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Highlights

Pursuant to congressional requests, GAO reviewed financial derivative products, focusing on: (1) the extent and nature of derivatives' use; (2) what risks derivatives pose to individual firms and the financial system; (3) firms' and regulators' attempts to control these risks; (4) gaps and inconsistencies in U.S. regulation of derivatives; (5) whether financial reports provided adequate information on firms' use of derivatives; and (6) the implications of the international use of derivatives for U.S regulation.

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Recommendations

Matter for Congressional Consideration

Matter Status Comments
Given the weaknesses and gaps that impede regulatory preparedness for dealing with a crisis associated with derivatives, Congress should require federal regulation of the safety and soundness of all major U.S. over-the-counter (OTC) derivatives dealers. Regulators should attempt to prevent financial disruptions from turning into crises and resolve crises to minimize risks to the financial system.
Closed - Not Implemented
Voluntary regulatory action by the Derivatives Policy Group, comprised of the six major securities dealers, in the absence of any major market catastrophe, has replaced the urgency for congressional action. General reform of the Commodity Exchange Act may also clarify the regulatory responsibility for the over-the-counter derivatives. No further action anticipated.
Congress should bring the currently 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 ensure that derivatives regulation is consistent and comprehensive across regulatory agencies by assigning the responsibility for the unregulated entities to the Securities and Exchange Commission (SEC) and creating an interagency commission to establish principles and standards for each federal financial regulator to use in supervising derivatives activities.
Closed - Implemented
This was provided as an option for Congress to consider and was not meant as a recommendation.
Congress should bring the currently 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 ensure that derivatives regulation is consistent and comprehensive across regulatory agencies by basing the approach on the concept that underlies the arrangement established for government securities dealers where responsibility for setting principles and standards applicable to all major U.S. derivatives dealers would be given to an existing agency based on agency expertise and mission. Extensive consultation with all of the agencies supervising derivatives activities would be required before any principles or standards were adopted.
Closed - Implemented
This was provided as an option for Congress to consider and was not meant as a recommendation.
Congress should begin systematically addressing the need to revamp and modernize the entire U.S. financial regulatory system. Many issues need to be debated and decided including the appropriate uses of federally insured deposits and the extent to which they should be used to finance nontraditional activities, such as derivatives, in banks. One of the first issues that needs to be addressed is how the U.S. regulatory system should be restructured to better reflect the realities of today's rapidly evolving global financial markets.
Closed - Implemented
Congress passed financial modernization legislation, the Gramm-Leach-Bliley Act of 1999 (GLBA), which was enacted on November 12, 1999. In addition to establishing functional regulation (banking, securities, and insurance), it also repealed certain sections of Glass-Steagall. GLBA allows, but does not require, investment bank holding companies to be supervised by the Securities and Exchange Commission (SEC). The investment bank holding company would have to file a notice that it wanted to be regulated by SEC.
Congress should hold hearings, at least annually, on developments that affect the safety, soundness, and stability of the U.S. financial system.
Closed - Not Implemented
Congress has not acted on this recommendation.

Recommendations for Executive Action

Agency Affected Recommendation Status
Office of the Comptroller of the Currency 1. To improve their capability to oversee OTC derivatives activities and to anticipate and respond to any financial crisis involving derivatives, the appropriate regulatory authorities, working closely with industry representatives, should develop and maintain accurate, current, and centralized information, that is accessible to all regulators, including information on the extent of major OTC dealers' counterparty concentrations and the sources and amounts of their derivatives earnings.
Closed - Not Implemented
SEC, CFTC, FRS, OCC, and FDIC have improved the information they collect on derivatives activities in ways that are consistent with the recommendation. The regulators claim they do not need a central repository of information because they share information informally as it is needed. They further claim that data collected in a manner that would make a centralized repository useful would be unnecessarily expensive.
