Financial Regulation: Perspectives on the Swaps Push-Out Rule
Released: 2017-09-29T00:00:00


Highlights: section_title: Why GAO Did This Study
paragraphs: Given the role of derivatives in contributing to the 2007—2009 financial crisis, the Dodd-Frank Act includes various provisions that subject the swap market and its participants to greater regulation, including section 716. Proponents of section 716 sought to prohibit banks from engaging in riskier swap activities that could cause the banks to need federal assistance backed by taxpayers. Opponents of section 716 maintained that swaps trading by banks did not significantly contribute to the financial crisis. In late 2014, section 716 was amended to narrow its scope of prohibited swap activities. Banks generally were required to begin complying with the amended section 716 in July 2015.

GAO was asked to examine various effects of the amended and original versions of section 716. This report examines the provision's effect on U.S. banks and their BHCs, end-users of swaps, and taxpayers in light of other Dodd-Frank Act reforms.

GAO analyzed publicly available data on swaps and derivatives held by banks and their BHCs and reviewed laws and regulations applicable to swaps as well as academic, industry, and GAO reports, research, and other materials. GAO also interviewed federal banking and swaps regulators, 15 U.S. banks that were registered as swap dealers and thus covered by section 716, end-users that were or would have been affected by section 716, an industry association, and experts, such as academics researching the swaps market.

section_title: What GAO Found
paragraphs: Since the 1980s, banks have been engaging in swaps: financial contracts (derivatives) in which two parties “swap,” or exchange, payments based on changes in asset prices or other values. A variety of firms (end-users) use swaps to hedge risk, to speculate, or for other purposes. For example, an airline may use swaps to lock in its fuel price to hedge against a future price rise. End-users engage in swaps through swap dealers, and some large banks act as swap dealers, exposing them to risks. Section 716 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act)—also known as the “swaps push-out rule”—requires banks registered as swap dealers, in effect, to stop engaging in certain swap activities to remain eligible for federal financial assistance but allows them to “push out” such activities to nonbank affiliates within the same bank holding company (BHC). As originally enacted, section 716 would have covered certain equity, commodity, and credit default swaps activities, but amendments made in 2014 now cover only certain swap activity based on asset-backed securities.

GAO analyses of the effects of the amended and original versions of section 716 on U.S. banks and their BHCs, swap end-users, and taxpayers in light of other Dodd-Frank Act reforms found the following:

A significantly larger volume of swaps would have been pushed out under the original section 716. The amended section 716 affected four U.S. banks and caused them to push out an estimated $265 billion of swaps in notional value as of September 30, 2016, or less than 1 percent of their total derivatives. The original version would have affected 11 U.S. banks (including the 4 banks) and could have affected an estimated $10.5 trillion of swaps in notional value, or about 6 percent of their total derivatives, if the provision had not been amended.

Section 716 increases risks and costs for BHCs and end-users . Under the amended version, banks moved their covered swap activities to nonbank affiliates, requiring the affiliates and clients to incur legal and operational costs. Banks and end-users told GAO that moving the swaps can increase their risks and, in turn, costs. Such risks and costs likely would have been greater under the original version because of its broader scope.

Other Dodd-Frank Act provisions mitigate risks . Section 716 seeks to reduce a bank's risk of failure and potential need for federal assistance, but the act's other reforms also seek to mitigate such risks. For example, regulators have subjected banks to enhanced prudential and other requirements that can help to mitigate their swap-related risks. Consistent with such requirements, GAO's analyses indicate the 11 U.S. banks that would have been affected by the original section 716 held financial resources needed to support their swap-related credit, liquidity, and market risk exposures as of September 30, 2016. Federal banking regulators and BHCs with the largest bank swap dealers are continuing to develop resolution strategies that seek to resolve a large BHC in an orderly manner and without federal assistance if it were to fail. These strategies, if successful, can help BHCs to wind-down or sell their swaps in an orderly manner and avoid value destruction.

section_title: Letter
paragraphs: Swaps and other over-the-counter (OTC) derivatives played a role in the  2007—2009 financial crisis in varying degrees and ways, as illustrated by  the failure of Lehman Brothers Holdings Inc. (Lehman) and the near  failure of American International Group, Inc. (AIG).  A swap is a type of  OTC derivative in which two parties agree to exchange payments based  on the value of an underlying asset, a reference rate, or an index over a  specified period.  According to a 2009 survey conducted by a derivatives  industry association, 94 percent of the world’s 500 largest companies use  derivatives to manage and hedge their business and financial risks.  A  number of large banks and other companies act as swap dealers by  buying or selling swaps and other derivatives to client companies, or  swap end-users.

Section 716 of the Dodd-Frank Wall Street Reform and Consumer  Protection Act (Dodd Frank Act)—also known as the “swaps push-out  rule”—effectively required banks registered as swap dealers or security- based swap dealers with the Commodity Futures Trading Commission  (CFTC) or the Securities and Exchange Commission (SEC), respectively,  to stop engaging in certain types of swaps or security-based swap  activities, or be prohibited from receiving certain types of assistance.  The  provision allowed covered banks to move such activity to nonbank  affiliates. Before banks had to begin complying with section 716 (that is,  stop engaging in certain swaps activity in order to retain access to certain  federal assistance), the provision was amended in December 2014 to  exclude most of the types of swaps that initially were subject to section  716.  Proponents of the original section 716 sought to prohibit banks with  access to federal assistance from engaging in riskier swap activities and  to reduce the potential for the federal government, and therefore  potentially taxpayers, to have to provide emergency assistance to banks  engaging in such swap activities. In contrast, opponents of the provision  maintained that swaps trading by banks did not significantly contribute to  the 2007—2009 financial crisis. While the largest bank swap dealers  supported amending section 716 to narrow its scope, other stakeholders  held that the amendment could increase the risk of a bank needing  federal assistance and could provide less protection to taxpayers. In  addition to section 716, the Dodd-Frank Act included other provisions to  address, among other things, the financial stability risks associated with  major financial companies and the swap market.

You asked us to examine various effects of the amended and original  section 716. This report examines  1.  the number of U.S. banks and the value of their swaps that were  affected under the amended section 716 and that would have been  affected under the original section 716,  2.  the actual and potential costs or negative effects of the amended and  original section 716 for U.S. banks and swap end-users,  3.  U.S. banks’ risks associated with swap activities that were covered  under the original section 716 but not subject to the amended version  of section 716, as well as mitigating factors, and  4.  the effects of section 716 and other Dodd-Frank Act requirements on  risk to taxpayers in the event of bank failure.

To examine the number of U.S. banks and the value of their swaps  affected by the amended and original section 716, we reviewed both  versions of section 716 and relevant analyses prepared by the federal  banking regulators, four large banks, selected law firms, and others. To  estimate the notional amount of swaps affected by the original and  amended section 716, we used data from the Consolidated Reports of  Condition and Income (Call Reports) as of September 30, 2016, and data  from SwapsInfo.com on structured finance swaps transacted between  July 16, 2015, and September 30, 2016.

To examine the costs or negative effects of the amended and original  section 716 for U.S. banks and swap end-users, we reviewed the 2-year  transition applications submitted by banks to the Board of Governors of  the Federal Reserve System (Federal Reserve) or the Office of the  Comptroller of the Currency (OCC); documentation on and materials  related to the International Swaps and Derivatives Association (ISDA)  Master Agreement and credit support annex; and reports addressing the  implementation of section 716 published by consulting firms, credit rating  agencies, and law firms.

To examine the banks’ and taxpayers’ risks associated with swap  activities covered by the original section 716, we reviewed the Dodd- Frank Act’s prudential and resolution reforms and related regulations;  publicly available regulatory filings submitted by U.S. banks registered as  swap dealers or their parent holding companies, including annual or  quarterly financial filings and resolution plans; and industry, academic,  and other studies or reports examining the role of derivatives in the  2007—2009 financial crisis and ways to mitigate risks posed by  derivatives under the U.S. Bankruptcy Code. To analyze credit, liquidity,  and market risks associated with swaps covered under the original  section 716, we used primarily Call Report data, including the net positive  and negative fair values of their trading derivatives (derivative assets and  liabilities), fair value of their collateral collected for their trading  derivatives, quarterly net gains or losses from their trading derivatives,  and total risk-based capital, as well as data from annual or quarterly  filings with SEC. We assessed the reliability of the data from the Call  Reports, SwapsInfo.com, and SEC annual and quarterly filings by  interviewing knowledgeable officials, reviewing relevant documentation,  or testing the data for missing or incorrect values. We determined the  data were sufficiently reliable for our reporting objectives.

For some or all of the objectives, we interviewed officials from the Federal  Reserve, Federal Deposit Insurance Corporation (FDIC), OCC, CFTC,  and SEC; 15 U.S. banks that were provisionally registered as swap  dealers with CFTC and thus were subject to the amended and original  section 716; 7 non-generalizable swap end-users that were judgmentally  selected based on their use of swaps covered under the original or  amended section 716; and other market participants or observers,  including an industry association, credit rating agencies, and academics  knowledgeable about section 716 or the swaps market. For more  information on our scope and methodologies, see appendix I.

We conducted this performance audit from March 2016 to August 2017 in  accordance with generally accepted government auditing standards.  Those standards require that we plan and perform the audit to obtain  sufficient, appropriate evidence to provide a reasonable basis for our  findings and conclusions based on our audit objectives. We believe that  the evidence obtained provides a reasonable basis for our findings and  conclusions based on our audit objectives.
subsections: section_title: Background
subsections: section_title: Prudential Regulators
paragraphs: In the banking industry, the specific regulatory configuration for a banking  institution generally depends on the type of charter the institution  chooses. Depository institution charter types include commercial bank  and thrift charters:

Commercial banks originally focused on the banking needs of businesses  but over time have broadened their services.

Thrifts include savings banks, savings associations, and savings and  loans and were originally created to serve the needs—particularly the  mortgage needs—of those not served by commercial banks.

Charters may be obtained at the state or federal level. State regulators  charter institutions and participate in the institutions’ oversight, but all  institutions that have federal deposit insurance have a federal prudential  regulator. The federal prudential regulators—which generally may issue  regulations, conduct supervision, and take enforcement actions against  industry participants within their jurisdiction—are OCC, Federal Reserve,  and FDIC, and their basic functions are summarized in table 1.   Additionally, FDIC insures deposits in banks and thrifts.

Large banking organizations in the United States generally are organized  as bank holding companies (BHC), which are companies that can control,  among other entities, one or more banks.  Typically, a large U.S. parent  (or top tier) BHC owns a number of domestic depository institutions that  also engage in lending and other activities. A BHC also may own  nonbanking and foreign entities that engage in a broader range of  business activities, which may include securities dealing and  underwriting, insurance, real estate, leasing and trust services, or asset  management. A BHC’s nonbank subsidiaries are affiliates of the BHC’s  bank subsidiaries.  Some large U.S. BHCs have thousands of  subsidiaries.

The Bank Holding Company Act of 1956, as amended, contains a  comprehensive federal framework for the supervision and regulation of  BHCs and their nonbank subsidiaries.  Generally, any company that  seeks to acquire control of an insured bank or BHC shall apply for  approval as a BHC with the Federal Reserve.  Under the Bank Holding  Company Act, BHCs are subject to, among other things, consolidated  supervision by the Federal Reserve.  Further, the act restricts the  activities of the BHC and its affiliates to those that are closely related to  banking or, for qualified financial holding companies, activities that are  financial in nature.

section_title: Types of Swaps and Swap End-Users
paragraphs: In general, swaps and security-based swaps (collectively referred to as  swaps in this report, unless otherwise noted) are types of derivative  contracts that involve ongoing exchanges of payments for a specified  period.  Swaps and other derivatives have one or more “underlyings”  (i.e., specified interest rate, security price, commodity price, foreign  exchange rate, index of prices or rates, or other variable) and one or  more notional amounts (i.e., number of currency units, shares, bushels,  pounds, or other units specified in the contract) that help determine the  amount of the payments. For example, an end-user seeking to hedge its  interest rate risk may enter into an interest rate swap with a dealer to  exchange fixed-rate interest payments of 5 percent of $10 million for  floating interest payments based on the 3-month London Interbank  Offered Rate. Under the terms of the swap, the dealer agrees to make  quarterly payments of 5 percent multiplied by $10 million to the end-user,  and the end-user agrees to make quarterly payments of the 3-month  London Interbank Offered Rate multiplied by $10 million. The notional  value of this contract would be $10 million because that is the specified  value on which exchanged interest payments are based. Swaps and  other derivatives volumes generally are measured by their notional  amounts. For example, the notional amount of derivative contracts held  by insured U.S. commercial banks and savings associations increased  from around $17 trillion in 1995 to around $165 trillion in 2016. However,  notional amounts generally do not represent amounts at risk.

Financial and nonfinancial firms use swaps and other derivatives to  hedge risk, to speculate, or for other purposes, such as to reduce  uncertainty. For example, an airline may enter into a commodity swap to  lock in its fuel price over a certain time horizon, so that it can better  manage its costs. Banks and other end-users that are exposed to  maturity, currency, or interest rate mismatches between assets and  liabilities may enter into swaps to hedge their exposure. Speculators may  enter into equity derivatives to speculate on the direction of equity  markets in order to make a profit, understanding that the profit or loss  from the swap can be large in comparison to the cost of entering the  swap.

Unlike futures contracts, which are standardized financial contracts that  are traded on exchanges, swaps traditionally have been privately  negotiated between two counterparties in the OTC market. Types of  swaps include the following:  Interest rate swaps are contracts in which two parties agree to exchange  interest cash flows or one or more notional principal amounts at certain  times in the future according to an agreed-on formula. Banks,  corporations, sovereigns, and other institutions use swaps to manage  their interest-rate risks or speculate on interest-rate movements.

Foreign exchange swaps are simultaneous purchases and sales of a  certain amount of foreign currency for two different value dates.  Corporations use such swaps to hedge their assets and liabilities  incurred as a result of their overseas operations. Investors (e.g.,  international mutual funds) use such swaps to gain exposure to markets  or to hedge currency risk.

Commodity swaps are agreements between two counterparties to make  periodic exchanges of cash based on notional quantity of a specified  commodity or related index. The term “commodity” encompasses  agricultural products, base metals, and energy products. Market  participants include commodity producers and users, hedge funds, and  mutual funds.

Equity swaps are transactions in which payments referenced to the return  on a certain equity index (e.g., S&P 500) or an equity and an interest rate  are exchanged and are usually based on a fixed notional amount. End- users of equity swaps include money managers, hedge funds, insurance  companies, corporations, and finance companies.

A credit default swap is a contract between a seller and buyer of  protection against the risk of default on a debt obligation issued by a  reference entity and serves as an insurance policy that protects the buyer  against the loss on the debt obligation in case of a default by the debt  issuer (i.e., reference entity).  The protection buyer makes periodic  payments over the contract’s life, and the premium is a percentage of the  contract’s notional value. If a credit event occurs (e.g., bankruptcy), the  premium payment stops, and the protection seller pays the buyer the  notional amount or agreed-to default payment. The debt obligation can  include a loan, a bond, an asset-backed security, or a credit index. For  example, an insurer that has invested in bonds issued by a company may  go to a bank swap dealer to buy protection against the risk of the  company defaulting on its bonds.  In general, credit default swaps are  between institutional investors and dealers.

For most OTC derivative transactions, a dealer is one of the two  counterparties to the contract. The 102 entities provisionally registered  with CFTC as swap dealers (as of April 2017) include U.S. and foreign  banks, securities broker-dealers, and futures commission merchants.  Some BHCs own two or more swap dealers. Dealers often trade with  other dealers, such as to hedge, or offset, risk from their OTC derivatives  trades with their client firms or other risks.

section_title: Section 716 of the Dodd- Frank Act
paragraphs: Section 716 prohibits the provision of federal assistance to banks that  engage in certain swap activities but allows them to move, or “push out,”  such activities to nonbank affiliates of the bank. As such, a BHC can  continue to engage in those swaps through its nonbank subsidiaries.
subsections: section_title: Bank Swap Dealers
paragraphs: Section 716 of the Dodd-Frank Act does not directly prohibit a bank from  engaging in swap activities. Rather, it provides that no federal assistance  be provided to any “swaps entity” unless the entity restricts its swap  activities to those permitted under the provision. The term “federal  assistance” is defined as the use of any advances from any Federal  Reserve credit facility or discount window that is not part of a program or  facility with broad-based eligibility under section 13(3)(A) of the Federal  Reserve Act, FDIC insurance or guarantees for the purpose of (A) making  any loan to, or purchasing any stock , equity interest, or debt obligation of  any swaps entity; (B) purchasing the assets of any swaps entity; (C)  guaranteeing any loan or debt issuance of any swaps entity; or (D)  entering into any assistance arrangement (including tax breaks), loss  sharing, or profit sharing with any swaps entity. Covered depository  institutions, including insured depository institutions, are included within  the definition of a swaps entity only if they are registered swap dealers or  security-based swap dealers.  Because banks do not want to jeopardize  their access to federal assistance, section 716 effectively prohibits bank  swap dealers from engaging in swap activity unless they restrict that  activity to swaps permitted under the provision.

