April 11 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke said that a ``light regulatory touch'' on hedge funds is justified because of the incentives that investors and creditors have to monitor risks.

``Because hedge funds deal with highly sophisticated counterparties and investors, and because they have no claims on the federal safety net, the light regulatory touch seems largely justified,'' Bernanke said in a speech to the New York University School of Law's Global Economic Policy Forum. ``Thus far, the market-based approach to the regulation of hedge funds seems to have worked well.''

Bernanke said market-based incentives can complement government regulation to promote financial stability, a concept promoted by his predecessor, Alan Greenspan. Critics of the approach say it has weakened the threat of supervisory enforcement and spawned excesses.

``Public policy has been increasingly influenced by the insight that the market itself can often be used to achieve regulatory objectives,'' Bernanke said today. ``The invisible- hand approach to regulation aims to align the incentives of market participants with the objectives of the regulator.''

Bernanke didn't comment on monetary policy or the economy in the text of his remarks. After he concluded his remarks, the central bank released minutes of its March 20-21 policy meeting, which said further rate increases might be necessary to lower inflation.

Clues from Bonds

When it comes to commercial banks, prices on subordinated debt, whose holders would be the last in line in the event of failure, give regulators ``useful information about the bank's riskiness,'' Bernanke said.

The Fed's approach is also endorsed by other federal regulators. The presidential working group on financial markets, in its report on hedge funds in February, endorsed a hands-off approach, relying on market pressures as the best way of dealing with risks. The group, including the Fed, Treasury and other regulators, undertook the study after hedge funds more than tripled in the past decade, to $1.4 trillion.

Bernanke said that one case where market discipline failed was Long Term Capital Management LP, a hedge fund that collapsed in 1998. He concluded that Congress was right to have avoided imposing a ``much more intrusive regulatory regime'' in the aftermath of LTCM's demise.

A heavy-handed regulatory approach ``would have increased moral hazard,'' relieving investors and counterparties from responsibility for monitoring their relations with hedge funds, the Fed chief said.

G-7 Talks

Germany, the rotating head of the G-7 this year, has sought increased scrutiny of hedge funds, including a possible code of conduct. Concern about the role of hedge funds rose after the collapse of Amaranth Advisors LLC, which lost a record $6.6 billion in September from bets on natural-gas contracts.

The Fed's approach to regulation has turned it into a ``consultant'' rather than ``a cop on the beat,'' said Tom Schlesinger, president of the Financial Markets Center, a Fed watchdog organization in Howardsville, Virginia.

The Securities and Exchange Commission, New York Fed bank and Britain's Financial Services Authority, are conducting a probe into whether banks and securities firms set strict enough limits on loans to hedge funds.

Finance ministers and central bank governors of the Group of Seven industrial nations, which includes the U.S., U.K., Japan, Germany, Italy, France and Canada, meet in Washington on April 13.

Bernanke noted that most economists agree that hedge funds have benefited financial markets, spurring innovation, increasing liquidity and enhancing the diffusion of risk.

``Market discipline is a powerful and proven tool for constraining excessive risk-taking,'' Bernanke concluded.

To contact the reporters on this story: Craig Torres in Washington at ctorres3@bloomberg.net; Anthony Massucci in Newark at amassucc@bloomberg.net. Scott Lanman in Washington at slanman@bloomberg.net.

Last Updated: April 11, 2007 15:59 EDT