Regulatory Framework

Derivatives dealers and end-user financial institutions may be regulated by federal bank regulators, the Securities and Exchange Commission (SEC), and the Commodity Futures Trading Commission (CFTC), depending on how the institutions are organized. Objectives, Scope, and Methodology

Our May 1994 report on derivatives identified the need for (1) strengthened corporate governance and internal controls for derivatives dealers and major end-users, (2) improved regulation of major U.S. derivatives dealers, (3) comprehensive federal oversight of major U.S. derivatives dealers that are unregulated affiliates of securities firms and insurance companies, (4) comprehensive and consistent accounting and disclosure requirements for derivatives, and (5) international harmonization of regulatory and accounting standards. To determine the current accounting standards for derivatives, we reviewed existing and proposed generally accepted accounting principles and other accounting guidance relevant to derivatives. That report recommended specific derivatives risk-management practices as benchmarks for entities’ use. SEC has acknowledged that there may be benefits associated with management or auditor reports on internal control systems of SEC registrants that are major dealers and end-users of complex derivative products, as GAO recommended. However, SEC has stated that it is focusing on accounting for and providing greater disclosure of market risk for derivative products, which it views as a more appropriate priority at this time. Bank Regulatory Oversight Continues to Improve

OCC, the Federal Reserve, FDIC, and OTS have made progress in improving their oversight of derivatives activities consistent with the recommendations we made to financial regulators in our 1994 report.They have expanded their risk-based capital standards to more accurately reflect risk exposures and to include market risk. We found that the 1994 examinations were more clearly focused on the banks’ derivatives risk-management and internal control systems. We said the immediate need was for Congress to bring the unregulated OTC derivatives activities of securities firm and insurance company affiliates under the purview of one or more of the existing federal financial regulators and to ensure that derivatives regulation is consistent and comprehensive across regulatory agencies. With regard to disclosure of derivatives activities in financial statements, we reported that two existing FASB disclosure standards required disclosure of information about the extent and nature of an entity’s financial instruments, including derivative products, with off-balance-sheet risk of accounting losses and about fair values of financial instruments. Although the proposed standard was an improvement over the existing requirements, it was our view that there were additional disclosures that would provide financial statement users with a more complete understanding of derivatives. FASB’s proposed standard is a step toward this solution. They also would require disclosure outside the financial statements of qualitative and quantitative information about market risk inherent in derivatives and other financial instruments. 1.) 4.) IOSCO has been involved in follow-up work relating to the areas identified by the regulators and has issued reports on some of these issues. The Barings crisis spurred efforts to improve international regulatory coordination, primarily through formal information-sharing agreements.
Why GAO Did This Study

GAO conducted a follow-up review of the regulation of financial derivative products, focusing on actions taken or proposed since May 1994 to: (1) strengthen corporate governance and internal controls for derivatives dealers and major end-users; (2) improve regulation of major U.S. derivatives dealers; (3) provide federal oversight of major derivatives dealers that are unregulated affiliates of securities firms and insurance companies; (4) promulgate comprehensive and consistent accounting and disclosure requirements for derivatives; and (5) harmonize regulatory and accounting standards internationally.

What GAO Found

GAO found that: (1) market participants, regulators, and others have taken or proposed a number of actions to improve the management, oversight, and disclosure of derivatives risks consistent with GAO's prior recommendations; (2) federal bank regulators are: (a) requiring capital that more accurately reflects derivatives risks; (b) collecting more extensive information on bank derivatives activities; and (c) examining banks using guidelines that are better focused on derivatives risks; (3) the Financial Accounting Standards Board (FASB) has issued enhanced disclosure rules, as GAO recommended, and has proposed an accounting standard for derivatives that should help stem misleading accounting practices and would require that all derivatives be recorded in financial statements; (4) the Securities and Exchange Commission (SEC) has also proposed more qualitative and quantitative disclosures about derivatives use by public companies; (5) internationally, there has been progress toward greater regulatory harmonization and coordination, as evidenced by major international regulatory initiatives and information-sharing agreements; (6) although market participants, regulators, and others have acted to improve the management, oversight, and disclosure of derivatives risks, many of the concerns that GAO identified in its 1994 report still remain; (7) compliance with guidelines and recommended risk management practices is essentially voluntary for derivatives dealers and end-users other than regulated entities; (8) SEC has acknowledged that there may be benefits associated with management or auditor reports on internal control systems of SEC registrants that are major dealers and end-users of complex derivative products as GAO recommended, but has stated that it is focusing on accounting for and providing greater disclosure of market risk for derivative products; (9) the over-the-counter derivatives dealing activities of securities firm and insurance company affiliates, which are still growing, continue to be largely unregulated; (10) FASB has proposed, but still has not issued, comprehensive accounting standards for derivatives that would provide financial statement users with appropriate, consistent financial information on which to base their investment, management, or oversight decisions; and (11) many of the concerns expressed in GAO's 1994 report are still valid; it is too soon to determine the effectiveness of many of the actions taken or proposed to date; and some of GAO's recommendations have yet to be fully implemented.