WASHINGTON -- Derivatives are not a threat to the financial system, Federal Reserve Board Governor Susan M. Phillips said yesterday.

"I see no reason to believe that derivatives activities, despite their phenomenal growth, are so large that they threaten either the solvency of individual institutions or the financial system as a whole," Phillips said at a derivatives conference sponsored by the World Bank.

Hoever, federal regulators must not be complacent about derivatives, she said. They must work to ensure that derivatives market participants understand the risks of derivatives and develop systems to control the risks, she said.

Phillips said that it is important for the federal regulations that govern derivatives to remain flexible because the derivatives markets are rapidly evolving and are international in scope.

The "regulatory structure must accommodate a wide range of products and market participants organized in different locations and along different lines," she said.

The key challenge for federal regulators, she said, is to find the "appropriate balance" between the benefits of derivatives and the management and control of their risks.

Phillips suggested that large, sophisticated banks should be allowed to use the models they have developed to evaluate risks in determining what capital requirements are most appropriate for their derivatives activities.

"I believe it is extremely important for supervisors to find a way to use banks' internal models for regulatory purposes -- at least for the more sophisticated banks," Phillips said.

This "would permit supervisors to exploit the evolving technology and would reduce the burden on banks, which would otherwise have to maintain and reconcile separate models for internal risk management and regulatory purposes," she said.

Federal regulators should make sure the internal models used by banks are "valid" and relatively accurate in monitoring and managing derivatives risks, Phillips said.

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