The original section 716 covered several types of swap activities: (1)  swaps involving rates or reference assets permissible for investment by a  national bank,  (2) credit default swaps that are cleared by a derivatives  clearing organization or a clearing agency, and (3) swaps transactions  used for hedging or other similar risk-mitigating activities directly related  to the bank’s activities. Consequently, the original section 716 generally  prohibited the provision of federal assistance to bank swap dealers that  engaged in swap activity involving most equity swaps, commodity swaps  referencing physical commodities (except for precious metals), and  noncleared credit default swaps, unless the swaps were used for hedging  or mitigating bank risk. As shown in figure 1, the original section 716  became effective in July 2013, but the law required the appropriate  federal banking agency to permit a transition period of up to 24 months  for swap entities that are insured depository institutions to divest or cease  certain swap activities.  Several banks applied for and were granted 2- year extensions by the Federal Reserve and OCC, and those financial  institutions had until July 16, 2015, or later to comply with section 716.  Under the statue, these entities had the option of applying for an  extension of the transition period for up to 1 additional year. Section 716  was amended in December 2014, before the end of each 2-year transition  period that had been granted.

The amended section 716 significantly narrowed the scope of the original  provision. The amended section 716 prohibits the provision of federal  assistance only to bank swap dealers that engage in swap activities  involving structured finance swaps (e.g., swaps on asset-backed  securities), unless the swaps are used for hedging or unless the asset- backed securities underlying the swaps satisfied credit quality and  classification requirements to be set forth by prudential regulators through  regulations.  Bank swap dealers are permitted to engage in swap  activities involving all other types of swaps without losing access to  federal assistance, including those that would have been covered by the  original section 716. Additionally, like the original section 716, the  amended section 716 allowed a covered bank to retain swaps entered  into before the bank’s compliance date (called legacy swaps). Thus, it  generally prohibits bank swap dealers that were granted 2-year  transitions from entering any new structured finance swaps on or after  July 16, 2015, without losing access to federal assistance, unless the new  swaps generally were used for hedging or risk-management purposes.

section_title: Nonbank Affiliates
paragraphs: The original and amended versions of section 716 allowed covered banks  to move their swap activities covered under section 716 to their nonbank  affiliates, so long as the bank was part of a BHC or savings and loan  holding company.  Figure 2 provides a simplified example of a BHC that  has both bank and nonbank subsidiaries. In the figure, the U.S.  commercial bank is a bank swap dealer that engages in section 716  covered swaps activities under either version of the provision. In  response, the BHC could move the bank’s covered swap activities to one  or both of these nonbank affiliates, including foreign nonbank affiliates.

section_title: Regulation of the Use of Derivatives by Banks
paragraphs: Currently, banks are permitted to structure, trade, or deal in a broad  range of exchange-traded and OTC derivatives.  For banks to conduct  derivatives activities, federal banking regulators generally require the  banks to have adequate risk management and measurement systems  and controls to conduct the activities in a safe and sound manner, and  they must have sufficient capital to support the risks associated with the  activities.  For example, before a bank conducts derivatives activities,  senior management should ensure that all appropriate regulatory  approvals are obtained and that adequate operational procedures and  risk control systems are in place. After the bank’s initial entry into  derivatives activities has been properly approved, any significant changes  in such activities or any new derivatives activities should be approved by  the board of directors or, as appropriate, senior management. Other  specific requirements include the following:

Banks should have comprehensive written policies and procedures to  govern their use of derivatives.

Senior management should establish an independent unit or individual  responsible for measuring and reporting derivatives risk exposures.

Banks should have comprehensive risk management systems that are  commensurate with the scope, size, and complexity of their activities and  the risks they assume.

Banks should have audit coverage of their derivatives activities adequate  to ensure timely identification of internal control weaknesses or system  deficiencies.

The board of directors should ensure that the bank maintains sufficient  capital to support the risk exposures (e.g., market risk, credit risk, liquidity  risk, operational risk, legal risk) that may arise from its derivatives  activities.

Bank swap dealers are subject to their federal banking regulator’s  prudential requirements, including minimum OTC swap margin (or  collateral) requirements.  In addition, as discussed in the next section,  banks that engage in swaps or security-based swap activities in amounts  above a specified threshold must also register as swap or security-based  swap dealers with CFTC or the SEC, respectively.

section_title: Regulation of the Swaps Market and Its Participants
paragraphs: Title VII of the Dodd-Frank Act establishes a new regulatory framework  for swaps. The act authorizes CFTC to regulate swaps and SEC to  regulate security-based swaps with the goals of reducing risk, increasing  transparency, and promoting market integrity in the financial system. Title  VII includes the following four major swaps reforms:

Registration, capital, margin, and other requirements. Title VII  provides for the registration and regulation of swap dealers and major  swap participants, including subjecting them to (1) prudential regulatory  requirements, such as minimum capital and minimum initial and variation  margin requirements and (2) business conduct requirements to address,  among other things, interaction with counterparties, disclosure, and  supervision.

Mandatory clearing. Title VII imposes mandatory clearing requirements  on certain swaps, but it exempts, among other things, certain end users  that use swaps to hedge or mitigate commercial risk.

Exchange trading. Title VII requires certain swaps subject to mandatory  clearing to be traded and executed on a regulated trading platform,  including an organized exchange or swap execution facility, unless no  facility offers the swap for trading.

Mandatory reporting. Title VII requires all swaps to be reported to a  registered swap data repository or, if no such repository will accept the  swap data, to CFTC or SEC, and requires that transaction and pricing  data for newly executed swaps be reported to the public.

Figure 3 illustrates these reforms and some of the differences between  swaps traded on exchanges and cleared through clearinghouses and  noncleared swaps.

section_title: Section 716 Affected a Small Number of U.S. Banks and a Relatively Small Percentage of Their Total Derivatives
paragraphs: Our analysis shows that of the 15 U.S. banks covered by section 716, 4  had to take steps to comply with the amended provision compared to 11  that would have had to take steps to comply with the original provision.  Approximately 1,400 U.S. banks reported holding swaps or other  derivatives in the second quarter of 2015, and 15 of them, about 1  percent, had registered with CFTC as swap dealers and were thus  covered entities under both versions of section 716.  As shown in figure  4, as of September 30, 2016, the 15 covered banks collectively held a  total notional amount of around $176 trillion in derivatives, which  represented around 99 percent of the derivatives held by all U.S. banks.  However, this activity was concentrated among four banks, which  collectively held a total notional amount of about $159 trillion in  derivatives, or around 90 percent of the derivatives held by the 15 U.S.  bank swap dealers. The amended section 716 affected four U.S. bank  swap dealers that conducted structured finance swap activities, and we  estimated that these banks “pushed out” about $265 billion of such swaps  in notional value (or less than 1 percent of the banks’ total derivatives).  Because originally covered swaps generally included credit, commodity,  and equity swaps, the original section 716 would have affected 11 banks  that are swap dealers in these markets. We estimated that these banks  continue to hold about $10.5 trillion of such swaps in notional value (or  around 6 percent of their total derivatives) due to the section 716  amendment.
subsections: section_title: Analysis of Swaps Affected by the Amended Section 716
paragraphs: Our analysis shows that of the 15 U.S. banks registered as swap dealers,  4 of the banks were dealers in structured finance swaps and had to stop  such swap activity by July 16, 2015, or lose access to federal assistance  under the amended section 716.  As discussed in more detail later, the  four banks moved their structured finance swap activity to their nonbank  affiliates. In that regard, the structured finance swaps entered into by  these nonbank swap dealers on or after July 16, 2015, represent the  amount of swaps that the four banks “pushed out” to the nonbank  affiliates. Based on data collected by swap data repositories and  simplifying assumptions, we estimated that nonbank affiliates of the four  swap dealers collectively entered into around 16,300 structured finance  swaps with a total notional amount of around $265 billion between July 16, 2015, and September 30, 2016. This total is the amount that  presumably would have been traded by the four banks if they did not  have to push them out to nonbank affiliates to remain eligible for federal  assistance. These swaps include only structured finance swaps on asset- backed securities indexes and exclude structured finance swaps on  single-name asset-backed securities.  Our estimate assumes that one of  the four nonbank swap dealer affiliates was a party to every new swap,  none of the new swaps were entered into for hedging or risk management  purposes, and there were no new structured finance swaps on single- name asset-backed securities.  According to our estimate, the amount of  swaps affected by the amended section 716 would represent less than 1  percent of the total notional amount of the derivatives held by the four  banks as of September 30, 2016 (or around 4 percent of their credit  derivatives), if the banks were allowed to hold such derivatives.

section_title: Analysis of Swaps That Would Have Been Affected under the Original Section 716
paragraphs: Our analysis shows that of the 15 U.S. banks registered as swap dealers,  11 banks (including the 4 that were affected by the amended section 716)  would have had to take steps to comply with the original provision.  The  11 banks are dealers in originally covered swaps and were able to  continue to engage in such swap activities (with the exception of certain  structured finance swaps) due to the section 716 amendment. Based on  Call Report data, we estimated that the 11 bank swap dealers collectively  held a total notional amount of around $10.5 trillion in credit, equity, and  commodity and other derivatives as of September 30, 2016.  This  amount, which is almost 40 times larger than our estimate of affected  swaps under the amended section 716, approximates the maximum  notional amount of covered swaps that the 11 dealers could have had to  move out of the banks under the original section 716, but it likely is an  overestimate for the reasons discussed later. As shown in figure 5, the  total notional amount of derivatives covered by the original section 716  comprises about 6 percent of the 11 banks’ total derivatives notional  value. Moreover, 4 of the 11 banks account for 94 percent of the $10.5  trillion estimated notional value.

Although our estimate of the amount of swaps affected by the original  section 716 is relatively small, our estimate likely is an overestimate for  several reasons. First, the original section 716 would have allowed bank  swap dealers to continue to hold covered legacy swaps after the provision  took effect.  Second, it also would have allowed bank swap dealers to  use covered swaps for hedging. Third, it would have covered noncleared  credit default swap activities but not cleared credit default swap activities.  These factors would affect the total notional amount of swaps that would  have been moved out of the banks under the original provision, but  publicly available data do not allow us to distinguish between (1) legacy  swaps and new swaps entered into on or after July 16, 2015, (2) swaps  used and not used for hedging, (3) commodity swaps referencing bullion and other commodity swaps, and (4) cleared and noncleared credit  default swaps.

section_title: Section 716 Imposes Costs on, and Increases Risks for, BHCs and Swap End- Users
paragraphs: According to affected BHCs and end-users we interviewed, the steps  required to implement the amended section 716 imposed certain costs on  BHCs and swap end-users, although BHCs generally indicated that the  costs were easily absorbed. In contrast, BHCs and end-users stated that  implementation costs would likely have been significantly greater under  the original section 716 due to the larger scope of covered swaps and the  much larger volume of affected end-users. In addition, because section  716 could cause affected end-users to enter into swaps with the bank’s  affiliated nonbank swap dealers—splitting end-users’ swaps into at least  two separate portfolios—the efficiency with which dealers and end-users  are able to manage their counterparty credit risk can be reduced. These  efficiency losses can lead to higher counterparty credit risk or collateral  costs and liquidity risk. Because significantly more end-users’ portfolios  likely would have been split under the original section 716, the losses in  efficiencies likely would have been much greater and likely would have  led to larger increases in risk or related collateral costs. However, end- users could mitigate their efficiency losses by having their bank swap  dealers move their legacy swaps to the nonbank swap dealer affiliates.
subsections: section_title: Implementing the Original Section 716 Likely Would Have Imposed Greater Operational and Legal Costs on BHCs and End- Users
paragraphs: To not be subject to the prohibition on federal assistance under the  amended section 716, BHCs had to undertake various steps to move the  covered swap activity out of the banks and into nonbank subsidiaries or to  cease such activity throughout the company. Generally, these steps  included (1) identifying swap activity covered by section 716 at the bank  swap dealer, (2) moving this swap activity out of the bank into nonbank  affiliates or ceasing such activity, and (3) for swaps moved to nonbank  affiliates, negotiating new master netting agreements—such as the widely  used ISDA Master Agreement published by the International Swaps and  Derivatives Association (ISDA)—with affected end-users, as needed.

According to stakeholders we interviewed, the actions that BHCs would  have been required to take to execute these steps would have been  significantly more complicated and costly under the original section 716  for both BHCs and end-users due to the larger scope of covered swaps  and the much larger volume of affected end-users relative to the  amended provision. As discussed previously, we estimated that the  notional value of affected swaps would have been almost 40 times larger  under the original versus the amended section 716. In addition,  regulators, market experts, and market participants we spoke with noted  that the structured finance swap market—that is, the swaps affected by  the amended 716—was active before the 2007—2009 crisis but since  then has become a relatively small market, with one or two actively traded  indices primarily used by some financial end-users, such as hedge funds  or investment companies.  In contrast, a wide variety and large number  of financial and commercial end-users use swaps that were covered by  the original section 716—commodity, equity, or noncleared credit default  swaps—to manage risks in their businesses.
subsections: section_title: Swap Dealers’ Implementation Costs
paragraphs: The four banks took action in response to the amended section 716 told  us that they generally have not had major difficulties implementing the  amended section 716.  To comply with the amended section 716, the  BHCs of the four banks engaged in structured finance swap activity  stopped their banks from engaging in such swap activity and moved the  activity to existing nonbank affiliates of the bank that were already  registered as swap dealers. The BHCs told us that they primarily incurred  legal and operational costs in doing so, but that such costs were generally  easily absorbed by the firm and would have been much larger under the  original provision.

Amended section 716 operational costs. BHCs stated that after  identifying affected structured finance swaps at the bank, each BHC also  identified one or two existing nonbank swap dealer affiliates of the bank  to which it could readily move its bank’s structured finance swap activity.  The BHCs stated that this decision was relatively self-evident because  they already had registered nonbank swap dealer affiliates that had the  infrastructure and processes in place to trade structured finance swaps.  Consequently—and also because the volume of swaps affected by the amended section 716 was relatively small—the operational costs of  moving the swaps to nonbank subsidiaries were relatively manageable,  according to the four BHCs.

Amended section 716 legal costs. The BHCs stated they incurred  some legal costs in establishing new ISDA Master Agreements when  needed. ISDA Master Agreements typically are entered into between two  swap counterparties, such as the bank swap dealer and a swap end- user. To trade structured finance swaps with a nonbank swap dealer as a  result of section 716 restrictions, an affected end-user had to enter into  another ISDA Master Agreement with the nonbank unless an agreement  was already in place. The four affected BHCs stated that affected clients  generally entered into new ISDA contracts with the nonbank affiliate as  needed. Some banks’ stated that they moved legacy swaps to nonbank  affiliates per client request.

Under the original section 716, implementation costs for the BHCs of the  11 bank swap dealers that would have been affected likely would have  been much larger because the original provision covered more types of  swaps and the number of affected end-users would have been  significantly larger.

Original section 716 operational costs. In response to the original  section 716, the BHCs that would have been affected stated that they  likely would have taken steps similar to those taken by BHCs affected by  the amended version. First, BHCs said they would have had to identify  affected originally covered swaps at the bank. Then, BHCs generally  stated that they were considering whether to move such swap activity to  existing nonbank affiliates and/or newly created nonbank affiliates, or  whether they should cease dealing originally covered swaps.  For  example, three BHCs told us that they might have had to move originally  covered swaps to multiple nonbank affiliates in the United States and  globally because no one nonbank affiliate could have served as a dealer  for such swaps. Moreover, two of them and two other BHCs stated that  they might not have viable nonbank affiliates that could have absorbed all  of the affected activity and might have had to create new nonbank  affiliates. In both cases, BHCs stated that they likely would have needed  to spend time, divert capital, and duplicate bank swap trading systems  and processes at the nonbank affiliates to make them viable.  Lastly, a  smaller BHC told us that the cost of creating new nonbank affiliates  would have been significant and that it likely would have stopped its swap  activity.

