WASHINGTON - Rep. Henry Gonzalez, D-Tex., chairman of the House Banking, Finance and Urban Affairs Committee, warned Friday that derivatives, left unchecked, "could be the next major crisis in our banking system."

In a speech to his fellow lawmakers in the House, Gonzalez said he was concerned that U.S. banks are increasingly becoming involved in derivative products entailing risks that are not fully understood by bank regulators and other market participants.

"I have long believed that growing bank involvement in derivative products is a tinderbox waiting to explode," Gonzalez said. "In the case of many market innovations, regulation lags behind until a crisis arrives."

Gonzalez said that his primary concern about derivatives is that "a large credit default or systematic problem in the underlying market could cause a catastrophe that could easily eclipse the capital of our largest banks and endanger our deposit insurance fund."

The notional principal amount of derivatives held by U.S. bank holding companies was more than $5 trillion as of June 1992, Gonzalez noted. This amount represents the principal amount of the underlying assets to which the derivative products are indexed.

The aggregate credit exposure from these derivative holdings to the U.S. banking industry, Gonzalez said, is roughly $100 billion to $200 billion. That amount is close to half the capital of the entire banking system, he said. However, he said, it is difficult to know what percentage of the exposure is real or at risk of default because the risk exposure depends on the worth of the underlying assets.

The total credit exposure from derivatives at money-center banks "is well in excess of 100% of their capital," Gonzalez said. "This enormous concentration of risk could pose an ominous threat to an individual bank if the underlying assets associated with the derivative product turn sour."

Another concern, Gonzalez said, is whether investors are engaging in derivative products for speculative purposes.

"Steps need to be taken to ensure that bank managements and bank regulators fully understand the risks of derivative product activities" and that they have adequate, properly functioning, risk-monitoring systems in place, he said.

Gonzalez said he plans to ask bank regulators for detailed information regarding their regulation of derivative activities. Letters will be sent to regulatory agencies in the next two weeks, an aide to the banking committee chairman said later.

In his speech, Gonzalez called on bank regulators to "police" derivative activities through on-site banking examinations. Bank regulators in the United States, he said, should "take the lead" in promoting U.S. and international efforts aimed at standardized reporting related to derivatives activities. They should coordinate their activities with foreign bank regulators, he said.

Gonzalez said he has asked the General Accounting Office to study derivative activities. The GAO study should be completed in the fall, the aide said.

Derivatives are "an essential feature of market economy" because they help investors minimize risks and increase profits, Gonzalez said.

However, he added, "We must ensure that bank dealers of derivatives in the U.S. and abroad are properly supervised and that derivative markets are adequately regulated" so that derivatives-related activities do not pose a serious threat to the health of money-center banks and the Deposit Insurance Fund.

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