WASHINGTON -- The Federal Reserve Board is planning to issue a letter in a few weeks that will provide detailed guidance on how banks should oversee derivative investments in their mutual funds and trust accounts.

Among other things, the letter will say that fund managers must let senior bank management and directors know that derivatives and related products pose potential risks, said Howard Amer, the Fed's assistant director overseeing mutual fund activities at banks.

The letter will also say that banks should conduct "stress tests" to make sure their derivatives holdings can withstand sudden market drops, Mr. Amer said.

He made the comments last week at the Bank Securities Association's national compliance conference here.

Mr. Amer said the letter will be signed by Richard Spillenkothen, director of the Fed's division of banking supervision and regulation.

The letter is expected to pro vide more detail than a supervisory letter the Fed sent to banks in August outlining some general concerns about structured notes and acceptable uses of these instruments by banking companies.

Structured notes are a type of derivative often issued by government agencies. Many banks have spent millions of dollars this year reimbursing their money market funds for losses on these instruments.

If bank-managed funds choose to invest in derivatives, the letter will say that certain safeguards must be in place, Mr. Amer said.

"A contingency plan for massive withdrawals is something you must consider," he said. "What happens if 40% of your customers decide to sell their funds overnight?"

Banks must make sure they can field "a horde of calls from customers wanting to know what's going on with their money," Mr. Amer added.

The Fed also wants assurances that procedures are in place to make money funds whole if they appear in danger.

"We can't operate on the premise it can't happen," Mr. Amer said. "You have to have a plan as to how you would replenish those losses."

A number of bank compliance officers at the conference said they already have safeguards in place as part of their overall mutual fund programs. The bankers added they would use the upcoming Fed letter as their cue for possible additional measures.

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