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. 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 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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). 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. 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. 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. 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 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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). 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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.

Summary: 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. 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.