Original section 716 legal costs. BHCs also noted the potential  challenges of negotiating a much larger volume of ISDA Master  Agreements under the original section 716. For example, a BHC told us  that the number of its counterparties affected by the amended section  716 was a few hundred, compared to several thousand that would have  been affected under the original section 716. Another BHC stated it had  less than 50 swaps in categories covered by the original section 716, but  other BHCs stated they had a couple thousand to hundreds of thousands  of such swaps. Like the amended section 716, the original section 716  did not require a bank swap dealer to move legacy swaps to its affiliated  nonbank swap dealer to remain eligible for federal assistance, but as  discussed later, the bank’s clients might have requested their swaps to  be moved to the nonbank swap dealer to take advantage of netting  efficiencies. According to market participants, negotiating an ISDA  Master Agreement could take 1 to 12 months, and some BHCs expected  that it would take them between 1 and 2 years to redocument the  agreements with all of their affected clients under the original section  716, in part depending on the extent to which clients would have sought  renegotiation of contract terms with the nonbank affiliates. In addition, all  11 BHCs likely would have had to negotiate these agreements with  thousands of the affected end-users at around the same time.

section_title: End-Users’ Implementation Costs
paragraphs: Because section 716 directly affects the relationship between bank swap  dealers and end-user clients, both the original and amended provisions  involve some operational and legal costs for affected end-users as well.  According to two market participants and a regulator, end-users affected  by the amended section 716 typically included hedge funds, banks,  pension funds, and insurance companies. BHCs and end-users we  interviewed stated that they incurred costs establishing new swap trading  relationships with nonbank affiliates of the bank, if a relationship did not  exist already, and maintaining these relationships. They said that  operationally, end-users would have had to ensure their information  management systems and processes were able to trade structured  finance swaps with the nonbank affiliates of the banks instead of bank  swap dealers. They also stated that legally, at least some affected end- users had to enter into new ISDA Master Agreements with nonbanks as a  result of the amended section 716. For example, two end-users we spoke  with stated that, in doing so, they used the same terms of their contracts  with the banks, and one end-user said this process took 4 to 8 weeks.

Overall costs to end-users under the original section 716 likely would  have been greater than under the amended section 716 because the  universe of affected clients would have been much larger. According to  BHCs and end-users we interviewed, both financial end-users (such as  hedge funds, other banks, insurance companies, and investment  companies) and commercial end-users (such as agricultural businesses,  airlines, and oil and natural gas producers) use commodity, equity, or  noncleared credit default swaps to manage risks in their businesses or for  other purposes. They stated, and regulators agreed, that many more end- users would have had to incur operational costs of maintaining trading  accounts with more dealers and spend legal resources and time  renegotiating ISDA agreements than they would have under the amended  section 716. Some BHCs and a market participant stated that at least  some affected end-users likely would have asked for better terms rather  than simply replicating the terms of their original contract with the banks,  as happened under the amended statute.

Lastly, some BHCs and end-users we spoke with stated that the original  section 716 could have increased the trading costs of affected BHCs  enough to increase the overall cost of trading swaps for end-users in the  long run. Specifically, they stated that it typically costs nonbank dealers  more to engage in swap activity than bank dealers due, in part, to  differences in their capital costs.  According to these stakeholders,  affected BHCs likely would have passed at least part of these higher  costs on to end-users, such as in the form of wider swap bid-ask  spreads.

section_title: Section 716 Can Result in Increased Risks and Collateral Costs That Would Have Been Larger under the Original Section 716
paragraphs: According to stakeholders we interviewed, because the restrictions under  both versions of section 716 may cause affected bank end-users to enter  into swaps with the bank swap dealer and its nonbank swap dealer  affiliate, end-users may split their swap portfolios into two portfolios (one  with each dealer). They stated that this scenario can reduce the efficiency  with which bank and nonbank dealers and end-users are able to manage  their counterparty credit risk and can lead to higher counterparty credit  risk or higher collateral costs and liquidity risk. Because more end-users  would have been affected under the original relative to the amended  section 716, more swap portfolios could have been split, and the losses in  efficiencies likely would have been greater and would have led to larger  increases in risk and related collateral costs. However, end-users could  mitigate their efficiency losses by having their bank swap dealers move  their legacy swaps to the nonbank swap dealer affiliates.
subsections: section_title: Netting and Counterparty Credit Risk
paragraphs: Under an ISDA Master Agreement, swaps transactions between the two  counterparties under the agreement become part of the same contract  and thus part of the same netting set, which allows the parties to  combine, or “net,” obligations owed to and from each other under their  transactions into a single obligation.  The ability to net their obligations  should one party default enables swap counterparties to reduce their  counterparty credit risk. For example, if a bank and an end-user have two  swaps and the end user defaults, the obligations of the parties are  terminated and the market-to-market values of the swaps are netted into  a single sum owed by, or owed to, the bank. If the marked-to-market  value of one swap is positive $100 and the marked-to-market value of the  other swap is negative $80, then the counterparty credit risk exposures  are as follows:

Under an ISDA Master Agreement, the two values are netted against  each other, resulting in a single obligation of $20 that the end-user  owes to the bank. As a result, the bank has a $20 credit exposure to  the end-user, and the end-user has no credit exposure to the bank.  The bank would have a $20 claim against the end-user.

Without an ISDA Master Agreement, the bank and the end-user are  not able to net the marked-to-market values of their swaps. As a  result, the bank’s credit exposure to its end-user is $100, and the end- user’s credit exposure to the bank is $80. In the event of an end-user  default, the bank would be obligated to pay the end-user the $80 and  would have a $100 claim against the end-user.

Because of section 716, end-users may split their swap transactions and,  in turn, their swap portfolios and netting sets between a BHC’s bank and  nonbank swap dealers—reducing the efficiency by which they can  manage their counterparty credit risk. Although an ISDA Master  Agreement allows a dealer and end-user to bilaterally net their swap  obligations between each other, officials from an industry association told  us that these agreements generally do not allow a BHC’s bank and  nonbank dealers to multilaterally net their obligations with the same end- user. As shown in figure 6, by splitting an end-user’s netting set between  a BHC’s two dealers, section 716 can reduce the ability of the  counterparties to net their obligations to reduce their counterparty credit  risk.

Our analysis indicates that the losses in netting efficiencies would likely  have been larger under the original section 716, primarily because the  original provision would have affected a greater number of end-users and  their ISDA agreements. Bank-provided examples indicate that the original  section 716 could have had a large effect on counterparty credit risk for  end-users that hold both swaps covered and not covered by the  provision. For example, one of a bank’s corporate clients would  experience a 22 percent increase in its counterparty credit risk exposure if  it split its foreign exchange derivatives (not covered by the original  provision) and commodity derivatives (covered by the provision) into two  netting sets. Similarly, one of a bank’s commercial client’s counterparty  credit risk exposure would increase from $0 to $5 million if its interest rate  and foreign exchange derivatives were split from its commodity  derivatives. Finally, a bank estimated that its counterparty credit risk to a  hedge fund would increase by more than 100 percent if the hedge fund  split its interest rate and foreign exchange derivatives and equity and  credit derivatives into two netting sets.

section_title: Counterparty Credit Risks and Collateral Costs
paragraphs: As a market practice, banks and other swap dealers have required certain  of their counterparties to post collateral (such as cash or securities) to  cover the amount owed on their swap exposures to mitigate counterparty  credit risk.  Moreover, as discussed in more detail later in this report,  pursuant to the Dodd-Frank Act, prudential regulators have imposed  margin requirements on noncleared swaps that generally require the  counterparty that originates the counterparty credit risk exposure to post  collateral to the other party commensurate to the risk.  The party that  collects the collateral can then use it to absorb losses if the counterparty  were to default on the swap. Before section 716 was enacted, if collateral  agreements that called for netting of collateral were in place in the  example shown in figure 6 discussed previously, then the client would  post $20 in collateral with the bank. After section 716, the client would  post $100 in collateral with the bank, and the nonbank dealer would post  $80 in collateral. Although the additional collateral mitigates the increase  in counterparty credit risk for one party, it also increases costs and  liquidity risk for the party posting the collateral.

The prudential regulators’ OTC swap collateral requirements generally  require banks to post and collect collateral to and from other swap  dealers and financial end-users, but not commercial end-users.   Consequently, both banks and financial end-users likely experienced and  would have experienced higher collateral costs under the amended and  original section 716 to the extent that the provision reduced or would have  reduced netting efficiencies. In contrast, commercial end-users—while  they may have posed increased credit risks to banks under the original  section 716 due to losses in netting efficiencies—would not necessarily  have had to post collateral accordingly.

Lastly, swap end-users theoretically could preserve netting efficiencies to  a greater extent if they moved all of their swaps under the same netting  set to the nonbank affiliate. This action likely would involve moving not  only section 716 covered swaps but also all other swaps—such as legacy  swaps (i.e., section 716 covered swaps entered into before the effective  date of the statute) or interest rate and foreign exchange swaps—to the  nonbank dealer. Such action would help preserve a larger part or all of an  end-user’s netting set and, thus, the ability to net and not incur additional  collateral requirements. Of the four BHCs affected by the amended  section 716, two told us that none of their clients asked to move any of  the legacy structured swaps to the nonbank affiliates, and two told us that  some of their clients asked to move their legacy swaps to the nonbank  affiliates. However, under the original section 716 some clients likely  would have requested their banks to transfer their legacy commodity,  equity, or noncleared credit default swaps or even some interest rate or  foreign exchange swaps to the nonbank affiliates to preserve netting  benefits.  A number of banks could not determine precisely how many  and to what extent clients would have done this, partly because the  decision is client-driven and made on a facts-and-circumstances basis.

section_title: Banks Continue to Engage in Swap Activity Covered under the Original Section 716 and Mitigate Associated Risks
paragraphs: Through its restrictions on banks engaging in certain commodity, equity,  or noncleared credit default swap activity, the original section 716 would  have required 11 U.S. bank swap dealers to cease such activity and thus  would have reduced the possibility for such swaps to contribute to these  banks’ potential failure. At the same time, this potential benefit likely  would have resulted in costs for their BHCs and swap end-users, as  discussed earlier. With the amendment to section 716, the 11 U.S. bank  swap dealers have been allowed to continue to engage in swap activity,  except for certain structured finance swaps, and take on the related risk  exposures. However, the 11 banks are required by the Dodd-Frank Act  and other regulations to have certain levels of financial resources to  support their swap activity and adequate systems to manage the  associated risks.

Consistent with such regulatory requirements, our analyses indicate that  the 11 U.S. banks that would have been affected by the original section  716 held financial resources needed to support their swap-related credit,  liquidity, and market risk exposures as of September 30, 2016. If the  banks continue to hold such levels of financial resources and maintain  adequate risk management systems, as required by their regulators and  certain Dodd-Frank Act reforms and related regulations, we believe that  losses stemming solely from swaps activity likely can be absorbed by the  banks without causing them serious financial distress. However, it is  important to note that, as illustrated by Lehman’s failure, derivatives can  exacerbate a firm’s financial distress caused by other losses.
subsections: section_title: Other Dodd-Frank Act Provisions Mitigate Risks Posed by Swap Activity
paragraphs: Although the swap activity that banks continue to engage in as a result of  the amendment of section 716 poses some degree of risk (which we  discuss in detail in the next section), other Dodd-Frank Act requirements  can help banks mitigate this risk. Besides section 716, other Dodd-Frank  Act provisions seek to reduce BHCs’ probability of failure by subjecting  them, including their banks, to enhanced prudential requirements and to  heightened supervision. Since the 1980s, banks have been permitted to  engage in various swap and other derivative activities but have been  required to have adequate management and measurement systems and  controls to conduct the activities in a safe and sound manner, as  previously discussed.  Banks also have been required to hold certain  levels of capital—which acts as a cushion to absorb unexpected losses— to support their derivatives-related risks.  More recently, banks have also  been subject to the Dodd-Frank Act’s enhanced prudential requirements  that are designed, in part, to better ensure that they hold sufficient  resources to support their swap activity and maintain risk management  and other systems to do so in a safe and sound manner.

A number of the Dodd-Frank Act’s prudential and other reforms required  the prudential regulators to issue regulations or take steps to help  mitigate risks that banks face due to their derivatives activities, such as  counterparty credit, liquidity, and market risks, including the following  examples (for a more comprehensive discussion of each regulation, see  app. III):

Capital and leverage requirements. Prudential regulators revised their  capital rules, in part to require banks to hold more capital against their  derivative credit exposures and, thus, provide a larger cushion to absorb  losses from such instruments, including derivatives trading losses and  losses from counterparty defaults. Thus, in our view, these requirements  help mitigate counterparty credit and market risks.

Margin rules. Prudential regulators adopted new margin rules to require  swap dealers of noncleared swaps to collect or post collateral (e.g., cash  or securities) from or to certain counterparties to help protect each other  against losses, including from counterparty default.  The collateral that a  bank collects from a swap counterparty provides an additional cushion  (before using the bank’s own capital) to absorb derivative losses from  swaps with that counterparty. Swap margin requirements are more  targeted and dynamic than capital requirements, reflecting changes in  risk of a specific swap counterparty’s portfolio. Thus, in our view, margin  rules help banks mitigate swap counterparty credit risk. However, as  discussed earlier, margin requirements can increase liquidity risk for  swap counterparties.

Single counterparty credit limit for BHCs. The Federal Reserve  proposed regulations to limit the aggregate net credit exposure of a BHC  with total consolidated assets of $50 billion or more to a single  counterparty. These BHCs would be subject to increasingly stringent  credit exposure limits.  Because the proposal would limit a BHC’s  combined exposures to a single counterparty including from swaps and  other derivatives, we view the requirement as helping to limit swap  counterparty credit risk.

Liquidity requirements. Prudential regulators have adopted or proposed  rules to impose minimum liquidity requirements and the Federal Reserve  conducts supervisory liquidity stress tests on BHCs to help ensure that  they have or can raise the funds needed to meet their near-term  obligations, including from derivatives.  Thus, in our view, liquidity  requirements help to mitigate liquidity risk faced by banks because of  their swap obligations.

Capital planning and stress testing. The Federal Reserve also  established supervisory stress test requirements for certain BHCs.   These tests generate forward-looking information about a BHC’s capital  adequacy under hypothetical scenarios that, among other things, impose  market losses, including from derivatives trading.  The Federal Reserve  uses these stress tests as part of quantitative and qualitative  assessments of BHCs’ capital adequacy and capital planning  processes.  Consequently, in our view, capital planning and stress test  requirements can help banks mitigate market and counterparty credit  risks.

Volcker Rule. The prudential regulators adopted regulations to  implement section 619 of the Dodd-Frank Act (also known as the Volcker  Rule) which, among other things, allows BHCs and their subsidiaries to  engage in swap activity and use swaps to hedge risks but subject to  certain restrictions and requirements. Thus, in our view, the Volcker Rule  generally seeks to limit the amount of market risk to which swap dealers  can be exposed.

Figure 7 highlights these and other Dodd-Frank Act requirements that  help mitigate the counterparty credit, liquidity, and market exposures that  banks face due to their derivatives activities. Based on our analysis, all 15  section 716 covered bank swap dealers or their BHCs are subject to the  requirements identified in figure 7’s lighter boxes. In addition, larger, more  complex BHCs are subject to additional capital, leverage, or other  requirements that may constrain a BHC’s bank from entering into new  swaps, for example, if such activity would cause the BHC’s capital to fall  below required levels. Based on our analysis, of the 15 covered banks or  BHCs, 11 larger, more complex BHCs and their banks are subject to some or all of the additional requirements identified in figure 7’s darker  boxes. These 11 are known as Advanced Approaches BHCs under the  risk-based capital rules, and 8 of the 11 are BHCs that the Federal  Reserve has identified as global systemically important BHCs (GSIB).

section_title: Risks Associated with Swaps Covered under the Original Section 716 in Relation to the Financial Resources of the Affected U.S. Banks
paragraphs: Due to the amendment of section 716, 11 U.S. bank swap dealers that  generally would have been prohibited from receiving federal assistance or  required to stop engaging in commodity, equity, or noncleared credit  default swap activity continued such swap activity, and the related  exposures remained within the banks.  Our analyses indicate the 11  U.S. banks that would have been affected by the original section 716 held  financial resources needed to support their swap-related credit, liquidity,  and market risk exposures as of September 30, 2016.  Our results are  consistent with the goals of the Dodd-Frank Act’s prudential and other  requirements designed to mitigate the risks banks face from their swap  activity and to reduce their probability of failure. If banks continue to hold  financial resources and maintain adequate risk management systems, as  required by their regulators and certain Dodd-Frank Act reforms and  regulations, losses stemming solely from the swap activity likely can be  absorbed by the banks without causing them serious financial distress.  However, as previously stated, it is important to note that derivatives can  exacerbate a firm’s financial distress caused by other losses as illustrated  by Lehman’s failure.
subsections: section_title: Counterparty Credit Risk
paragraphs: For the 11 U.S. banks, our analyses indicate that the banks held the  capital needed to support counterparty credit exposures (accounting for  netting but not collateral) from their equity, commodity, or credit  derivatives as of September 30, 2016.  Our analyses also show that the  fair value of the collateral held by banks in relation to their OTC trading  derivative counterparties was, on average, sufficient to cover at least 68  percent of net current credit exposures of their derivatives as of that  date.  These results indicate that as of September 30, 2016—about a  year after most banks would have had to comply with the original section  716—the banks had capital to absorb losses from such derivatives, and  that such losses likely would have been mitigated to a significant degree  with the collateral received from bank OTC derivative counterparties. We  used banks’ estimated or reported net trading derivative assets and  liabilities as our measure of the banks’ current counterparty credit risk  exposure and compared the values to the banks’ capital.

