Federal Reserve Chairman Ben Bernanke offered his support to financial innovation Friday, despite the fact that some of these new products have contributed to the current economic crisis. Bernanke argued that increased regulation would be a better response than eliminating innovation.

Speaking at the Federal Reserve System's Sixth Biennial Community Affairs Research Conference in Washington, D.C., Bernanke noted that while financial innovation can misfire, more often the benefits outweigh the downside.

Financial innovation has improved access to credit, reduced costs, and increased choice, he said in prepared remarks. We should not attempt to impose restrictions on credit providers so onerous that they prevent the development of new products and services in the future.

That said, the recent experience has shown some ways in which financial innovation can misfire, the Fed chairman continued. Regulation should not prevent innovation, rather it should ensure that innovations are sufficiently transparent and understandable to allow consumer choice to drive good market outcomes.

The Fed chairman did not address current financial conditions or the economic outlook in his prepared remarks.

Reflecting on the financial crisis, Bernanke noted that the difficulty of managing financial innovation both for protecting consumers and financial institutions was underestimated.

Specifically, he referenced structured credit products, which include the structure investment vehicles and credit default swaps associated with the subprime mortgage crisis. The packaging and selling of mortgages brought the U.S. banking system to its knees when the foreclosure rate soared following the collapse of the subprime mortgage market.

Indeed, innovation, once held up as the solution, is now more often than not perceived as the problem, he said. Many of the poor underwriting practices in the subprime market were also potentially unfair and deceptive to consumers.

It seems clear that the difficulty of managing financial innovation in the period leading up to the crisis was underestimated, and not just in the case of consumer lending, Bernanke continued. For example, complexity and lack of transparency have been a problem for certain innovative products aimed at investors, such as some structured credit products.

The challenge for regulators going forward is to weigh the importance of consumer protection, which was the focus of the summit, and allowing the financial system the freedom to develop new products.

In sum, 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. Our goal should be a financial system in which innovation leads to higher levels of economic welfare for people and communities at all income levels.

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