Commodity Futures Trading Commission 2. To improve their capability to oversee OTC derivatives activities and to anticipate and respond to any financial crisis involving derivatives, the appropriate regulatory authorities, working closely with industry representatives, should develop and maintain accurate, current, and centralized information, that is accessible to all regulators, including information on the extent of major OTC dealers' counterparty concentrations and the sources and amounts of their derivatives earnings.
Closed - Not Implemented
SEC, CFTC, FRS, OCC, and FDIC have improved the information they collect on derivatives activities in ways that are consistent with the recommendation. The regulators claim they do not need a central repository of information because they share information informally as it is needed. They further claim that data collected in a manner that would make a centralized repository useful would be unnecessarily expensive.
Federal Deposit Insurance Corporation 3. To improve their capability to oversee OTC derivatives activities and to anticipate and respond to any financial crisis involving derivatives, the appropriate regulatory authorities, working closely with industry representatives, should develop and maintain accurate, current, and centralized information, that is accessible to all regulators, including information on the extent of major OTC dealers' counterparty concentrations and the sources and amounts of their derivatives earnings.
Closed - Not Implemented
SEC, CFTC, FRS, OCC, and FDIC have improved the information they collect on derivatives activities in ways that are consistent with the recommendation. The regulators claim they do not need a central repository of information because they share information informally as it is needed. They further claim that data collected in a manner that would make a centralized repository useful would be unnecessarily expensive.
Board of Governors 4. To improve their capability to oversee OTC derivatives activities and to anticipate and respond to any financial crisis involving derivatives, the appropriate regulatory authorities, working closely with industry representatives, should develop and maintain accurate, current, and centralized information, that is accessible to all regulators, including information on the extent of major OTC dealers' counterparty concentrations and the sources and amounts of their derivatives earnings.
Closed - Not Implemented
SEC, CFTC, FRS, OCC, and FDIC have improved the information they collect on derivatives activities in ways that are consistent with the recommendation. The regulators claim they do not need a central repository of information because they share information informally as it is needed. They further claim that data collected in a manner that would make a centralized repository useful would be unnecessarily expensive.
United States Securities and Exchange Commission 5. To improve their capability to oversee OTC derivatives activities and to anticipate and respond to any financial crisis involving derivatives, the appropriate regulatory authorities, working closely with industry representatives, should develop and maintain accurate, current, and centralized information, that is accessible to all regulators, including information on the extent of major OTC dealers' counterparty concentrations and the sources and amounts of their derivatives earnings.
Closed - Not Implemented
SEC, CFTC, FRS, OCC, and FDIC have improved the information they collect on derivatives activities in ways that are consistent with the recommendation. The regulators claim they do not need a central repository of information because they share information informally as it is needed. They further claim that data collected in a manner that would make a centralized repository useful would be unnecessarily expensive.
Office of the Comptroller of the Currency 6. To improve their capability to oversee OTC derivatives activities and to anticipate and respond to any financial crisis involving derivatives, the appropriate regulatory authorities, working closely with industry representatives, should develop and adopt a consistent set of capital standards for OTC derivatives dealers sufficient to ensure that all of the major risks associated with derivatives as well as legally enforceable netting are reflected in capital.
Closed - Implemented
FRS and the other bank regulators have modified their capital standards to reflect market risk and minimum capital standards have been revised to reflect interest rate risk. Bank regulators issued final rules that were effective in December 1994, allowing broader recognition of bilateral netting agreements. They have added a multiplier used in calculating capital that is intended to reflect other risks.
Commodity Futures Trading Commission 7. To improve their capability to oversee OTC derivatives activities and to anticipate and respond to any financial crisis involving derivatives, the appropriate regulatory authorities, working closely with industry representatives, should develop and adopt a consistent set of capital standards for OTC derivatives dealers sufficient to ensure that all of the major risks associated with derivatives as well as legally enforceable netting are reflected in capital.
Closed - Implemented
Securities and futures regulators worked with the six U.S. securities firms that had major derivatives dealing affiliates (the Derivatives Policy Group) to develop a voluntary self-regulatory framework for their derivatives activities. Under the framework, five of these firms (the derivatives activities of the sixth firm, which is foreign-owned, were regulated overseas) voluntarily developed an approach for evaluating firms' risks in relation to their capital.