For the four largest bank swap dealers, we estimate that their net credit  exposures from their equity, commodity, and credit derivatives (not  accounting for collateral) constituted from 1 percent to 10 percent of their  total capital as of September 30, 2016.  As discussed in appendix IV,  we estimated the banks’ net credit exposures because the banks do not  publicly report such data by type of derivative, and our methodology has  important limitations.  In addition, we estimate that the four largest bank  swap dealers on average collectively held collateral against 99 percent of  their collective net current credit OTC derivatives exposures as of  September 30, 2016. However, this percentage does not mean that  almost all current credit exposure would be mitigated with collateral, as  some counterparties over-collateralize and others under-collateralize  exposures, and collateral is not fungible across swap counterparties.

For the other seven bank swap dealers, we estimate that their actual net  current credit exposures (not accounting for collateral) of all their trading  derivatives—including swaps not covered under the original section  716—comprised from 4 percent to 16 percent of their total capital as of  September 30, 2016. We could not reliably estimate the net trading  derivative assets of the seven banks’ equity, commodity, and credit  derivatives. As a result, we used the actual total net trading derivative  assets, which include interest rate and foreign exchange derivatives that  were not covered by the original section 716 and typically comprise the  majority of the banks’ trading derivatives.  In addition, we estimate that  these banks on average collectively held collateral against 68 percent of  their collective net current credit OTC derivatives as of September 30,  2016.  Again, this percentage does not mean that 68 percent of their  current credit exposure would be mitigated with collateral, as some  counterparties over-collateralize and others under-collateralize  exposures, and collateral is not fungible across swap counterparties.

section_title: Liquidity Risk
paragraphs: For the 11 U.S. banks, our analyses indicate the banks held the high- quality liquid assets needed to support their equity, commodity, or credit  derivatives’ payment and collateral obligations as of September 30, 2016.  Derivative liabilities expose banks to liquidity risk, in part because the  derivative contracts typically require the banks to make regular payments  as agreed in the contracts and post collateral to counterparties as the fair  value of the contracts moves in the counterparties’ favor.  To assess  liquidity risk, we used estimated or reported net derivative liabilities for  banks’ trading derivatives as our measure of the banks’ derivatives  liquidity risk, and we compared those values against the banks’ high- quality liquid assets. Because banks, like their counterparties, post  collateral for some of their derivative liabilities and because our analyses  do not account for such collateral, our results likely overestimate the  actual derivatives-related liquidity risk exposures.

For the four largest bank swap dealers, we estimate that the net  derivative liabilities for their equity, commodity, and credit derivatives (not  accounting for posted collateral) constituted from less than 1 percent to  about 5 percent of the banks’ high-quality liquid assets as of September  30, 2016. We used the same methodology described previously to  estimate the net derivative liabilities for the banks’ equity, commodity,  and credit derivatives as we did to estimate the net derivative assets for  the banks’ equity, commodity, and credit derivatives.

For the other seven bank swap dealers, we estimate that the actual total  net trading derivative liabilities (including swaps not covered under the  original section 716 but not accounting for collateral) constituted from  about 1 percent to about 9 percent of their high-quality liquid assets as of  September 30, 2016. As discussed earlier, due to data limitations, we  could not reliably estimate the net derivative liabilities for the banks’  equity, commodity, and credit derivatives. As a result, we used the actual  total net trading derivative liabilities, which included interest rate and foreign exchange derivatives that were not covered by the original  section 716 and typically comprise the majority of the banks’ trading  derivatives.

section_title: Market Risks
paragraphs: Our analyses of the 11 banks’ quarterly mark-to-market losses from  trading equity, commodity, and credit derivatives between the first quarter  of 2007 and the third quarter of 2016 show that banks held the capital  needed to support related trading losses. These results provide a  backward-looking measure of the market risk associated with the trading  of such swaps.

For the four largest bank swap dealers, we estimate that quarterly net  trading losses from their equity, commodity, and credit derivatives ranged  from 5 percent to 7.6 percent of their total capital between the first  quarter of 2007 and the third quarter of 2016.

For six of the other seven bank swap dealers, we estimate that their  quarterly net trading losses from their equity, commodity, and credit  derivatives ranged from 0 percent to about 2 percent of their total capital  between the first quarter of 2001 and third quarter of 2016. For the other  bank, its largest loss during a quarter was around 14 percent of its  capital.

Value-at-risk (VaR), which is a forward-looking measure of market risk  generally posed by derivatives and other trading activities, suggests that  the 11 banks have the capital needed to support expected losses from  derivatives under regular market conditions.  Banks control market risk  by establishing limits against potential losses using VaR models. The  models use historical data to quantify the potential losses from adverse  market moves in normal markets. Based on our analyses, the reported  VaR measures for the BHCs of the four largest bank swap dealers  indicate that the market risk from each BHC’s trading activities, which  include the BHC’s section 716 bank’s derivatives trading activities, is a  small percentage of each of the four bank’s capital: for example, ranging  from 0.02 percent to 0.22 percent of their capital in the third quarter of  2016.

In addition, based on results from the Federal Reserve’s supervisory  stress tests, the BHCs of the 11 banks had sufficient capital to cover  trading losses, including from their banks’ trading derivatives, under  stressed market conditions. The BHCs of the 11 bank swap dealers are  subject to the Federal Reserve’s stress tests, which evaluate the BHCs’  revenues, losses, and ultimately their capital levels under baseline,  adverse, and severely adverse scenarios. In its 2015 and 2016 reviews,  the Federal Reserve did not object to any of the capital plans, including  the supervisory stress test results, of the 11 BHCs. For example, under  the stress tests, all 11 BHCs were able to maintain at least minimum  regulatory capital requirements under stressed scenarios.

section_title: Other Dodd-Frank Act Reforms Mitigate the Potential Need for Taxpayer-Backed Federal Assistance
paragraphs: Section 716 seeks to reduce the risk of the federal government having to  provide assistance backed by taxpayers to cover losses of a failed bank,  but other Dodd-Frank Act provisions also mitigate this risk.  While the  Dodd-Frank Act’s prudential reforms discussed earlier seek to lower the  probability of failure of large BHCs or their banks, the act’s resolution  reforms seek to reduce the risk that the failure of a large BHC would  adversely affect U.S. financial stability. Federal banking regulators and  large BHCs are developing resolution strategies that seek to resolve a  large BHC, if it were to fail, in an orderly manner and without federal  assistance. For example, under the resolution strategies being developed  by the BHCs with the four largest bank swap dealers, only the BHC would  enter bankruptcy; its bank and other subsidiaries would remain solvent.   These strategies, if successful, could help enable the BHC and its bank  swap dealer to unwind or sell its swaps in an orderly manner and avoid  value destruction.

A bank’s swaps may not always result in losses that reduce its resolution  value because swaps and other derivatives can be either assets or  liabilities. In resolution, a failed bank’s trading derivatives portfolio could  be (1) a net asset that increases the bank’s resolution value or (2) a net  liability that decreases the failed bank’s resolution value.  Because  banks hedge market risk, their trading derivative assets and liabilities  typically are close to each other in value.  As discussed earlier, the  Volcker Rule also serves to help minimize the market risk to which banks  can be exposed through their swaps activity, in part by limiting the extent  to which the value of their trading derivative assets can differ from the  value of their trading derivative liabilities. Consequently, if a bank can  wind down its trading derivatives portfolio in an orderly manner, it could  avoid value destruction, if any. However, as illustrated by the failure of  Lehman, the legal right of a bank’s swaps counterparties to terminate  their swaps early if the bank or its BHC were to fail can result in the  disorderly unwinding of the bank’s swaps and cause the bank to suffer  avoidable losses on its swaps that decrease the bank’s resolution value.

We found that prudential regulators are implementing the Dodd-Frank  Act’s resolution reforms that seek to help ensure that the largest BHCs, if  they were to fail, can be resolved in an orderly manner and avoid asset  fire sales and value destruction.  (See app. V for a more detailed  discussion of Dodd-Frank Act resolution reforms in relation to BHCs with  a bank swap dealer subsidiary.) Before the act, the government generally  had two options to address the potential failure of a systemically  important BHC or other nonbank financial firm: (1) allow it to enter  bankruptcy or (2) provide it with aid. The act preserved bankruptcy as the  preferred option and required the large BHCs to develop resolution plans  describing how they can be resolved under the U.S. Bankruptcy Code in  a rapid and orderly manner.

In the public sections of their resolution plans, the BHCs of the four  largest bank swap dealers generally have stated they have adopted the  Single Point of Entry (SPOE) strategy as their preferred resolution  strategy under the U.S. Bankruptcy Code. Under the SPOE strategy, only  the top-tier BHC would enter bankruptcy. The BHC would use its financial  resources, as needed, to support and recapitalize its operating  subsidiaries to keep them solvent and preserve their going-concern value.  For example, a loss that caused a BHC to fail would be passed up from  the subsidiary that incurred the loss and absorbed by the BHC’s equity  holders and unsecured creditors, which would have the effect of  recapitalizing the BHC’s subsidiary. By keeping their bank subsidiaries  solvent in the event of their failure, the BHCs could enable their banks to  wind down or sell their swaps in an orderly manner and preserve their  value. If one of the BHCs was not able to keep its bank solvent under its  resolution strategy, FDIC would resolve the bank separately under the  Federal Deposit Insurance Act (outside of the BHC’s resolution strategy)  and could transfer the bank’s swaps to a solvent company to preserve  their value.

We found that the four U.S. BHCs, along with other resolution plan filers,  have faced a number of challenges and obstacles developing their  resolution plans.  The four BHCs are continuing to revise their plans to  address such challenges and obstacles, and regulators have proposed or  finalized regulations to help improve the ability of the BHCs to execute  their plans.  According to the Federal Reserve and FDIC, resolution  planning cannot guarantee that a BHC’s resolution would be executed  smoothly, but the preparations can help ensure that the BHC could be  resolved under bankruptcy without government support or imperiling the  broader financial system.  In 2016, we concluded that whether the plans  of the largest BHCs actually would facilitate their rapid and orderly  resolution under the U.S. Bankruptcy Code is uncertain, in part because  none has used its plan to go through bankruptcy.

In cases where resolution of a large BHC under the U.S. Bankruptcy  Code may result in serious adverse effects on U.S. financial stability, the  Dodd-Frank Act’s Orderly Liquidation Authority serves as the backstop  alternative.  Orderly Liquidation Authority gives FDIC the authority,  subject to certain constraints, to resolve large financial companies outside  of the bankruptcy process.  Since 2013, FDIC has been developing a  SPOE strategy to implement this authority.  FDIC would be appointed  receiver of the top-tier holding company and establish a bridge financial  company into which it would transfer the holding company’s assets.  The  bridge company would continue to provide the holding company’s  functions, and the company’s subsidiaries would remain operational. As  its SPOE strategy has evolved, FDIC has focused on developing multiple  options for liquidating the subsidiaries, such as by winding down or selling  subsidiaries or selling a subsidiary’s assets. Importantly, FDIC is  authorized to transfer swaps and other qualified financial contracts to the  bridge company or another solvent financial company.  According to  FDIC, the agency intends to maximize the use of private funding in a  systemic resolution, and the law expressly prohibits taxpayer losses from  the use of Orderly Liquidation Authority.

section_title: Agency Comments
paragraphs: We provided a draft of this report to CFTC, the Federal Reserve, FDIC,  OCC, and SEC for review and comment. CFTC, the Federal Reserve,  FDIC, OCC, and SEC provided technical comments that we incorporated  as appropriate.

As agreed with your offices, unless you publicly announce the contents of  this report earlier, we plan no further distribution until 30 days from the  report date. At that time, we will send copies to the appropriate  congressional committees and members, CFTC, the Federal Reserve,  FDIC, OCC, and SEC. This report will also be available at no charge on  our website at http://www.gao.gov.

Should you or your staff have questions concerning this report, please  contact me at (202) 512-8678 or evansl@gao.gov. Contact points for our  Offices of Congressional Relations and Public Affairs may be found on  the last page of this report. Key contributors to this report are listed in  appendix VII.

section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: We examined the effects of the amended and original versions of section  716 of the Dodd-Frank Wall Street Reform and Consumer Protection Act  (Dodd-Frank Act).  Specifically, we examined (1) the number of U.S.  banks and the value of their swaps affected under the amended section  716 and that would have been affected under the original section 716; (2)  the actual and potential costs or negative effects of the amended and  original section 716 for U.S. banks and swap end-users, (3) U.S. banks’  risks associated with swap activities that continue to be carried on by the  banks due to the section 716 amendment and mitigating factors, and (4)  the effects of section 716 and other Dodd-Frank Act requirements on risk  to taxpayers in the event of a bank failure.
subsections: section_title: Objective 1
paragraphs: To examine the number of U.S. banks and the value of their swaps  affected under the amended section 716 and that would have been  affected under the original section 716, we reviewed both versions of the provision; analyses of section 716 prepared by the federal bank regulators (the  Board of Governors of the Federal Reserve System (Federal Reserve),  Federal Deposit Insurance Corporation (FDIC), and Office of the  Comptroller of the Currency (OCC)) and four large banks;  regulations issued by the Commodity Futures Trading Commission  (CFTC) and Securities and Exchange Commission (SEC) on the  registration of swap and security-based swap dealers and major swap  and security-based swap participants;  list of entities provisionally registered as swap dealers with CFTC; and  reports, studies, and other materials on section 716, swaps, or asset- backed securities issued by GAO, law firms, market participants, and  others.

We also interviewed federal regulators, including the Federal Reserve,  FDIC, OCC, CFTC, and SEC; an industry association; and the 15 U.S.  banks that were provisionally registered as swap dealers with CFTC and  thus were covered entities under both versions of section 716.  According  to 4 of the 15 U.S. banks registered as swap dealers, they were engaged  in structured finance swaps activity and thus affected by the amended  section 716. In comparison, according to 11 of the 15 U.S. banks  registered as swap dealers (including the 4 banks that were affected by  the amended section 716), they were engaged in equity, commodity, or  noncleared credit default swaps activities and thus would have been  affected by the original section 716 had it not been amended.

To estimate the notional amount of swaps affected by the amended  section 716—that is, the swap activity in which the four affected U.S.  banks stopped engaging due to the amended section 716—we used data  from SwapsInfo.com, a website managed by the International Swaps and  Derivatives Association, Inc. (ISDA).  The site uses publicly disseminated  data from swap data repositories to which registered swaps dealers in the  United States are required to provide such information. ISDA’s  SwapsInfo.com captures data on credit default swap transactions,  including some of those covered under the amended section 716—those  structured finance swaps based on groups or indexes primarily comprised  of asset-backed securities. However, the data do not include structured  finance swaps on single-name asset-backed securities.

Based on the data provided by ISDA’s SwapsInfo.com, we calculated the  total notional value of new structured finance swap transactions that were  executed between July 16, 2015, and September 30, 2016, and reported  to U.S. swap data repositories. We used the total notional amount as our  estimate of the volume of structured finance swaps affected by the  amended section 716 based on the assumption that the nonbank affiliates  of the four U.S. banks affected by the amended section 716 were on one  side of every new transaction and that no U.S. bank swap dealer entered  into a new structured finance swap for hedging or risk management  purposes.  On one hand, our estimate could overestimate the amount of  swaps affected by the amended section 716, in part because some of the  transactions may not have involved one of the nonbank affiliates. On the  other hand, our estimate could underestimate the amount, in part  because it does not include all structured finance swaps entered into  during our time period.

