interest rate swaps in total derivatives of the banking system has risen sharply from 15 % in march 2002 to 53 % in march 2006. the risks arising on account of obs activities of banks are controlled through a combination of both banks ’ internal risk management and control policies and risk mitigation mechanism imposed by the regulators. the board approved internal control policies covering various aspects of management of risks arising both on and off balance sheet exposures constitute the first line of defence to the bank. holding of minimum defined regulatory capital for all obs exposures, collection of periodic supervisory data and incorporating transparency and disclosure requirements in bank balance sheet are some of the major regulatory initiatives undertaken to control and monitor obs exposures of the banking system. the rapid proliferation of derivatives exposures inevitably poses a challenge on account of the downside risks associated with them, if not managed properly. there are issues relating to use of structured products, valuation, counterparty related issues, risk management and reporting issues and last but not the least, training and skill development. while derivatives facilitate risk hedging and risk transfer to institutions more willing to bear the risks, the tendency of participants to use derivatives to assume excessive leverage, and lack of prudential accounting guidelines are matters of concern. one of the features of in the indian derivative market relates to concentration risk in respect of both the market makers ( banks ) and the corporates. the combined share of top 15 banks has steadily grown from around 74 % in march 2002 to 82 % of total obs exposures of the banking system in march 2006, of which 62 % is accounted for by foreign banks. concentration of knowledge is another risk which results in the concentration of derivative activity among few players. rbi has been stressing on the need to carry out due diligence regarding customer appropriateness and suitability of products before offering derivative products to their customers. there is need to use risk mitigation techniques such as collaterals and netting to reduce systemic risks and evolve appropriate accounting guidelines. " credit risk modeling : the federal reserve bank of philadelphia's perspective " anthony m. santomero, president, federal reserve bank of philadelphia rbi has also issued two separate draft guidelines, one for valuation / accounting of investment portfolio in general and the second relating to derivatives. the proposed guidelines attempt to put in place fair value accounting norms for derivatives broadly in line with ias 39, the international accounting standard for valuation and accounting for financial instruments. for investments, the proposed framework envisages a symmetrical

this framework as a part of the overall risk perceptions of the bank and the capital planning strategy of the bank. issues in data infirmity still remain to some extent. in many cases, the alco ’ s role remains confined to deciding on interest rates of the bank. this is partly due to lack of decision support system available to the alco. availability of impact and scenario analysis of changes in yield structures would be a significant enabling factor. the reserve bank has recently issued draft guidelines to banks with the objective of graduating from the current maturity ladder approach prevalent in most banks to a duration gap approach. the later approach makes it possible for banks to calculate the modified duration of assets and liabilities, the duration gap and duration of equity. the concept of duration of equity gives banks, subject to certain limitations, a single number indicating the impact of a one per cent change of interest rate on its capital, captures the interest rate risk and thereby helps move a step forward towards assessment of risk based capital / economic capital. credit risk : another important issue is that bank resources and supervisory resources have concentrated on credit risk modeling of commercial and industrial portfolios, with relatively fewer resources devoted to risk quantification in the retail credit area 1. the possible reasons could be ( i ) from a systemic perspective, it makes economic sense to devote more resources to evaluating the risk factors of larger loans ( ii ) there is a long history of ratings agency evaluations for publicly traded firms which, along with the extensive data available for publicly traded firms, provided an extremely useful benchmark for the development of quantification methods for commercial portfolios. however, despite this commercial side emphasis, retail credit is a substantial part of the risk borne by the banking industry, and can not be ignored. recognizing this, over the last decade or so, the industry and academia have devoted significant resources to developing more sophisticated creditscoring models for measuring this risk. like their counterparts on the commercial side, these models also rely heavily on quantitative analysis. derivatives : there has been a spurt of derivatives exposures in the off balance sheet exposures. the composition of derivatives portfolio of the banking system has also undergone a significant transformation. forward foreign exchange contracts which accounted for around 80 % of total derivatives in march 2002 declined steadily and stood at almost 43 % in march 2006 while the share of interest rate contracts went up from 19 % to 54 % during the same period. foreign currency options have recorded noticeable increase during the last year. the share of single currency