Description
Derivatives, namely, futures, options and swaps, are off-balance sheet instruments that allow banks to transform the duration of their balance sheets in order to manage market risk without incurring additional capital requirements. Banks' use of derivatives has been growing rapidly in recent years due, in part, to regulatory changes concerning the amount of capital banks are required to hold as well as an increase in market risk exposure.
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An Analysis of the Determinants of Financial
Derivative Use By Commercial Banks
By Katie Hundman
I. INTRODUCTION
Derivatives, namely, futures, options and
swaps, are off-balance sheet instruments that allow
banks to transform the duration of their balance
sheets in order to manage market risk without
incurring additional capital requirements. Banks’
use of derivatives has been growing rapidly in recent
years due, in part, to regulatory changes concerning
the amount of capital banks are required to hold as
well as an increase in market risk exposure. The
use of future and forward contracts grew from $95
billion in 1985 to nearly $2.5 trillion in 1993 — a
growth rate of almost 2500%. (Simmons 95) The
increasing popularity of financial derivatives has
brought about much concern regarding the potential
risks and complexities involved in derivative
trading. This paper will explore the determinants
of the use of such instruments by commercial banks
to ascertain whether they increase or decrease banks’
exposure to risk.
Section Two will provide background
information defining financial derivatives and
discussing their increasing popularity among
commercial banks. A summary of recent regulatory
developments surrounding capital requirements and
derivative use will also be presented. Section Three
will describe previous research that has been done
on derivative use in the financial services industry.
A theoretical model will be developed in Section
Four, and an empirical model will be presented in
Section Five. The results and future implications
of the study will be presented in Section Six and
Seven, respectively.
II. BACKGROUND INFORMATION
Derivatives are financial contracts whose
values are derived from the values of other
underlying assets, such as foreign exchange, bonds,
equities or commodities. For example, a Treasury
bond futures contract commits the parties to
exchange a Treasury bond at a future date for a
predetermined price. The value of the futures
contract depends on the value of the underlying
Treasury bond. If, for instance, the price of Treasury
bonds increases then the value of the futures contract
will increase because the buyer of the futures
contract is now entitled to receive a more valuable
asset.
Banks typically participate in derivatives
markets because their traditional lending and
borrowing activities expose them to financial market
risk. Interest rate risk, or market risk, is, in general,
the potential for changes in rates to reduce a bank’s
earnings or value. As financial intermediaries,
banks encounter interest rate risk in several ways.
The primary source of interest rate risk stems from
timing differences in the repricing of bank assets,
liabilities, and off-balance-sheet instruments. These
repricing mismatches are fundamental to the
business of banking and generally occur from either
borrowing short term to fund long-term assets or
borrowing long term to fund short-term assets.
Financial derivatives provide banks with an effective
way to manage interest rate risk without incurring
additional capital charges. Derivatives can be used
to hedge asset and liability positions by allowing
banks to take a position in the derivatives market
that is equal and opposite to a current or planned
future position in the spot or cash market. Therefore,
regardless of the movement in prices, losses in one
market will be offset by gains in the other. Banks
can also take a derivative position uncovered by
potential earnings or losses. In this case they are
speculating on interest rate changes that the market
doesn’t anticipate.
It has been argued that federal deposit
insurance held by banks provides an incentive to
use derivatives in a speculative manner in order to
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increase the value of shareholder equity by
expanding into activities that shift risk onto the
deposit insurer. (Jason and Taylor 1994)
Speculating with derivatives involves gambling on
the future performance of the underlying assets in
an attempt to reap trading profits. However, as has
been the case in several instances, using derivatives
in such a manner subjects banks to higher, rather
than lower, risk exposure and can lead to significant
financial losses. (Jason and Taylor 1994)
It is important from a policy perspective to
determine how banks are using derivatives. If used
properly as hedging instruments
then derivatives can be quite
useful as explained previously.
Yet, speculating with
derivatives would seem to be
unacceptable from a safety and
soundness standpoint. It is my
hypothesis that banks engage in
derivatives to hedge their
exposure to interest rate risk
rather than to increase it by
speculating.
The acceleration of
bank derivative use began in the
late 1970s and 1980s, when
banks’ market risk exposure
proved fatal to many institutions. During this period,
interest rates were extremely volatile — mortgage
rates rose to over 15 percent while the prime rate
surpassed 20 percent. Banks found themselves in a
more vulnerable position. Further, because
Regulation Q was being phased out, banks’ costs
of borrowing rose significantly. Many banks
experienced a dramatic drop in their market values,
and as a result 1000 insured banks with
approximately $92 billion in deposits failed over
the decade. (Hanwek 3)
Because of the rapidly rising number of
bank failures during the 1980s, the Federal
Regulatory Agencies became concerned about the
amount of capital held by commercial banks. At
the time capital requirements for a bank were based
solely on its total assets. No consideration was given
to the risk embedded in the assets. The Committee
assigned to investigate the problem formulated the
Federal Deposit Insurance Corporation
Improvement Act (FDICIA), passed in 1991. In an
effort to develop formal capital charges that
conformed more closely to banks’ true risk exposure
regulators implemented risk-based capital
requirements through FDICIA in accordance with
the Basel Accord of 1988. The new risk-based
capital requirements took into account the amount
of credit risk of the assets held by a particular bank
in determining the level of capital required for that
bank. The requirements called for assets to be
divided into four categories according to their
riskiness. Cash and its
equivalents, including short term
Treasury securities, were
assigned a zero weight, municipal
general obligation bonds and
mortgage-backed securities a 20
percent weight. Moderate risk
assets and assets in a bank’s loan
portfolio, including residential
mortgages, carried a 50 percent
weight and commercial loans,
loans made to developing
countries (LDC loans) and
corporate bonds held a 100
percent weight. A required
minimum ratio of total capital to
risk-weighted assets was established at 7.25 percent.