To estimate the notional amount of swaps affected by the original section  716—that is, the swap activity in which the 11 affected U.S. banks would  have stopped engaging due to the original section 716 if it had gone into  effect—we used data from the Consolidated Reports of Condition and  Income (Call Reports) as of September 30, 2016. Specifically, banks  report the notional amount of their interest rate, foreign exchange, equity,  commodity and other, and credit derivatives in their Call Reports, and the  equity, commodity, and credit default swaps covered under the original  section 716 are subsets of the derivatives reported in the Call Reports. In  that regard, we used the notional amounts reported by the banks for their  equity, commodity, and credit derivatives as of September 30, 2016, to  estimate the total notional amount of swaps that would have been  affected by the original section 716. Our estimate likely overestimates the  total notional amount of swaps that would have been affected by the  original section 716, because the estimate includes swaps that might not  have been required to be pushed out to retain eligibility for federal  assistance, such as (1) swaps used for hedging, (2) swaps entered into  before affected banks were required to comply with section 716 (i.e.,  legacy swaps), or (3) cleared credit default swaps.

section_title: Objective 2
paragraphs: To examine the costs or negative effects of the amended and original  versions of section 716 for U.S. banks and swap end-users, we reviewed  and analyzed the 2-year transition applications submitted by banks to the  Federal Reserve or OCC; OCC examinations of and guidance provided to  banks covering section 716; documents on the ISDA Master Agreement  and credit support annex; regulations issued by the Federal Reserve,  FDIC, OCC, CFTC, and SEC, including on margin or capital requirements  for swap and security-based swap dealers; and reports or other materials  addressing the implementation of 716 or related issues published by  consulting firms, credit rating agencies, and law firms. In addition, we  interviewed the 15 section 716 covered banks, 7 non-generalizable end- users of swaps judgmentally selected based on their use of swaps  covered under the original or amended section 716, 3 credit rating  agencies that issued analyses on section 716 or structured finance  swaps, and 3 academics whose research focused on the derivatives  markets or section 716.

section_title: Objectives 3 and 4
paragraphs: To examine the banks’ risks associated with swap activities that continue  to be carried on by the banks due to the section 716 amendment and the  effects of section 716 and other Dodd-Frank Act requirements on risk to  taxpayers in the event of a bank failure, we reviewed  the Dodd-Frank Act’s prudential and resolution reforms and related  regulations, including on risk-based and leverage capital requirements,  liquidity requirements, total loss-absorbing capacity, global systemically  important bank holding companies, the Volcker rule, orderly liquidation  authority, and resolution plan requirements;  joint feedback and guidance provided by the Federal Reserve and FDIC  to bank holding companies on their resolution plans;

Federal Reserve’s and OCC’s bank examination manuals and related  derivatives guidance; publicly available regulatory filings submitted by U.S. banks registered as  swap dealers or their parent holding companies, including SEC annual or  quarterly filings and resolution plans; and industry, academic, and other studies or reports examining the role  of derivatives in the recent financial crisis and ways to mitigate risks  posed by derivatives under the U.S. Bankruptcy Code.

To analyze credit, liquidity, and market risks associated with swaps  covered under the original section 716 for the 11 affected U.S. banks, we  primarily used Call Report data, including the net positive and negative  fair values of their trading derivatives, fair value of their collateral  collected for their trading derivatives, and quarterly net gains or losses  from their trading derivatives, total risk-based capital. For more  information on our methodology, our results, and the limitations of our  analysis, see appendix IV. In addition, we interviewed federal banking  regulators, banks registered as swap dealers, and others mentioned  above about the risks related to the amended and original section 716.

As discussed earlier, we used data from the Call Reports, SEC annual  and quarterly filings, and SwapsInfo.com to estimate the total notional  value of swaps affected by the amended and original section 716 and to  measure and assess the credit, liquidity, and market risks raised by  swaps covered under the original section 716. We assessed the reliability  of the data by interviewing knowledgeable officials, reviewing relevant  documentation, or testing the data for missing or incorrect values. We  determined the data were sufficiently reliable for our reporting objectives.

We conducted this performance audit from March 2016 to August 2017 in  accordance with generally accepted government auditing standards.  Those standards require that we plan and perform the audit to obtain  sufficient, appropriate evidence to provide a reasonable basis for our  findings and conclusions based on our audit objectives. We believe that  the evidence obtained provides a reasonable basis for our findings and  conclusions based on our audit objectives.

section_title: Appendix II: Banks’ Reported Derivative Measures and Their Relationship to Derivative Risks
paragraphs: In their Consolidated Reports of Condition and Income (Call Reports),  banks report information about their derivatives, including their notional  amounts, gross and net derivative assets and liabilities (also called  derivative receivables and payables, or positive and negative fair values  of derivatives), and amounts of associated collateral. Such publicly  available information can be used to assess how a bank’s derivatives can  affect its risk exposures.  (See app. IV for estimates of certain derivatives  risks using swap dealer banks’ public financial statements). In this  appendix we analyze the relationship among these reported derivatives  measures and derivative risks. We explain why derivative notional  amounts do not generally represent derivatives risks, how the gross and  net values of derivative assets and liabilities can help approximate certain  risks associated with derivatives, and how collateral received or paid can  further reduce such risks.

Swaps and other derivatives can be assets or liabilities. As explained in  the sections that follow, a bank’s counterparty credit risk associated with  its derivatives can be estimated with varying levels of precision by  calculating the value of its (1) gross derivative assets, (2) derivative  assets after accounting for netting, and (3) net derivative assets after  accounting for the collateral collected from counterparties on those  derivatives.  A bank’s liquidity risk associated with its derivatives can be  estimated by calculating the value of its (1) gross derivative liabilities, (2)  derivative liabilities after accounting for netting, (3) and the net derivative  liabilities after accounting for the collateral posted to counterparties for  those derivatives.

Because the dollar amounts associated with these derivatives measures  can vary significantly for a given bank, it is important to understand how  the measures are related to counterparty credit risk and liquidity risk in  order to accurately estimate such risks. For example, the derivatives held  by four U.S. banks account for the vast majority of derivatives held by  U.S. banks.  As of September 30, 2016, the different reported derivatives  measures for these four large bank swap dealers were as follows:

The notional amounts of their derivatives ranged from around $22 trillion  to $51 trillion.

Their gross derivative assets ranged from around $395 billion to $1.1  trillion.

Their net derivative assets ranged from around $12 billion to $65 billion,  representing 1 percent to 7 percent of their gross derivative assets.

Their gross derivative liabilities ranged from around $394 billion to $1.1  trillion.

Their net derivative liabilities ranged from around $5 billion to $53 billion,  representing 1 percent to 5 percent of their gross derivative liabilities.

The value of the collateral the four banks held against their derivative  assets (for over-the-counter (OTC) derivatives) ranged from 87 percent to  110 percent of their net derivative assets. However, these results  overestimate the extent to which the collateral would mitigate credit risk  as some counterparties over-collateralize and others under-collateralize  exposures, and collateral is not fungible across swap counterparties.  Banks typically require hedge funds to post an amount of collateral  greater than the value they are owed (i.e., greater than the net asset  amount of the derivatives with that counterparty), but banks may not  require commercial firms to post collateral. While a bank’s total held  collateral may nearly equal the total value of its net derivative assets, the  bank still may have uncollateralized derivative assets from swaps with  commercial firms.
subsections: section_title: Notional Amounts of Derivatives
paragraphs: Notional amounts alone do not provide useful measures of a bank’s  credit, liquidity, or market risks associated with its derivatives. The  notional amount of a derivative contract is a reference amount that is  used with the contract’s other terms to calculate payments. Notional  amounts generally are measured in dollar amounts but can reference  other amounts, such as the number of currency units, shares, bushels, or  pounds. Counterparties generally do not exchange the notional amounts  except in certain circumstances for certain types of credit derivatives. The  examples that follow show the role that notional amounts play in an  interest rate derivative contract and a credit default swap contract. In both  examples, the notional amount is a dollar amount. In the interest rate  derivative example, the notional amount is not exchanged. In the credit  default swap example, the notional amount is exchanged.

Example 1—Interest Rate Swap. Company C wants to hedge its risk  with a security paying a floating rate and enters into a 1-year interest rate  swap with Bank B. Under the swap, Bank B agrees to make quarterly  fixed payments of 5 percent multiplied by $10 million to Company C, and  Company C agrees to make quarterly floating payments of 3-month  London Interbank Offered Rate (LIBOR) multiplied by $10 million to Bank  B. The swap’s notional amount is $10 million. Table 2 shows the quarterly  amounts that Bank B owes Company C, the quarterly amounts that  Company C owes Bank B, and the net cash flows between the two  counterparties. Bank B and Company C do not exchange the notional  amount.

Example 2—Credit Default Swap. Insurer I invested $10 million in  Company C’s bonds and entered into a credit default swap with Bank B to  protect itself against a loss if Company C defaults on its debt. Under the  swap, Insurer I agrees to make quarterly payments of 5 percent of $10  million to Bank B, as long as Company C (a third party that is not a party  to this contract) does not default on its bonds, and Bank B agrees to pay  Insurer I $10 million in exchange for Company C’s bonds if Company C  defaults. The contract terminates in 5 years, or earlier if Company C  defaults. The swap’s notional amount is $10 million. Table 3 shows that  Insurer I made quarterly payments to Bank B for 6 quarters until  Company C defaulted. In the seventh quarter, Bank B pays Insurer I $10  million, and Insurer I delivers Company C’s bonds to the bank. Although  Bank B paid Insurer I the notional amount, it received $750,000 in  quarterly payments and Company C’s bonds, which could have some  recovery value.

section_title: Gross and Net Derivative Assets and Liabilities
paragraphs: Gross and net values of derivatives assets and liabilities can help  approximate certain risks associated with derivatives. As mentioned  earlier, swaps and other derivatives can be assets or liabilities. To see if a  derivative represents an asset or a liability to the bank, a bank estimates  the fair value of the contract. The fair value of a derivative contract is the  price at which the contract would be transferred in an orderly  transaction—one that occurs under sufficient time and exposure to the  market to allow for usual or customary marketing activities to unfold—between market participants in its principal (or most advantageous)  market. Generally, bank swap dealers recalculate the fair market value of  their derivatives contracts based on current market prices (called marking  to market) on a daily basis. A bank’s total gross derivative assets and  liabilities are an initial approximation of derivatives risks as follows:

The total for all contracts with positive fair values to the bank is the gross  value of its derivative assets. Counterparty credit risk is the potential for  financial losses resulting from the failure of a counterparty to perform on  an obligation. Thus, a bank’s gross derivative assets—or the gross value  of what it is owed on its derivatives—represents an initial measurement  of the bank’s counterparty credit exposure associated with its  derivatives.

The total for all contracts with negative fair values to the bank is the gross  value of its derivative liabilities. Liquidity risk is the risk to an institution’s  financial condition from its inability to meet its contractual obligations.  Similarly, a bank’s gross derivative liabilities—or the gross value of what  it owes on its derivatives—represents a measurement of the bank’s  liquidity risk exposure associated with its derivatives.

Accounting for the ability to net obligations with a derivatives counterparty  better approximates risks associated with derivatives. When a bank has  entered into multiple derivative contracts with the same counterparty that  are covered by a legally enforceable master netting agreement, the fair  values of all of the contracts with that counterparty—both positive and  negative—can be combined into a single net positive or negative fair  value of all the contracts with that counterparty.  That is, the combined  fair values of the contracts under an enforceable master netting  agreement with a counterparty result in a net asset or a net liability for the  bank with respect to that counterparty. This reduces counterparty credit  risk and, possibly, liquidity risk because netting can reduce or eliminate  exposures to a particular counterparty. For example, table 4 shows Bank  B has three outstanding derivatives with Company C under a legally  enforceable master netting agreement, allowing the contracts with  positive and negative fair values to be combined into a net derivative  asset of $845,000. Bank B also has two outstanding derivatives with  Insurer I under a legally enforceable master netting agreement, resulting  in a net derivative liability of $10,000. For the swaps under the same  legally enforceable master netting agreement with Company C, the gross  counterparty credit exposures to the company are reduced from  $1,070,000 to $845,000. For the swaps under the same legally  enforceable master netting agreement with Insurer I, counterparty credit  exposures are eliminated by netting.

section_title: Collateral Posted or Collected
paragraphs: Better measures of counterparty credit risk and liquidity risk would take  into account the value of the collateral received and paid by the bank,  respectively. As a market practice and more recently as a regulatory  requirement, swap dealers and other counterparties have used collateral  arrangements to mitigate counterparty credit risk. Under one type of  collateral arrangement, both counterparties post collateral (e.g., cash or  liquid securities) when they enter a derivative transaction and each  counterparty posts additional collateral based on the periodic marking to  market of the position. The counterparty whose position has a negative  fair value would post collateral with its counterparty. Collateral provides  protection to both parties in the event of a default on a transaction of the  other party, because the collateral receiver has recourse to the collateral  and can thus make good some or all of the loss suffered before having to  tap into its own capital to cover losses. The collateral held by a bank  helps the bank mitigate its credit risk exposure to the counterparty that  provided the collateral. Similarly, the collateral paid by the bank to a  counterparty helps mitigate the strain that future swap obligations with  that counterparty may pose on the bank.

Example 3: Bank B’s Derivatives Portfolio after Accounting for  Netting and Collateral. Table 5 shows the total notional amounts and  total gross derivative assets and liabilities of Bank B’s derivatives and the  effects of netting and collateral on Bank B’s counterparty credit risk  exposure. The total notional amount of derivatives contracts with positive  fair value is $55 million, and the total gross positive fair value of the  contracts (i.e., the bank’s value of its gross derivative assets) is $1.54  million. The total notional amount of derivatives contracts with negative  fair value is $45 million, and the total gross negative fair value of the  contracts (i.e., the bank’s value of its gross derivative liabilities) is about  $795,000. After accounting for netting, gross derivative assets are  reduced to $975,000 and gross derivative liabilities are reduced to  $430,000. After accounting for collected and posted collateral, the total  net derivative assets are $878,000, and total net derivative liabilities are  $349,000. As mentioned earlier, these are more accurate measures of  counterparty credit risk and liquidity risk for bank B, because they  measure the bank’s outstanding risks after taking into account netting and  collateral received and paid.

section_title: Appendix III: Select Dodd-Frank Act Requirements That Help Mitigate Risks Associated with Banks’ Swap Activities
paragraphs: In addition to section 716, the Dodd-Frank Wall Street Reform and  Consumer Protection Act (Dodd-Frank Act) includes other provisions that  serve to limit, reduce, or mitigate risks faced by banks because of their  swap or security-based swap (collectively referred to as swaps, unless  otherwise noted) activities.  Specifically, the Dodd-Frank Act establishes  a framework to address the financial stability risks associated with major  financial companies. Part of this framework seeks to reduce major  financial companies’ probability of failure, including from their swap  activities, by requiring the Board of Governors of the Federal Reserve  System (Federal Reserve) to subject them to enhanced capital, liquidity,  and other prudential requirements and to heightened supervision.

In addition, the Dodd-Frank Act also establishes a new regulatory  framework specifically for swaps to reduce risk, increase transparency,  and promote market integrity in swaps markets. Under the new  framework, banks that deal swaps or security-based swaps in amounts  above a specified threshold must register as swap or security-based  swap dealers with the Commodity Futures Trading Commission (CFTC)  or the Securities and Exchange Commission (SEC), respectively.  These  bank swap dealers also are subject to margin, capital, and other  requirements set by their respective federal prudential banking regulator:  the Federal Reserve, the Office of the Comptroller of the Currency (OCC),  or the Federal Deposit Insurance Corporation (FDIC).
subsections: section_title: Dodd-Frank Act Capital and Leverage Requirements for Banking Organizations
subsections: section_title: Quantitative Capital and Leverage Requirements
paragraphs: Federal prudential banking regulators established an integrated  regulatory capital framework by implementing many aspects of the Basel  III regulatory capital reforms and the Dodd-Frank Act’s prudential  reforms.  The reforms include implementing a number of minimum risk- based capital and leverage requirements and a capital conservation  buffer for banking organizations, including U.S. banks and their holding  companies (see table 6).