Federal Deposit Insurance Corporation 8. To improve their capability to oversee OTC derivatives activities and to anticipate and respond to any financial crisis involving derivatives, the appropriate regulatory authorities, working closely with industry representatives, should develop and adopt a consistent set of capital standards for OTC derivatives dealers sufficient to ensure that all of the major risks associated with derivatives as well as legally enforceable netting are reflected in capital.
Closed - Implemented
FRS and the other bank regulators have modified their capital standards to reflect market risk and minimum capital standards have been revised to reflect interest rate risk. Bank regulators issued final rules that were effective in December 1994, allowing broader recognition of bilateral netting agreements. They have added a multiplier used in calculating capital that is intended to reflect other risks.
Board of Governors 9. To improve their capability to oversee OTC derivatives activities and to anticipate and respond to any financial crisis involving derivatives, the appropriate regulatory authorities, working closely with industry representatives, should develop and adopt a consistent set of capital standards for OTC derivatives dealers sufficient to ensure that all of the major risks associated with derivatives as well as legally enforceable netting are reflected in capital.
Closed - Implemented
FRS and the other bank regulators have modified their capital standards to reflect market risk, and minimum capital standards have been revised to reflect interest rate risk. Bank regulators issued final rules that were effective in December 1994, allowing broader recognition of bilateral netting agreements. They have added a multiplier used in calculating capital that is intended to reflect other risks.
United States Securities and Exchange Commission 10. To improve their capability to oversee OTC derivatives activities and to anticipate and respond to any financial crisis involving derivatives, the appropriate regulatory authorities, working closely with industry representatives, should develop and adopt a consistent set of capital standards for OTC derivatives dealers sufficient to ensure that all of the major risks associated with derivatives as well as legally enforceable netting are reflected in capital.
Closed - Implemented
In March 1995, the Derivatives Policy Group (DPG), consisting of the six largest OTC derivatives dealers that are securities firms, issued a Framework for Voluntary Oversight in cooperation with SEC and CFTC. The document calls for the dealers to use their proprietary models to estimate credit and market risk, and to independently verify their models' accuracy, and share this information regularly with SEC and CFTC. SEC's review of its capital requirements is ongoing.
Office of Thrift Supervision 11. To improve their capability to oversee OTC derivatives activities and to anticipate and respond to any financial crisis involving derivatives, the appropriate regulatory authorities, working closely with industry representatives, should establish specific requirements for independent, knowledgeable audit committees and internal control reporting for all major OTC derivatives dealers. Internal control reporting by boards of directors, managers, and external auditors should include assessments of derivatives risk-management systems.
Closed - Not Implemented
The Department of the Treasury noted that implementation of section 36 of the Federal Deposit Insurance Corporation Improvement Act required banks to further strengthen internal controls and specific requirements for independent, knowledgeable audit committees and internal control reporting. Banking regulators have made considerable progress. Treasury believes that it is not appropriate to mandate specific management policies applicable to dealers in derivatives. Any further requirements would freeze the "state of the art" and result in inappropriate micromanagement.
Office of the Comptroller of the Currency 12. To improve their capability to oversee OTC derivatives activities and to anticipate and respond to any financial crisis involving derivatives, the appropriate regulatory authorities, working closely with industry representatives, should establish specific requirements for independent, knowledgeable audit committees and internal control reporting for all major OTC derivatives dealers. Internal control reporting by boards of directors, managers, and external auditors should include assessments of derivatives risk-management systems.
Closed - Not Implemented
OCC noted that implementation of section 36 of the Federal Deposit Insurance Corporation Improvement Act required banks to further strengthen internal controls and specific requirements for independent, knowledgeable audit committees and internal control reporting. Banking regulators have made considerable progress. OCC believes that it is not appropriate to mandate specific management policies applicable to dealers in derivatives. Any further requirements would freeze the "state of the art" and result in inappropriate micromanagement.
