Federal Reserve Board Chairman Alan Greenspan has reassured the chairman of the Senate Banking Committee that despite explosive growth in the derivative securities market, the Fed is actively and effectively monitoring bank activities in those markets.

His Sept. 11 letter to Sen. Donald W. Riegle Jr.. D-Mich., was the latest in a series of responses by regulators to questions raised by Riegle and his colleagues about the impact of derivatives, including those backed by mortgages, on safety and soundness of financial institutions.

Total holdings of interest rate swap contracts, including mortgage swaps, by insured commercial banks increased to $1.8 trillion at the end of the first quarter of this year from $1.7 trillion at the end of 1990. But Greenspan said these figures overstate credit exposures by as much as 40% to 60% because participants in these markets have made widespread use of agreements that provide for the bilateral netting of gains and losses on multiple derivative contracts with a single counterparty.

"The challenges created by derivative instruments have complicated the supervisory process for at least some institutions and require examiners to keep informed about new product developments and their related market risks," conceded Greenspan. "However, when used properly, these transactions can do much to reduce risks that banks incur as normal parts of their banking business and enhance the efficiencies of capital markets worldwide.

"That they have also increased the complexity of risk management is a concern that we as bank supervisors take seriously and are actively addressing through continuing education and by evaluating the industry's own risk management techniques and enforcing strong capital standards," he added.

Greenspan said the Fed's research and monitoring efforts "help shape policy statements regarding derivative activities of regulatory concern. For example, in February of this year, the Federal Reserve and other supervisory agencies issued a policy statement through the (Federal Financial Institutions Examination Council) that identified certain mortgage derivative products as unsuitable investments for the vast majority of institutions."

Riegle and his banking panel colleagues have expressed concern on several occasions about the impact of derivatives on financial institutions' safety and soundness. At a June 10 hearing with officials of the Fed, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation, Riegle asked them to examine holdings of MBS derivatives. Those questions have developed into a more comprehensive project that won't be completed this year, committee staff sources says. (See Mortgage Marketplace, June 15, Page 2).

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