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. Section 716 of the Dodd- Frank Act

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. 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). 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. 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. 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. End-Users’ Implementation Costs

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. At the same time, this potential benefit likely  would have resulted in costs for their BHCs and swap end-users, as  discussed earlier. 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. 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. 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. 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. Objective 1

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. Objectives 3 and 4

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. In 2015 and 2016, all section 716 banks  and their BHCs were market risk firms. Appendix IV: Estimating Certain Risks for U.S. Banks That Would Have Been Affected by the Original Section 716

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. Our methodology included the following steps. 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.
Why GAO Did This Study

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.

What GAO Found

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.