WASHINGTON -- Federal banking regulators are increasing their surveillance of banks' derivatives activities to ensure that they do not pose undue risks, but must avoid taking action that stifles the benefits that such products provide, Alan Greenspan, chairman of the Federal Reserve Board, said yesterday.

"We need to ensure that banks have proper safeguards in place and that they not expose themselves to undue risks," Greenspan told the American Bankers Association's annual convention in San Diego. "However it is also important that, in our efforts to contain risk-taking, we do not unduly stifle innovation or unnecessarily reduce the competitiveness of U.S. banks."

Greenspan said that the success with which banks conduct derivatives activities will "substantially affect" the supervision of those activities.

In any case, he said, regulators are becoming more focused on how banks manage the risks posed by derivatives. Derivatives, Greenspan said, are forcing bank examiners to develop different examination techniques such as requiring banks to make greater use of simulations and stress-testing to evaluate the risks from their derivatives activities.

These risks, he said, include credit, settlement, operating, and other kinds of risks that banks have always faced.

Bank supervisors are most concerned about systemic risk -- the extent to which the failure of a large derivatives market player or a derivatives market disruption could pose problems for the stock, bond, and other financial markets.

Greenspan reminded those at the conference that stock portfolio insurance in the late 1980s was considered an important tool for avoiding risk for individual investors, but failed to perform as expected in the stock crash of 1987 when collective selling pressures exceeded liquidity.

Nevertheless, Greenspan said, concerns about systemic risks have led to "significant endeavors to limit potential spillover effects" such as the industry's widespread use of netting agreements which allow firms to net their payment obligations and payments from a series of transactions with the same other party.

"Mistakes will be made with derivatives, just as they have been with loans. The key is to provide a framework for limiting the damage they cause," Greenspan said.

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