Commodity Futures Trading Commission 13. To improve their capability to oversee OTC derivatives activities and to anticipate and respond to any financial crisis involving derivatives, the appropriate regulatory authorities, working closely with industry representatives, should establish specific requirements for independent, knowledgeable audit committees and internal control reporting for all major OTC derivatives dealers. Internal control reporting by boards of directors, managers, and external auditors should include assessments of derivatives risk-management systems.
Closed - Not Implemented
CFTC believes that current assessments of internal controls are adequate and cover derivatives. CFTC does not believe that it is appropriate to mandate specific management policies applicable to dealers in derivatives.
Federal Deposit Insurance Corporation 14. To improve their capability to oversee OTC derivatives activities and to anticipate and respond to any financial crisis involving derivatives, the appropriate regulatory authorities, working closely with industry representatives, should establish specific requirements for independent, knowledgeable audit committees and internal control reporting for all major OTC derivatives dealers. Internal control reporting by boards of directors, managers, and external auditors should include assessments of derivatives risk-management systems.
Closed - Not Implemented
FDIC noted that implementation of section 36 of the Federal Deposit Insurance Corporation Improvement Act required banks to further strengthen internal controls and specific requirements for independent, knowledgeable audit committees and internal control reporting. Banking regulators have made considerable progress. FDIC believes that it is not appropriate to mandate specific management policies applicable to dealers in derivatives. Any further requirements would freeze the "state of the art" and result in inappropriate micromanagement.
Board of Governors 15. To improve their capability to oversee OTC derivatives activities and to anticipate and respond to any financial crisis involving derivatives, the appropriate regulatory authorities, working closely with industry representatives, should establish specific requirements for independent, knowledgeable audit committees and internal control reporting for all major OTC derivatives dealers. Internal control reporting by boards of directors, managers, and external auditors should include assessments of derivatives risk-management systems.
Closed - Not Implemented
FRS noted that implementation of section 36 of the Federal Deposit Insurance Corporation Improvement Act required banks to further strengthen internal controls and specific requirements for independent, knowledgeable audit committees and internal control reporting. Banking regulators have made considerable progress. FRS believes that it is not appropriate to mandate specific management policies applicable to dealers in derivatives. Any further improvements would freeze the "state of the art" and result in inappropriate micromanagement.
United States Securities and Exchange Commission 16. To improve their capability to oversee OTC derivatives activities and to anticipate and respond to any financial crisis involving derivatives, the appropriate regulatory authorities, working closely with industry representatives, should establish specific requirements for independent, knowledgeable audit committees and internal control reporting for all major OTC derivatives dealers. Internal control reporting by boards of directors, managers, and external auditors should include assessments of derivatives risk-management systems.
Closed - Not Implemented
SEC does not believe that it would be appropriate to adopt a federally imposed mandate governing the composition of audit committees for all public companies. SEC does not believe that it is appropriate to mandate specific management policies applicable to dealers in derivatives. SEC believes that current assessments of internal controls are adequate and cover derivatives.
Office of the Comptroller of the Currency 17. To improve their capability to oversee OTC derivatives activities and to anticipate and respond to any financial crisis involving derivatives, the appropriate regulatory authorities, working closely with industry representatives, should perform comprehensive, annual examinations of the adequacy of major OTC derivatives dealers' risk-management systems, using a consistent set of standards established for this purpose and including consideration of the internal control assessments performed by boards of directors, management, and auditors.
Closed - Not Implemented
Bank regulators believe that current coverage of risk management and internal controls in their annual full-scope examination meets GAO's principal objectives. Therefore, this recommendation should be closed regarding bank regulators.
Commodity Futures Trading Commission 18. To improve their capability to oversee OTC derivatives activities and to anticipate and respond to any financial crisis involving derivatives, the appropriate regulatory authorities, working closely with industry representatives, should perform comprehensive, annual examinations of the adequacy of major OTC derivatives dealers' risk-management systems, using a consistent set of standards established for this purpose and including consideration of the internal control assessments performed by boards of directors, management, and auditors.