In addition, prudential regulators have imposed more stringent capital and  leverage requirements on larger, more complex firms that serve as an  additional capital buffer. These firms include (1) large, internationally  active bank holding companies (BHC), also referred to as Advanced  Approaches BHCs, and (2) global systemically important BHCs (GSIB).   There are 15 U.S. banks that are registered with CFTC as swap dealers  and thus are covered by the amended section 716 of the Dodd-Frank Act.  As of September 30, 2016, 11 of the banks were subsidiaries of  Advanced Approaches BHCs, and of these 11 BHCs, 8 of them also were  GSIBs. A BHC that does not hold capital sufficient to meet or exceed its  combined buffer level is subject to restrictions on capital distributions and  discretionary bonus payments to executives, which become progressively  stricter as its capital level falls deeper into the buffer. The additional  capital buffer requirements are the following:

Supplementary leverage ratio: Generally, Advanced Approaches BHCs  (including GSIBs) and their bank subsidiaries, must maintain a  supplementary leverage ratio of at least 3 percent on top of the minimum  leverage ratio requirement described in table 6. The Advanced  Approaches BHCs that are GSIBs also must maintain a leverage buffer  of 2 percentage points on top of the 3 percent. Additionally, bank  subsidiaries of GSIBs must maintain a supplementary leverage ratio of at  least 6 percent to be considered “well capitalized” for purposes of Prompt  Corrective Action.

GSIB capital surcharge: The Federal Reserve established criteria for  identifying a GSIB based on indicators in broad categories that are  correlated with systemic importance, such as size, interconnectedness,  cross-jurisdictional activity, substitutability, and complexity.  The rule also  imposed a risk-based capital surcharge for identified GSIBs based on  calculations of risk derived from methods detailed in the rule. When the  Federal Reserve issued the final rule on July 20, 2015, it estimated  surcharges for the eight GSIBs it identified ranging from 1.0 percent to  4.5 percent of each firm’s total risk-weighted assets.

Countercyclical capital buffer: Advanced Approaches BHCs and their  banks are also subject to additional capital buffer requirements that  expand the uniform capital conservation buffer in times of increasing  financial vulnerabilities.

Market risk capital rule: BHCs and banks with significant trading  operations are required to report their market risk-weighted assets and  include this amount in the total risk-weighted assets amount used to  calculate their capital ratios.  In 2015 and 2016, all section 716 banks  and their BHCs were market risk firms.

Under the capital and leverage ratio requirements (the minimum capital  and leverage ratios and the supplementary leverage ratio) a BHC or  bank’s weighted or unweighted derivatives exposures will increase the  denominator of the ratios and, thus, require the BHC or bank to hold  additional capital (as specified in the numerators of the ratios) to comply  with the requirements. The capital buffer requirements (the capital  conservation buffer and the countercyclical buffer) effectively increase the  minimum ratio requirements, consequently increasing the required capital  that covered BHCs or banks have to hold. In addition, the market risk  capital rule and the more stringent Basel III risk weights on certain types  of risky assets, including derivatives, increase risk-weighted assets which  in turn increase the denominator of many of the ratio requirements.  Because capital provides an institution with a cushion to absorb losses  from its various activities, including derivatives trading, the capital and  leverage requirements identified above help covered banks and their  BHCs mitigate losses from swaps activity.

section_title: Capital Planning and Stress Test Requirements
paragraphs: The Federal Reserve also established supervisory stress test  requirements for certain BHCs and certain banks, in part as a result of  Dodd-Frank Act reforms. Dodd-Frank Act stress tests (DFAST) generate  forward-looking information about a BHC’s capital adequacy and are  used, in part, to project how hypothetical baseline, adverse, and severely  adverse scenarios would affect the BHC’s revenues and losses and  ultimately its capital levels. The Federal Reserve also uses the  Comprehensive Capital Analysis and Review (CCAR), which builds on  information from DFAST, to quantitatively and qualitatively evaluate the  capital adequacy and capital planning processes of large BHCs.  Under  CCAR, the Federal Reserve may object to a BHC’s capital plan on either  quantitative or qualitative grounds. A quantitative objection is made when  the stress test reveals that a firm would not be able to maintain its post- stress capital ratios above the regulatory minimum levels over the  planning horizon, taking into account its planned capital distributions. The  Federal Reserve may object on qualitative grounds if it finds that the  BHC’s capital planning processes are not sufficiently reliable. If the  Federal Reserve objects on quantitative or qualitative grounds, the BHC  may not make any capital distributions without the Federal Reserve’s  permission.

As required under the Dodd-Frank Act, the Federal Reserve annually  defines three stress test scenarios—baseline, adverse, and severely  adverse—that it uses for the supervisory stress test and requires DFAST  BHCs to use in their annual company-run tests.  The scenarios consist  of hypothetical projections for macroeconomic and financial variables,  such as measures of the unemployment rate, gross domestic product,  housing and equity prices, interest rates, and financial market volatility.  The stress tests’ post-stress capital ratios, which are an important output  of the stress tests, reflect projections of risk-weighted assets and balance  sheet and income statement items under the stress scenarios and  measure the amount of capital a BHC would have available to cover  unexpected losses.

Federal Reserve staff told us that stress tests do not separately stress a  BHC’s over-the-counter (OTC) derivatives portfolios. However, the stress  tests are a forward-looking method to help ensure that a BHC has  sufficient capital to withstand losses, including from OTC derivatives,  under stressed scenarios. In addition, BHCs with large trading operations,  including from derivatives, are subject to additional components in the  severely adverse and adverse DFAST scenarios designed to stress their  trading and private equity (in the case of the global market shock), or  counterparty positions (in the case of the counterparty default  component).  All section 716 covered banks’ BHCs are subject to  DFAST and CCAR stress tests. Six of the covered banks’ BHCs are  subject to the global market shock component, and eight of the covered  banks’ BHCs are subject to the counterparty default component in their  adverse and severely adverse scenarios.  Lastly, the Dodd-Frank Act  also requires banks and other financial companies with $10 billion in  assets or more to conduct annual stress tests pursuant to regulations  prescribed by their respective primary financial regulatory agencies. All of  the banks covered by section 716 are subject to such company-run stress  tests.

section_title: Swap Margin (Collateral) Requirements
paragraphs: Title VII of the Dodd-Frank Act provides for the registration and regulation  of swap dealers and major swap participants and subjects them to CFTC,  SEC, and prudential regulatory requirements, such as minimum capital  and minimum initial and variation margin requirements (also referred to as  collateral requirements, because margin requirements are satisfied by  collecting or posting collateral such as cash or certain securities).   Prudential regulators’ collateral requirements mandate the exchange of  initial and variation margin for noncleared swaps between bank swap  dealers and certain counterparties. The amount of required margin varies  based on the risk posed by a covered swap entity’s counterparty.

Initial margin protects the collecting party from the potential future  exposure that could arise from changes in the mark-to-market value of  the contract in the event that the margin-posting party defaults. The  amount of initial margin reflects the size of the potential future exposure.  A covered swap entity generally must post and collect initial margin when  it engages in noncleared swaps with another swap entity or with a  financial end-user with material swaps exposures.  Swap transactions  used by other end-users to hedge or mitigate commercial risk are exempt  from initial margin requirements. If the end-user is not using the swap for  hedging purposes, a covered swap entity must collect initial margin that  has been determined to appropriately address the credit risk posed by  the counterparty and the risks of such swap.

Variation margin protects the transacting parties from the current  exposure that has already been incurred by one of the parties from  changes in the mark-to-market value of the contract after the transaction  has been executed. The amount of variation margin reflects the size of  this current exposure. A covered swap entity generally must post and  collect variation margin on trades with other swap entities or with financial  end-users. Swap transactions used by commercial (i.e., non-financial)  end-user counterparties to hedge or mitigate commercial risk are exempt  from collateral requirements. If the commercial end-user is not using the  swap for hedging purposes, a covered swap entity must collect variation  margin that has been determined to appropriately address the credit risk  posed by the counterparty and the risks of such swap.

section_title: Dodd-Frank Act Liquidity Requirements for Banking Organizations
paragraphs: The prudential regulators also are establishing a new liquidity framework  for U.S. BHCs, as well as certain savings and loan holding companies  and large insured depository institution subsidiaries, by implementing  Basel III and Dodd-Frank Act liquidity requirements. The reforms include  two new quantitative liquidity standards: the Liquidity Coverage Ratio  (LCR) and the proposed Net Stable Finding Ratio (NSFR) (see table 7).  The LCR standard is designed to promote the short-term resilience of the  liquidity risk profile of large banking organizations and to improve the banking sector’s ability to absorb shocks arising from economic and  financial stress over a short term.  The proposed NSFR rule focuses on  the stability of a company’s funding structure over a longer, one-year  horizon. The LCR generally applies to banking organizations with $250  billion or more in total consolidated assets or $10 billion or more in on- balance sheet foreign exposure and their subsidiary depository  institutions that have assets of $10 billion or more. The LCR final rule also  applies a less stringent, modified LCR to BHCs and certain savings and  loan holding companies that do not meet these thresholds but have $50  billion or more in total assets. Covered companies must hold high-quality  liquid assets at least equal to 100 percent (70 percent for the modified  LCR) of their net cash outflows over a 30-day stress period. As proposed,  the NSFR would apply to bank holding companies, certain savings and  loan holding companies, and depository institutions that have $250 billion  or more in total consolidated assets or $10 billion or more in total on- balance sheet foreign exposure, and to their consolidated depository  institution subsidiaries that have total consolidated assets of $10 billion or  more. The proposed rule also would apply a less stringent, modified  NSFR to BHCs and certain savings and loan holding companies that do  not meet these thresholds but have $50 billion or more in total  consolidated assets. The proposal would require covered companies to  maintain available stable funding that equals or exceeds 100 percent (or  70 percent in the case of modified NSFR) of its required stable funding on  an ongoing basis.

Under the liquidity requirements, a BHC’s derivative activity can increase  the denominator of the ratios and, thus, require the BHC, savings and  loan holding company, bank, or thrift to hold more liquid assets or stable  funding to comply with the requirements. In the case of the LCR, the  denominator of the ratio can increase with (1) net derivative cash outflows  (i.e., the amount, if greater than zero, of the payments and collateral  made or delivered to each counterparty, less the sum of payments and  collateral due from each counterparty, if subject to a valid qualifying  master netting agreement), or (2) net collateral outflows (i.e., outflows  related to changes in collateral positions that could arise during a period  of financial stress).  In the case of the NSFR, the denominator increases  if an aggregated measure of a covered company’s derivatives portfolio is  a net asset, as the regulators believe such assets require full stable  funding. The denominator also increases based on a measure of gross  derivative values that are liabilities to account for potential changes in the  value of the derivatives that may require the firm to post additional  collateral or settlement payments.

In addition, the Federal Reserve launched in 2012 the Comprehensive  Liquidity Assessment and Review (CLAR) for GSIBs and other large  firms. According to Federal Reserve staff, CLAR is a supervisory annual  quantitative and qualitative assessment of a GSIB’s and other large firms’  liquidity positions and liquidity risk management practices. Under CLAR,  the Federal Reserve evaluates firms’ liquidity positions both through a  range of supervisory liquidity metrics and through analysis of firms’  internal stress tests that each firm uses to make funding decisions and to  determine its liquidity needs. According to Federal Reserve staff, in  evaluating the firms’ stress testing practices the Federal Reserve has  focused on assumptions regarding liquidity needs for derivatives trading,  among other issues. Unlike the capital stress tests, CLAR does not  include specific standardized minimum liquidity ratios based on stress  tests. But according to Federal Reserve staff, through supervisory  direction, stress test ratings downgrades, or enforcement actions, the  Federal Reserve directs firms with weak liquidity positions under CLAR’s  liquidity metrics to improve their practices and, as warranted, their liquidity  positions.

section_title: Limits on BHCs’ Credit Exposures and Restrictions on Their Swap Activities
paragraphs: The Federal Reserve has proposed regulations imposing single  counterparty credit limits for BHCs with total consolidated assets of $50  billion or more. The proposal would limit the aggregate net credit  exposure, including credit exposure from swaps and other derivatives, of  a BHC with total consolidated assets of $50 billion or more to a single  counterparty. For U.S. BHCs, the proposed credit exposure limits are as  follows: (1) A GSIB would be required to limit its aggregate net credit  exposure to another GSIB or to a nonbank financial company supervised  by the Federal Reserve to 15 percent of its tier 1 capital, and to other  counterparties to 25 percent of its tier 1 capital,  (2) an advanced  approaches firm that is not a GSIB would be required to limit its  aggregate net credit exposure to a counterparty to 25 percent of its tier 1  capital, and (3) any other covered BHC would have to limit its exposure to  a counterparty to 25 percent of its consolidated capital stock and surplus.

Additionally, in an effort to restrain risk taking at BHCs and to reduce the  potential for these entities to require federal support because of their  speculative trading activity, section 619 of the Dodd-Frank Act (also  known as the Volcker Rule) prohibits banking entities from engaging in  proprietary trading, subject to certain exceptions.  Proprietary trading  generally refers to using the institution’s own funds to profit from short- term price changes and includes derivatives trading.  The prohibition  applies broadly to banking entities that are registered swap dealers.  Exceptions from the prohibition exist for derivatives transactions entered  into for purposes of risk-mitigating hedging, market-making, or  underwriting.  Consequently, section 619 and section 716 have some  similarities, although they are different in their scope of covered entities or  products. Under section 619, banking entities can engage in proprietary  trading in derivatives if they meet the requirements of a permitted activity,  including market-making or risk-hedging; under section 716, only swap  entities have additional restrictions regarding the types of swap activities  in which they may engage.  While section 716 applies to bank swap  dealers, the Volcker Rule generally restricts proprietary trading by insured  depository institutions and companies that control insured depository  institutions and their affiliates and subsidiaries. In this regard, the Volcker  Rule seeks to limit the amount of speculative derivatives exposures that  can generate large gains but also unmanageably large losses throughout  a BHC, as was the case with American International Group, Inc. (AIG)  during the 2007—2009 crisis.

Table 8 summarizes Dodd-Frank Act requirements imposed on bank  swap dealers or their BHCs that serve to help reduce their probability of  failure.

section_title: Appendix IV: Estimating Certain Risks for U.S. Banks That Would Have Been Affected by the Original Section 716
paragraphs: The original section 716 of the Dodd-Frank Wall Street Reform and  Consumer Protection Act (Dodd-Frank Act) generally prohibited the  provision of federal assistance to banks registered as swap dealers that  engaged in equity swaps, commodity (except for precious metals) swaps,  and noncleared credit default swaps activity, unless, among other things,  the institution limited its swap activities to hedging and other similar risk  mitigating activities directly related to the institution’s activities. In  December 2014, section 716 was amended before the transition periods  for complying with the original provision expired, and the provision’s  scope was reduced to cover only structured finance swaps activity (e.g.,  swaps on asset-backed securities), unless the swaps were undertaken for  hedging or risk management purposes. To analyze the risks associated  with swaps covered under the original section 716, we focused on the 11  U.S. banks that were registered as swap dealers and dealt equity,  commodity, or noncleared credit default swaps before the original section  716 was amended.  Had section 716 not been amended, these 11 U.S.  banks would have had to stop engaging in swaps activity for such swaps  on or before July 16, 2015, generally when their transition periods  expired, in order to retain access to federal assistance. With the  amendment, the 11 bank swap dealers were allowed to continue to deal  equity, commodity, or noncleared credit default swaps (with the exception  of certain structured finance swaps due to the section 716 amendment).  We analyzed how equity, commodity, and credit derivatives affected the  counterparty credit, liquidity, and market risks of the 11 bank swap  dealers from July 16, 2015, through September 30, 2016.
subsections: section_title: Data, Limitations, and Assumptions for Our Methodology
paragraphs: To analyze counterparty credit and liquidity risks associated with swaps  covered under the original section 716, we primarily used data from the  11 U.S. banks’ Consolidated Reports of Condition and Income (commonly  referred to as Call Reports). As discussed in appendix II, an initial  measurement of a bank’s counterparty credit risk is the sum of a bank’s  derivative contracts that have a positive fair value, called gross derivative  assets. Similarly, a measurement of a bank’s liquidity risk from its  derivatives is the sum of the bank’s derivative contracts that have a  negative fair value, called gross derivative liabilities. In Call Reports,  banks report gross derivative assets and liabilities by type of underlying— interest rate, foreign exchange, equity, commodity, and credit  derivatives.  However, gross derivative assets and liabilities can  significantly overestimate a bank’s counterparty credit or liquidity  exposures, because they do not account for netting that can significantly  reduce such risks.

As discussed in appendix II, a bank that has multiple derivative contracts  with the same counterparty under a legally enforceable master netting  agreement can combine all contracts’ gross positive and negative fair  values (i.e., gross assets and liabilities) into a single net positive or  negative fair value (i.e., net asset or liability) with that counterparty.  Such  netted derivative assets and liabilities across a bank’s counterparties is  the primary metric that the Office of the Comptroller of the Currency uses  to evaluate banks’ counterparty credit risk from their derivatives. In Call  Reports, banks report net derivative assets and liabilities of their trading  derivatives in aggregate and not by type of underlying (i.e., interest rate,  foreign exchange rate, equity, or credit derivative contracts).  Because  interest rate and foreign exchange swaps were not covered under the  original section 716, such data cannot be used to measure a bank’s  counterparty credit or liquidity risk on a net basis for only its swaps  covered under that version of the provision.

