WASHINGTON -- The Federal Reserve has developed a new set of guiding principles to help bank examiners regulate the use of derivatives, Fed governor Susan M. Phillips said Tuesday.

The agency is also drafting a supervisory letter to "provide guidance to both examiners and banking organizations about risk management and internal controls for derivatives," she said in a speech to Women in Housing and Finance.

The Fed governor likened the Fed's supervisory letter to the Comptroller of the Currency's recent circular on risk management of financial derivatives, which establishes guidelines but does not require specific risk management techniques.

Concern for Customers

Ms. Phillips also told the professional association that, like the Comptroller, the Fed wants to make sure banks are not selling derivatives to unsophisticated customers. But she added that most players in the derivatives markets are larger and sophisticated companies.

In addition, the Fed - along with other banking regulators - is working on a plan to require stepped-up disclosure of derivatives activities by banks, she said. The new disclosures could include a description of derivatives activity and the impact of derivatives on banks' balance sheets.

"According and disclosure are critical issues, in my view, because they are the key to better asessments of derivatives activity by investors, as well as supervisors and managers," Ms. Phillips said.

Monitoring Riskiest Players

Separately, Rep. Jim Leach, R-Iowa, said Monday that regulators must distinguish between prudent and imprudent players in the derivatives market and give more attention to those who present the greatest risk.

"Just as well-run, well-capitalized financial institutions have a a powerful case for deregulation today, poorly run, poorly capitalized institutions demand significant, if not draconian, oversight," he said.

Rep. Leach, the senior Republican on the House Banking Committee, told an audience of U.S.-based foreign bank executives that it is difficult to determine how much capital should be dedicated by banks to their derivatives business.

However, he added, if too little capital is provided by market participants, "it will be nonparticipants -- community banks in the first instance through the deposit insurance safety net and taxpayers in the event of a market debacle -- who will pick up the tab for the mistakes of a few."

Protecting the Little Guy

The GOP lawmaker, a leading advocate on Capitol Hill for tighter regulation of the derivatives markets, also said it is important that regulators protect smaller financial institutions from larger ones.

As activities move outside the money-centers, he said, "the more likely bottom-line incentives will override enthical concerns in the relations of larger financial intermediaries to smaller, less sophisticated end users."

"In these markets, the small fish must be protected from the sharks," he added.

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