Closed - Not Implemented
CFTC noted that there are no regulatory requirements for OTC market participants that correspond to those applicable in the exchange-traded derivatives environment. GAO did not identify any major OTC derivatives dealers that were subject solely to CFTC jurisdiction. Therefore, this recommendation should be closed regarding CFTC.
Federal Deposit Insurance Corporation 19. To improve their capability to oversee OTC derivatives activities and to anticipate and respond to any financial crisis involving derivatives, the appropriate regulatory authorities, working closely with industry representatives, should perform comprehensive, annual examinations of the adequacy of major OTC derivatives dealers' risk-management systems, using a consistent set of standards established for this purpose and including consideration of the internal control assessments performed by boards of directors, management, and auditors.
Closed - Not Implemented
Bank regulators believe that current coverage of risk management and internal controls in their annual full-scope examination meets GAO's principal objectives. Therefore, this recommendation should be closed regarding bank regulators.
Board of Governors 20. To improve their capability to oversee OTC derivatives activities and to anticipate and respond to any financial crisis involving derivatives, the appropriate regulatory authorities, working closely with industry representatives, should perform comprehensive, annual examinations of the adequacy of major OTC derivatives dealers' risk-management systems, using a consistent set of standards established for this purpose and including consideration of the internal control assessments performed by boards of directors, management, and auditors.
Closed - Not Implemented
Bank regulators believe that current coverage of risk management and internal controls in their annual full-scope examination meets GAO's principal objectives. Therefore, this recommendation should be closed regarding bank regulators.
Office of the Comptroller of the Currency 21. To improve their capability to oversee OTC derivatives activities and to anticipate and respond to any financial crisis involving derivatives, the appropriate regulatory authorities, working closely with industry representatives, should provide leadership in working with industry representatives and regulators from other major countries to harmonize disclosure, capital, legal requirements including netting enforceability, and examination and accounting standards for derivatives.
Closed - Implemented
U.S. financial regulators have been working through the Basle Committee on Banking Supervision and the Group of Ten countries to harmonize international standards. In December 1994, the Basle Capital Accord was amended to allow recognition of legally enforceable bilateral netting agreements for risk-based capital purposes, and U.S. bank regulators implemented the amendment. In April 1995, the Accord was amended to allow recognition of the effects of netting in the calculation of potential future exposure amounts and to expand the matrix of add-on factors. Final rules to incorporate market risk from trading activities into risk-based capital calculations were added as amendments to the Basle Accord in January 1996.
Commodity Futures Trading Commission 22. To improve their capability to oversee OTC derivatives activities and to anticipate and respond to any financial crisis involving derivatives, the appropriate regulatory authorities, working closely with industry representatives, should provide leadership in working with industry representatives and regulators from other major countries to harmonize disclosure, capital, legal requirements including netting enforceability, and examination and accounting standards for derivatives.
Closed - Implemented
CFTC states that the recommendation is consistent with ongoing regulatory efforts. On July 27, 1994, SEC, CFTC, and the United Kingdom Securities and Investments Board issued guidance for regulators on a framework of management control mechanisms for securities firms conducting OTC derivatives activities.
Federal Deposit Insurance Corporation 23. To improve their capability to oversee OTC derivatives activities and to anticipate and respond to any financial crisis involving derivatives, the appropriate regulatory authorities, working closely with industry representatives, should provide leadership in working with industry representatives and regulators from other major countries to harmonize disclosure, capital, legal requirements including netting enforceability, and examination and accounting standards for derivatives.
Closed - Implemented
U.S. financial regulators have been working through the Basle Committee on Banking Supervision and the Group of Ten countries to harmonize international standards. In December 1994, the Basle Capital Accord was amended to allow recognition of legally enforceable bilateral netting agreements for risk-based capital purposes, and U.S. bank regulators implemented the amendment. In April 1995, the Accord was amended to allow recognition of the effects of netting in the calculation of potential future exposure amounts and to expand the matrix of add-on factors. Final rules to incorporate market risk from trading activities into risk-based capital calculations were added as amendments to the Basle Accord in January 1996.