In light of the data limitations, we took two approaches to measure the 11  banks’ counterparty credit and liquidity risks from their trading derivatives.  For the four largest bank swap dealers, which account for around 90 percent of all derivatives held by U.S. banks, we used a methodology to  estimate net derivative assets and liabilities for the swaps covered and  not covered under the original section 716.   As mentioned earlier,  interest rate and foreign exchange derivatives were not covered by the  original section 716 but in September 30, 2016, accounted for over 90  percent of each of the four banks’ total derivatives notional amounts.  Thus, not excluding such derivatives from our counterparty credit and  liquidity risk measures would significantly overestimate risks arising solely  from section 716 covered swaps. For the 7 other bank swap dealers, we  used a simpler but less precise approach that included their interest rate  and foreign exchange derivatives.
subsections: section_title: Four Largest Bank Swap Dealers
paragraphs: For the four largest bank swap dealers (Bank of America, N.A., Citibank,  N.A, Goldman Sachs USA Bank, and JPMorgan Chase Bank, N.A.), we  developed a methodology using the gross derivative assets and liabilities  of their trading derivatives as reported in the September 30, 2016, Call  Reports to estimate net derivative assets and liabilities by type of  underlying. Our methodology included the following steps.

Of the four banks, only one of their bank holding companies (BHC)  reports gross trading derivative assets and liabilities by type of underlying  in its annual and quarterly filings with the Securities and Exchange  Commission (SEC).  We divided the reported BHC’s net assets and  liabilities for its interest rate, foreign exchange, equity, commodity, and  credit derivatives by their respective gross assets and liabilities to  develop “netting ratios” for each type of underlying, covering data from  2009 through 2016. For example, to calculate the netting ratios for  interest rate derivative assets and liabilities, we did the following: We  divided (1) interest rate derivative net assets by interest rate derivative  gross assets, and (2) interest rate derivative net liabilities by interest rate  derivative gross liabilities.

We calculated the minimum, median, and maximum netting ratios over  the selected period, resulting in three netting ratios for derivative assets  under each type of underlying (i.e., interest rate, foreign exchange equity,  commodity, and credit derivatives) and three netting ratios for derivative  liabilities under each type of underlying. We calculated minimum, median,  and maximum netting ratios over the time period, because the banks’  netting ratios may differ from the BHC’s netting ratios.

For each bank, we multiplied the minimum, median, and maximum  netting ratios by the bank’s respective gross derivative assets or liabilities  by type of underlying (as reported in the September 30, 2016, Call  Reports). These calculations produced a range of minimum, median, and  maximum estimates of net trading derivative assets and liabilities by type  of underlying for each bank. We summed the minimum, median, and  maximum estimates to produce three estimates of total net derivative  assets and liabilities for each bank.

To determine whether we should use the minimum, median, or maximum  estimate, we compared each estimated total against the total net  derivative assets and liabilities for each bank’s trading derivatives, as  reported in the September 30, 2016, Call Reports. We selected the  estimates closest in value to the actual reported values. We used the  minimum estimated totals for Goldman Sachs USA Bank, the median  estimated totals for JPMorgan Chase Bank N.A., and the maximum  estimated totals for Citibank N.A., and Bank of America N.A. We also  compared each bank’s actual netting ratios and our estimated netting  ratios on a portfolio basis (e.g., total net derivative assets and liabilities  divided by total gross derivative assets and liabilities). JPMorgan Chase  Bank N.A.’s, Citibank N.A.’s, and Bank of America N.A.’s actual and  estimated netting ratios differed by less than a half of a percentage point.  Our estimated netting ratios for Goldman Sachs USA Bank were 2.0  percentage points and 1.5 percentage points higher than its actual  netting ratios.

After selecting the estimates of the net derivatives assets and liabilities  for each bank’s total trading derivatives that was closest in value to the  bank’s actual reported values, we then used the estimates to measure  the bank’s net exposures to swaps covered under the original section  716. For derivative assets and liabilities, each total net estimate is  comprised of net estimates of the bank’s interest rate, foreign exchange,  equity, commodity, and credit derivatives. We added the estimated net  derivative assets of each bank’s equity, commodity, and credit derivatives  to estimate each bank’s counterparty credit exposure associated with  section 716 originally covered swaps. Similarly, we added the estimated  net derivative liabilities of each bank’s equity, commodity, and credit  derivatives to estimate each bank’s liquidity exposure associated with  section 716 originally covered swaps.

Our methodology assumes that the four banks’ netting ratios are  comparable to the netting ratios of the BHC that reported gross and net  derivatives assets and liabilities by underlying. To the extent this  assumption does not hold true, such as because of differences in the  composition of the banks’ derivatives trading portfolios or counterparties,  our estimates would be adversely affected. As discussed earlier, to  assess the reasonableness of our assumption and estimates, we  compared our estimates of each bank’s total net derivative assets and  liabilities with each bank’s actual total net derivative assets and liabilities.  Also, we recognize that our estimates likely overestimate the banks’  counterparty credit and liquidity exposures associated with section 716  originally covered swaps, in part because they do or likely include (1)  swaps that were used for hedging and, thus, would have been  permissible under the original section 716, (2) swaps that the banks  entered into before section 716 would have taken effect and thus could  have been retained by the banks, and (3) swaps that were not covered  by the original section 716, such as commodity swaps referencing bullion  or cleared credit default swaps.

section_title: Seven Other Bank Swap Dealers
paragraphs: For the other seven bank swap dealers that would have had to stop  engaging in swaps activity for swaps covered by the original section 716  had it not been amended, in order to retain access to federal assistance,  we used the total net derivatives trading assets and liabilities as reported  in the September 30, 2016, Call Reports. As discussed earlier, such data  include interest rate and foreign exchange derivatives that were not  covered by the original section 716. As with the four largest bank swap  dealers, the majority of the derivatives of the other seven dealers are  interest rate and foreign exchange derivatives.  However, they hold  significantly less derivatives than the four largest bank swap dealers.  Because of such differences, we could not use our netting ratios to  estimate the net derivative assets and liabilities of the seven banks’  equity, commodity, and credit derivatives based on their reported gross  derivative assets and liabilities. As a result, our measures of the  derivatives-related counterparty credit and liquidity risks associated with  section 716 originally covered swaps for these seven bank swap dealers  overestimate the actual counterparty credit and liquidity risk they face  from those swaps.

section_title: Estimates of Counterparty Credit Risk Associated with Swaps Covered under the Original Section 716
paragraphs: Counterparty credit risk is the potential for financial losses resulting from  the failure of a borrower or counterparty to perform on an obligation. For  the 11 U.S. banks, our analyses indicate that the banks held the capital  needed to support counterparty credit exposures (accounting for netting  but not collateral) from their equity, commodity, or credit derivatives as of  September 30, 2016. Our analyses also show that the fair value of the  collateral held by banks in relation to their over-the-counter (OTC) trading  derivative counterparties was, on average, sufficient to cover at least 68  percent of net current credit exposures of their derivatives. These results  indicate that the banks had capital to absorb potential losses from their  swaps covered by the original section 716 and that such losses likely  would have been mitigated to a significant degree with the collateral  received from bank OTC derivative counterparties.

For the four largest bank swap dealers, our analyses indicate that their  estimated net counterparty credit exposures from their swaps covered by  the original section 716 comprise from around 1 percent to 10 percent of  their total capital as of September 30, 2016. In addition, the four largest  bank swap dealers on average collectively held collateral against 99  percent of their collective net current credit OTC derivatives exposures  (see table 9).  However, this percentage does not mean that almost all  current credit exposure would be mitigated with collateral, as some  counterparties overcollateralize and others undercollateralize exposures,  and collateral is not fungible across swap counterparties.

For the seven other bank swap dealers, our analyses shows that their net  counterparty credit exposures from all of their trading derivatives— including swaps not covered under the original section 716—comprised  from around 4 percent to 16 percent of their total capital as of September  30, 2016.  In addition, these banks, on average, collectively held  collateral against 68 percent of their collective net current credit OTC  derivatives exposures (see table 10). Again, this percentage does not  mean that 68 percent of their current credit exposure would be mitigated  with collateral, as some counterparties over-collateralize and others  under-collateralize exposures, and collateral is not fungible across swap  counterparties.

section_title: Estimates of Liquidity Risk Associated with Swaps Covered under the Original Section 716
paragraphs: Liquidity risk is risk to an institution’s financial condition from its inability to  meet its contractual obligations. Derivatives liabilities expose banks to  liquidity risk, in part because the derivative contracts typically require the  banks to make regular payments as agreed in the contracts and post  collateral to counterparties as the value of the contracts moves in the  counterparties’ favor.  Net derivative liabilities, however, do not take into  account collateral that the bank may have already posted to its  counterparties (and thus would be available to counterparties to absorb  losses).

For the 11 U.S. banks, our analyses indicate the banks held high-quality  liquid assets needed to support their equity, commodity, or credit  derivatives’ payment and collateral obligations as of September 30, 2016.  This result suggests that the banks would have had liquidity to meet the  obligations from their equity, commodity, and credit derivatives. To  assess liquidity risk, we used estimated or reported net derivative  liabilities for banks’ trading derivatives as our measure of the banks’  derivatives liquidity risk, and we compared those values with the banks’  high-quality liquid assets.

For the four largest bank swap dealers, our analyses indicate that the  estimated net derivative liabilities for their equity, commodity, and credit  derivatives (not accounting for posted collateral) constituted from less  than 1 percent to about 5 percent of the banks’ high-quality liquid assets  as of September 30, 2016. Because banks have posted collateral for  some of these derivatives and because our analyses do not account for  such posted collateral, our percentages overestimate the actual  derivatives-related liquidity risk exposures.

For the other seven bank swap dealers, our analyses show that the  actual total net trading derivative liabilities (including swaps not covered  under the original section 716 but not accounting for collateral)  constituted from about 1 percent to about 9 percent of their banks’ high- quality liquid assets as of September 30, 2016. The total includes interest  rate and foreign exchange derivatives, which were not covered by the  original section 716 and typically comprise the majority of the banks’  trading derivatives.

section_title: Estimates of Market Risk Associated with Swaps Covered under the Original Section 716
paragraphs: Market risk is the potential for financial losses due to the increase or  decrease in the value or price of an asset or liability resulting from broad  movements in prices such as changes in interest rates, foreign exchange  rates, equity prices, or commodity prices. To estimate market risks  associated with swaps, we analyzed the quarterly net gains or losses  from trading commodity, equity, and credit derivatives and cash  instruments for the 11 banks that would have been required to stop  engaging in activity for such swaps, or lose access to federal assistance,  under the original section 716 from the first quarter of 2007 through the  third quarter of 2016. Our analyses of the 11 banks’ quarterly mark-to- market losses from trading equity, commodity, and credit derivatives  between the first quarter of 2007 and the third quarter of 2016 show that  banks held the capital needed to support related trading losses.

For the four largest bank swap dealers, our analysis found that quarterly  net losses did not exceed 7.6 percent of any of the bank’s capital from  the first quarter of 2007 through the third quarter of 2016 (see fig. 8).

For the other seven bank swap dealers, our analysis found that their  quarterly net losses ranged from 0 percent to about 2 percent of any  bank’s capital for six of the seven banks between the first quarter of 2001  and third quarter of 2016. For the other bank, its largest loss during a  quarter was around 14 percent of its capital (see fig. 9).

More forward-looking measures of market risk posed by derivatives  suggest that the expected losses from derivatives may be relatively small  under regular and stressed market conditions. First, banks primarily  control market risk in trading operations by establishing limits against  potential losses using value-at-risk models (VaR).  The models use  historical data to quantify the potential losses from adverse market moves  in normal markets. The reported VaR measures for the BHCs of the four  largest bank swap dealers indicate that the market risk from each BHC’s trading activities, which includes its section 716 bank’s derivatives  activities, is less than 1 percent of their capital: for example, ranging from  0.02 percent to 0.22 percent of their capital in the third quarter of 2016.

Second, as discussed in appendix III, the Board of Governors of the  Federal Reserve System’s (Federal Reserve) supervisory stress tests  estimate losses that large BHCs may suffer, including from their  derivatives, under stressed market conditions. The BHCs of the 11 bank  swap dealers are subject to the Federal Reserve’s stress tests, which  evaluate the BHCs’ revenues and losses and ultimately their capital levels  under baseline, adverse, and severely adverse scenarios. In its 2015 and  2016 reviews, the Federal Reserve did not object on quantitative or  qualitative grounds to any of the capital plans, including the supervisory  stress test results, of the 11 BHCs. All 11 BHCs were able to maintain at  least minimum regulatory capital requirements under stressed scenarios  and had no significant deficiencies in their capital planning processes. In  addition, 6 of the 11 BHCs are subject to the additional global market  shock component, and 8 of the 11 BHCs are subject to the counterparty  default component in their adverse and severely adverse scenarios.

section_title: Appendix V: Dodd-Frank Act Resolution Reforms and Largest U.S. Bank Swap Dealers
paragraphs: Prudential regulators are implementing the Dodd-Frank Wall Street  Reform and Consumer Protection Act’s (Dodd-Frank Act) resolution  reforms to help ensure that large bank holding companies (BHC),  including their banks, can be resolved in an orderly manner, if necessary.  These reforms, if successful, can help BHCs with banks that are large  swap dealers wind-down their swaps in an orderly manner and preserve  their value.  Fifteen U.S. banks are provisionally registered as swap  dealers with the Commodity Futures Trading Commission. However, four  U.S. bank swap dealers—Bank of America, N.A.; Citibank, N.A.; Goldman  Sachs Bank USA; and JPMorgan Chase Bank N.A.—account for the  large majority of derivatives held by U.S. banks. These bank swap  dealers are subsidiaries of BHCs that the Board of Governors of the  Federal Reserve System (Federal Reserve) has identified as global  systemically important BHCs (GSIB) in light of the threat their failure or  material financial distress would pose to U.S. financial stability.  This  section’s discussion and analyses primarily focus on the four U.S. GSIBs  and their bank swap dealers.
subsections: section_title: Resolution Plans under the Dodd-Frank Act
paragraphs: In the event of their failure, the four BHCs with the largest U.S. bank swap  dealers plan to enter bankruptcy but keep their operating subsidiaries  (e.g., banks and broker-dealers) solvent, in part to help them wind-down  their swaps in an orderly manner. The Dodd-Frank Act requires certain  institutions, including the four BHCs, to develop resolution plans for rapid  and orderly resolution in the event of material financial distress or failure.   According to the Federal Reserve and the Federal Deposit Insurance  Corporation (FDIC), resolution planning cannot guarantee that a BHC’s  resolution would be executed smoothly, but the preparations can help  ensure that the BHC could be resolved under bankruptcy without  requiring government support or imperiling the broader financial system.   We concluded in 2016 that whether the largest BHCs’ resolution plans  would facilitate their rapid and orderly resolution under the U.S.  Bankruptcy Code is uncertain, in part because none has used its plan to  go through bankruptcy.

Since 2012, the four U.S. BHCs with the largest swap dealers, along with  other large U.S. BHCs, have submitted resolution plans annually to the  Federal Reserve and FDIC. Through their review of the plans, the  regulators have provided additional guidance and feedback based on  their review and expectations. Based on their review of the 2015 plans  submitted by these four BHCs, the regulators jointly determined that two  of the plans were not credible or would not facilitate an orderly resolution  under the U.S. Bankruptcy Code.  The regulators sent these two BHCs  feedback letters that identified the plan deficiencies and required  corrective actions.  In addition, in their feedback letters, the regulators  identified shortcomings in all four of the BCHs’ resolution plans and  directed them to address the shortcomings in their plans submitted by  July 1, 2017.  As summarized in table 11, the regulators jointly identified  in their feedback letters to the four BHCs a deficiency or shortcoming with  each one’s 2015 plan to wind-down its derivatives in an orderly manner.

Following their review of the 2015 resolution plans, the Federal Reserve  and FDIC issued new guidance to all of the BHCs required to submit  resolution plays by July 1, 2017. As part of the guidance, the regulators  included a section on derivatives and trading activities that applied to the  four U.S. BHCs with the largest bank swap dealers. According to the  guidance, a dealer’s plan to stabilize and wind down a large derivative  portfolio in an orderly manner following the BHC’s bankruptcy raises a  number of significant issues that the four U.S. BHCs should address in  their 2017 plans.  As summarized in table 12, the four U.S. BHCs  reported in the public sections of their 2016 plan filings a high-level  summary of selected actions that they have taken.

