusing our attention on the large institutions at the core of the financial system."

The application of rules is consistent with a principles-based approach, Bernanke said, noting that the FSA has an 8,500-page rulebook to support its 11 main regulatory principles. In fact, rules can provide clarity or a "safe haven" from legal and regulatory risks, but they "should implement principles rather than develop in an ad hoc manner," he added.

Bernanke said a narrowly focused approach to regulation could provide incentives for "regulatory arbitrage," driving investors to less-regulated financial instruments.

He said the biggest objectives should be ensuring financial stability, investor protection and preserving the integrity of the market.

Rapid financial innovation pose challenges to these objectives, particularly with the complexity of contemporary instruments and trading strategies, the potential for market illiquidity to magnify the riskiness of such instruments and the greater use of leverage that they often entail.

A principles-based approach would be better than ad-hoc rules for addressing such risks and taking into account financial innovations.

"To avoid moral hazard and let market discipline work, investors must be allowed to bear the consequences of the decisions they make and the risks they accept. But investors are entitled to the information they need to make decisions appropriate to their personal circumstances," Bernanke said.