Board of Governors 24. To improve their capability to oversee OTC derivatives activities and to anticipate and respond to any financial crisis involving derivatives, the appropriate regulatory authorities, working closely with industry representatives, should provide leadership in working with industry representatives and regulators from other major countries to harmonize disclosure, capital, legal requirements including netting enforceability, and examination and accounting standards for derivatives.
Closed - Implemented
U.S. financial regulators have been working through the Basle Committee on Banking Supervision and the Group of Ten countries to harmonize international standards. In December 1994, the Basle Capital Accord was amended to allow recognition of legally enforceable bilateral netting agreements for risk-based capital purposes, and U.S. bank regulators implemented the amendment. In April 1995, the Accord was amended to allow recognition of the effects of netting in the calculation of potential future exposure amounts and to expand the matrix of add-on factors. Final rules to incorporate market risk from trading activities into risk-based capital calculations were added as amendments to the Basle Accord in January 1996.
United States Securities and Exchange Commission 25. To improve their capability to oversee OTC derivatives activities and to anticipate and respond to any financial crisis involving derivatives, the appropriate regulatory authorities, working closely with industry representatives, should provide leadership in working with industry representatives and regulators from other major countries to harmonize disclosure, capital, legal requirements including netting enforceability, and examination and accounting standards for derivatives.
Closed - Implemented
SEC states that the recommendation is consistent with ongoing regulatory efforts. On July 27, 1994, SEC, CFTC, and the United Kingdom Securities and Investments Board issued guidance for regulators on a framework of management control mechanisms for securities firms conducting OTC derivatives activities.
Financial Accounting Standards Board 26. The Financial Accounting Standards Board (FASB) should proceed expeditiously to issue the existing exposure draft on disclosures of derivatives and fair value of financial instruments.
Closed - Implemented
FASB issued the exposure draft. Therefore, this recommendation should be closed.
Financial Accounting Standards Board 27. The Financial Accounting Standards Board (FASB) should proceed expeditiously to develop and issue an exposure draft that provides comprehensive, consistent accounting rules for derivative products, including expanded disclosure requirements that provide additional needed information about derivatives activities.
Closed - Implemented
FASB issued a final version of this new standard in June 1998. Under its provisions, organizations will record derivatives at fair market value. Gains or losses resulting from changes in the values of derivatives are to be accounted for depending on the use of the derivative and whether it qualifies for hedge accounting, which is a determination that hinges on how effectively the derivative offsets changes in the fair value or cashflows of the hedged position.
Financial Accounting Standards Board 28. FASB should consider adopting a market value accounting model for all financial instruments, including derivative products.
Closed - Implemented
FASB 133, which became effective in 2000, establishes accounting and reporting standards for derivative instruments. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value.
United States Securities and Exchange Commission 29. The Chairman, SEC, should establish specific requirements for independent, knowledgeable audit committees and internal control reporting for SEC registrants that are major end-users of complex derivative products. Internal control reporting by boards of directors, managers, and external auditors should include assessments of derivatives risk-management systems.
Closed - Not Implemented
On September 5, 1996, the SEC Chief Accountant advised GAO that effective boards of directors and audit committees can play an important role in safeguarding the interests of public investors. However, SEC has concentrated its efforts on developing requirements for improved disclosure in financial results, rather than making adjustments to the makeup of audit committees. SEC issued its final derivatives disclosure rules on January 31, 1997.
United States Securities and Exchange Commission 30. The Chairman, SEC, should ensure that FASB proceeds expeditiously to develop and adopt comprehensive, consistent accounting rules and disclosure requirements for derivative products.
Closed - Implemented
SEC monitored FASB's progress in developing this standard and also issued its own disclosure rule for such instruments. In June 1998, FASB issued a final version of its new standard.

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