In the public sections of their resolution plans, the four U.S. BHCs with  the largest bank swap dealers generally have adopted the Single Point of  Entry (SPOE) strategy as their preferred resolution strategy under the  U.S. Bankruptcy Code. Under the SPOE strategy, only the top-tier BHC  would enter bankruptcy. The BHC would use its financial resources, as  needed, to recapitalize and support its operating subsidiaries to keep  them solvent and preserve their going-concern value. For example, a loss  that caused a BHC to fail would be passed up from the subsidiary that  incurred the loss and would be absorbed by the BHC’s equity holders and  unsecured creditors, which would have the effect of recapitalizing the  BHC’s subsidiary. As shown in figure 10, the SPOE resolution approach  serves to enable a BHC’s subsidiaries to continue to operate while the  BHC enters bankruptcy, reducing the potential for negative impact on its  customers and the overall economy. In the example, the bank transfers  losses up to its BHC in the event of distress, and only the BHC enters  bankruptcy. As permitted by the bankruptcy court, the BHC transfers its  subsidiaries to a new BHC, and these subsidiaries are then sold or wound  down in an orderly manner.

While the four U.S. BHCs face a number of obstacles or challenges in  implementing their SPOE strategies, they and prudential regulators are  taking actions to address such obstacles or challenges. For example, the  Federal Reserve has finalized a rule to help ensure that the BHCs have  sufficient financial resources to implement their SPOE strategies. Also,  the regulators and BHCs are reducing the ability of swap counterparties  to a BHC’s bank swap dealer to terminate their swaps early in the event  of the BHC’s filing for bankruptcy and cause a disorderly wind-down of  the bank swap dealer’s swaps and other qualified financial contracts.

Total Loss-Absorbing Capacity. To implement their SPOE strategies,  the four U.S. BHCs with the largest bank swap dealers must have  sufficient financial resources to absorb losses by their banks or other  operating subsidiaries and prevent them from failing. In January 2017, the  Federal Reserve finalized its total loss-absorbing capacity rule, the  objective of which is to reduce the financial impact of a failure by requiring  companies to have sufficient loss-absorbing capacity.  The rule requires,  among other things, covered BHCs to maintain an outstanding minimum  level of eligible external total loss-absorbing capacity comprised of capital  issued by the BHC and eligible external long-term debt.  The term  “external” conveys that the requirement would apply to loss-absorbing  instruments issued by the GSIB to third-party investors, and the  instrument would be used to pass losses from the BHC to the third-party  investors in bankruptcy or other resolution.  For example, while a bank  or other subsidiary would pass up its losses to its BHC in the event of  distress, the BHC would pass its losses in the event of distress to its  equity holders and unsecured creditors, including external long-term debt  holders.

Cross-Default Rights and ISDA Stay Protocol. Even if the four U.S.  BHCs with the largest bank swap dealers had sufficient financial  resources to keep their banks solvent under their SPOE strategies, the  potential for their banks’ counterparties to terminate their swaps early  under their International Swaps and Derivatives Association (ISDA)  Master Agreements could undermine the banks’ ability to wind down or  sell their swaps in an orderly manner.  Under an ISDA Master  Agreement, a solvent bank’s counterparties may exercise their cross- default rights to terminate their swaps with the bank early if the bank’s  BHC files for bankruptcy.  As illustrated by the failure of Lehman  Brothers, such counterparty actions could result in a disorderly unwinding  of the bank’s swaps that causes the bank to suffer avoidable losses on its  swaps and contributes to its failure.  For example, counterparties to  whom the bank owes money may terminate their swaps early, and  counterparties that owe the bank money may not terminate their swaps  but may suspend their swap-related payments—exposing the bank to  price risk and reducing the bank’s liquidity.

Banking regulators and derivatives market participants have taken steps  to address the threat that early terminations of swaps can pose to a  BHC’s orderly resolution. Working with its members, U.S. and foreign  regulators, and others, ISDA published protocols in 2014 and 2015 that  enable parties to ISDA Master Agreements and certain other financial  contracts to amend their financial contracts, in effect, to recognize the  applicability of special resolution regimes (including Orderly Liquidation  Authority discussed subsequently) and to restrict cross-default provisions  to facilitate orderly resolution under the U.S. Bankruptcy Code.  For  example, provided certain conditions are met, parties that adhere to the  2015 protocol generally would be prohibited from exercising their cross- default rights to terminate early with a BHC’s bank if the bank’s BHC  entered bankruptcy.

In 2016, the Federal Reserve, FDIC, and OCC separately proposed rules  that generally require a U.S. GSIB and its subsidiaries to amend their swaps (and other qualified financial contracts), so that their counterparties  would be stayed from exercising their cross-default rights based on the  GSIB’s or its subsidiary’s entry into resolution.  The proposed rules  would require GSIBs and their subsidiaries to amend the contractual  default provisions of the financial contracts, including by adhering to the  ISDA 2015 protocol. The four U.S. BHCs with the largest bank swap  dealers (and their bank swap dealers) have adhered to the protocol in  order to enhance their ability to implement their SPOE strategy and avoid  a disorderly wind-down of their swaps.
subsections: section_title: FDIC Could Use Its Authority to Transfer Swaps from a Failed Bank to Help Preserve the Value of the Swaps
paragraphs: Although the four U.S. BHCs with the largest bank swap dealers plan to  keep their banks solvent under their SPOE strategies, circumstances  could arise in which a BHC lacks the financial resources to absorb losses  suffered by its bank.  If the BHC’s bank is insolvent and cannot be  recapitalized by the BHC, the bank would be resolved by FDIC under the  Federal Deposit Insurance Act.  Federal assistance backed by taxpayers  could be needed to help temporarily support FDIC’s Deposit Insurance  Fund if the failed bank’s losses, for example, were large enough to  deplete the fund.  However, FDIC could use its authority under the Federal Deposit Insurance Act to help preserve the value of the bank’s  swaps and reduce taxpayer risk. For example, under its statutory  authority, FDIC may transfer a failed bank’s swaps and other derivatives  to a bridge bank or other financial company within 1 business day after  the bank’s failure, preventing the exercise of the default rights of the  bank’s counterparties to terminate their swaps.  As a result, FDIC could  avoid the selective terminations of swaps by the failed bank’s  counterparties and, in turn, the value destruction that such terminations  could produce, as was the case in Lehman’s failure.

section_title: FDIC and the Dodd-Frank Act’s Orderly Liquidation Authority
paragraphs: In cases where the failure of a large BHC and its resolution under the  U.S. Bankruptcy Code would have serious adverse effects on U.S.  financial stability, the Dodd-Frank Act’s Orderly Liquidation Authority  serves as the backstop alternative.  Orderly Liquidation Authority gives  FDIC the authority, subject to certain constraints, to resolve large financial  companies outside of the bankruptcy process.  Since 2012, FDIC has  been developing a SPOE strategy to implement its Orderly Liquidation  Authority.  Under its SPOE strategy, FDIC would be appointed receiver  of the top-tier U.S. holding company and establish a bridge financial  company into which it would transfer the holding company’s assets to  preserve their value.  The bridge company would continue to provide the  holding company’s functions, and the company’s subsidiaries would  remain operational. As its SPOE strategy has evolved, FDIC has focused  on developing multiple options for liquidating the subsidiaries, such as by  winding down or selling subsidiaries or selling a subsidiary’s assets. Title  II authorizes FDIC to transfer swaps and other qualified financial  contracts to the bridge company or another solvent financial company.   To give FDIC time to make such transfers and to avoid a disorderly wind- down of swaps, Title II generally prohibits counterparties to qualified  financial contracts from exercising their default rights with the holding  company or its subsidiaries.  By keeping the holding company’s  subsidiaries solvent and preventing swap terminations, FDIC could  minimize market disruptions and preserve the value of the swaps.

According to FDIC, the agency intends to maximize the use of private  funding in an Orderly Liquidation Authority resolution and expects the  bridge financial company and its subsidiaries to obtain funding from  customary sources of liquidity in the private markets. If private-sector  funding cannot be obtained, the Dodd-Frank Act provides for an Orderly  Liquidation Fund to serve as a back-up source of liquidity support that  would be available only on a fully secured basis. Ultimately any Orderly  Liquidation Fund borrowings are to be repaid either from recoveries on  the assets of the failed firm or, in the event of a loss on the collateralized  borrowings, from assessments against the eligible financial companies.   The law expressly prohibits taxpayer losses from the use of Orderly  Liquidation Authority.

section_title: Appendix VI: Regulators’ Oversight of Section 716 Compliance
paragraphs: As amended, section 716 of the Dodd-Frank Wall Street Reform and  Consumer Protection Act (Dodd-Frank Act)—also known as the “swaps  push-out rule”—effectively required banks registered as swap dealers or  security-based swap dealers to stop engaging in certain types of swaps  or security-based swap activities, or be prohibited from receiving federal  assistance.  Officials from four banks told us that they engaged in  structured finance swaps activity and moved such activity to their  nonbank swap dealer affiliates by July 2015, when their 2-year extension  periods expired. These four banks are supervised by the Office of the  Comptroller of the Currency (OCC) or the Board of Governors of the  Federal Reserve System (Federal Reserve). Regulators and the four  banks told us they have not had major difficulties overseeing or  implementing the amended section 716, respectively. Regulators stated  that they assess compliance, including with section 716 requirements,  through ongoing supervision and examinations.
subsections: section_title: Regulators Have Not Issued Any Rules to Implement the Amended Section 716, but Banks Told Us That They Have Not Faced Any Major Compliance Challenges
paragraphs: Unlike section 619 (also referred to as the Volcker rule) and some other  Dodd-Frank Act provisions, section 716 does not require prudential  regulators to issue any rules.  Federal Reserve and OCC told us that they  chose not to issue any rules to implement the amended section 716  because they perceive the provision’s requirements to be sufficiently  clear. For example, the amended section 716 defines the term “structured  finance swap” as a swap or security-based swap based on an asset- backed security (or group or index primarily comprised of asset-backed  securities); as a result, Federal Reserve and OCC said that they did not  need to issue a rule to define the term.  Although the amended section  716 does not require the prudential regulators to issue rules, it permits  them to issue a joint rule to make additional exemptions to section 716  restrictions on structured finance swap activity.  However, the regulators  told us that they do not currently plan to issue any such rules.

The four bank swap dealers told us that they have not encountered any  major challenges in complying with the amended section 716 and do not  need guidance from the prudential regulators. Similarly, bank swap  dealers that engaged in structured finance swaps activity told us that they  were able to move their structured finance swaps activity to their affiliated  broker-dealers to comply with the amended provision. The banks relied  on their legal teams to identify which units within their banks traded  covered swaps and on their operations teams to implement controls to  prevent these units from trading impermissible swaps. Banks told us that,  because they also must comply with Volcker Rule restrictions, they use  the Volcker Rule’s definition of risk-mitigating hedging to interpret section  716’s exemption.

section_title: Regulators Assess Compliance with Statutory Requirements, including Amended Section 716, through Their On-site Supervision and Examinations
paragraphs: Regulators conduct onsite supervision of banks within their jurisdiction,  including those affected by the amended section 716. The regulators’  onsite supervision includes monitoring activities, assessing risks,  completing core assessments, and communicating with bank  management throughout the supervisory cycle. Examiners regularly  review management information system reports and profit and loss  reports from bank dealers’ trading desks to identify any structured finance  swap activity requiring further investigation. For example, Federal  Reserve and OCC staff told us that they can detect compliance issues  related to section 716 through their supervision of the banks’ and bank  holding companies’ (BHC) compliance with, among other things, the  Volcker Rule’s reporting requirements.  Federal Reserve and OCC told  staff us that they take a risk-based supervisory approach and would  weigh the volume and complexity of trades associated with section 716 in  that overall approach.

OCC conducts targeted examinations in various areas, including for  section 716. These targeted examinations generally include reviewing the  banks’ policies, associated controls, and governance framework for  complying with statutory requirements, including section 716, and  meeting with key personnel across the bank’s affected business lines and  independent control functions to assess bank readiness.

section_title: Appendix VII: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact

section_title: Staff Acknowledgments
paragraphs: In addition to the contact name above, Richard Tsuhara (Assistant  Director), Silvia Arbelaez-Ellis (Analyst-in-Charge), Jessica Artis, Rachel  DeMarcus, Risto Laboski, Courtney L. LaFountain, Marc W. Molino,  Patricia Moye, Jennifer Schwartz, and Kwame Som-Pimpong made  significant contributions to this report.


Question-summary annotations: questions: question: What are bank swaps?
answer: Since the 1980s, banks have been engaging in swaps: financial contracts (derivatives) in which two parties “swap,” or exchange, payments based on changes in asset prices or other values.
child_questions: question: How do firms use swaps?
answer: A variety of firms (end-users) use swaps to hedge risk, to speculate, or for other purposes. For example, an airline may use swaps to lock in its fuel price to hedge against a future price rise.

question: How do end-users engage in swaps?
answer: End-users engage in swaps through swap dealers, and some large banks act as swap dealers, exposing them to risks.

question: What does the Dodd-Frank Act require?
answer: Section 716 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act)—also known as the “swaps push-out rule”—requires banks registered as swap dealers, in effect, to stop engaging in certain swap activities to remain eligible for federal financial assistance but allows them to “push out” such activities to nonbank affiliates within the same bank holding company (BHC).
child_questions: question: How did the 2014 amendments change the coverage of swap activity?
answer: As originally enacted, section 716 would have covered certain equity, commodity, and credit default swaps activities, but amendments made in 2014 now cover only certain swap activity based on asset-backed securities.

questions: question: How did the amended section of 716 affect U.S. banks?
answer: The amended section 716 affected four U.S. banks and caused them to push out an estimated $265 billion of swaps in notional value as of September 30, 2016, or less than 1 percent of their total derivatives.
child_questions: question: How did this differ from the swaps that would have been pushed out under the original 716?
answer: A significantly larger volume of swaps would have been pushed out under the original section 716. The original version would have affected 11 U.S. banks (including the 4 banks) and could have affected an estimated $10.5 trillion of swaps in notional value, or about 6 percent of their total derivatives, if the provision had not been amended.

questions: question: How does section 716 affect BHCs?
answer: Section 716 increases risks and costs for BHCs and end-users .
child_questions: question: What is the affect of the amended version?
answer: Under the amended version, banks moved their covered swap activities to nonbank affiliates, requiring the affiliates and clients to incur legal and operational costs. Banks and end-users told GAO that moving the swaps can increase their risks and, in turn, costs.

question: How would the risks and costs have been different under the original version?
answer: Such risks and costs likely would have been greater under the original version because of its broader scope.

questions: question: How do Dodd-Frank Act provisions attempt to help banks?
answer: Other Dodd-Frank Act provisions mitigate risks . Section 716 seeks to reduce a bank's risk of failure and potential need for federal assistance, but the act's other reforms also seek to mitigate such risks. For example, regulators have subjected banks to enhanced prudential and other requirements that can help to mitigate their swap-related risks.
child_questions: question: Under the original section 716, how would banks have been impacted?
answer: Consistent with such requirements, GAO's analyses indicate the 11 U.S. banks that would have been affected by the original section 716 held financial resources needed to support their swap-related credit, liquidity, and market risk exposures as of September 30, 2016.

question: What is the goal of the new resolution strategies?
answer: Federal banking regulators and BHCs with the largest bank swap dealers are continuing to develop resolution strategies that seek to resolve a large BHC in an orderly manner and without federal assistance if it were to fail. These strategies, if successful, can help BHCs to wind-down or sell their swaps in an orderly manner and avoid value destruction.

questions: question: How does the Dodd-Frank Act alter the regulations for participants in the swap market?
answer: Given the role of derivatives in contributing to the 2007—2009 financial crisis, the Dodd-Frank Act includes various provisions that subject the swap market and its participants to greater regulation, including section 716.
child_questions: question: In what way does section 716 hope to limit banks?
answer: Proponents of section 716 sought to prohibit banks from engaging in riskier swap activities that could cause the banks to need federal assistance backed by taxpayers.

question: What did opponents of section 716 argue?
answer: Opponents of section 716 maintained that swaps trading by banks did not significantly contribute to the financial crisis.

question: How was section 716 altered in 2014?
answer: In late 2014, section 716 was amended to narrow its scope of prohibited swap activities.
child_questions: question: What was the timeline for banks' compliance with the amended section 716?
answer: Banks generally were required to begin complying with the amended section 716 in July 2015.