(Hanwek 49)
The risk-based capital requirements
discussed above are based solely on credit risk;
however, in developing FDICIA, regulators realized
the need to establish guidelines for protecting banks
against interest-rate risk as well. From the
regulatory perspective in a risk-based capital
environment, interest-rate risk should be
incorporated into existing capital requirements as
well as credit risk. Thus, as outlined in FDICIA,
regulators set out to incorporate interest rate risk
into capital charges based on the interest rate
sensitivity of the assets and liabilities of the bank.
Specifically, assets, liabilities and off-balance sheet
instruments are divided into seven maturity groups:
0 to 3 months; 3 months to 1 year; 1 year to 3 years;
3 to 5 years; 5 to 10 years; 10 to 20 years; and more
than 20 years. Each group is then assigned a
The acceleration of
bank derivative use
began in the late
1970s and 1980s
when banks’ market
risk exposure proved
fatal to many
institutions.
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duration based on a benchmark instrument
representative of the assets and the liabilities in that
group. Duration is the measure of the approximate
change in the value of an asset or liability for a
change of 100 basis points in interest rates. Once
the durations are computed, they are multiplied by
the balances in each of the respective groups, and
the net balance sheet duration is calculated.
(Fabozzi 71) The results provide an estimate of the
amount by which the surplus or equity position, (the
difference between a bank’s assets and liabilities) is
expected to change as a result of a given change in
interest rates. According to
the proposal, if the surplus
changes by more than one
percent of assets, the bank
must hold additional capital
in an amount equal to the
excess. (Fabozzi 71)
Although the
recommendation was part of
the 1991 proposal, the
incorporation of interest rate
risk into capital requirements
was not immediately
implemented by the
regulatory agencies. It was
subjected to further study as regulators struggled to
devise a method to measure the effects of interest
rate changes as well as a method to model the effects
of such changes on the market value of a bank’s
portfolio or net worth. (Hanweck 150) Finally, in
1996, an amendment to the Basel Capital Accord
proposed that commercial banks with significant
trading activities set aside capital to cover the market
risk exposure in their trading accounts. The U.S.
bank regulatory agencies have adopted this
amendment and began enforcing it in 1998.
Beginning on January 1, 1998, any bank or bank
holding company whose trading activity equals
more than 10 percent of its total assets or whose
trading activity is equal to more than $1 billion must
hold regulatory capital against their market risk
exposure. These capital charges are based on value
at risk estimates generated by banks’ own internal,
risk measurement models using the standardizing
regulatory parameters of a 10-day (k = 10) holding
period and 99 percent (alpha = 1) coverage. Thus,
as described previously, a bank’s market risk capital
charge is based on its estimate of the potential loss
that would not be exceeded with 99 percent certainty
over the subsequent 2-week period. (Lopez 4)
Although the capital charges against market
risk exposure were not implemented until January
of 1998, the credit risk-based capital requirements
outlined in FDICIA have changed the way banks
manage market risk. Traditional interest rate risk
management techniques involved simply changing
the maturity structure of the bank’s assets and
liabilities to minimize
exposure to changes in
interest rates. However, the
new regulations left many
banks with a short supply of
capital thus, making it more
difficult for banks to
increase asset holdings to
change balance sheet
duration while maintaining
an adequate level of capital.
Banks often needed a way
to manage interest rate risk
without additional capital
on their balance sheet.
Financial derivatives seemed to be the solution.
III. LITERATURE REVIEW
Several studies examined the use of
derivatives by banks. Deshmukh, Greenbaum, and
Kanatas (1983) argue that an increase in interest
rate uncertainty encourages depository institutions
to decrease their lending activities, which entail
interest rate risk, and to increase their fee for service
activities, which do not. Therefore, they argue that
if interest rate risk can be controlled by derivatives,
then perhaps banks that use derivatives would
experience less interest rate uncertainty and can
increase their lending activities which result in
greater returns relative to the return on fixed fee for
service activities. Thus their overall profitability
would be higher compared to those banks that do
not use derivatives to control for interest rate
uncertainty. (Brewer 482)
Brewer, Jackson, Moser and Saunders found
Banks often need a way
to manage interest rate
risk without additional
capital on their balance
sheet. Financial deriva-
tives seem to be a rela-
tively common solution.
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that there is a negative correlation between risk and
derivative usage for savings and loan institutions.
In fact, it was found that S&Ls that used derivatives
experienced relatively greater growth in their fixed-
rate mortgage portfolios. (Brewer 481) These
results indicate that financial institutions use
derivatives for hedging purposes, which would
explain the reduction in the volatility risk with an
increase in derivative use. Jason and Taylor (1994),
and Stern and Linan (1994) found that trading
derivatives for profit is risky and may expose firms
to large losses. (Brewer 482)
In an earlier study, Katerina Simmons used
quarterly Call Report data to examine the pattern
of derivative use by banks between 1988 and 1993.
She found that banks with weaker asset quality tend
to use derivatives more intensely than banks with
better asset quality. Simmons found no relationship
between duration gap measures and derivative use.
Thus, her study provided no indication as to whether
banks use derivatives to increase or reduce interest
rate risk. (Simmons 104)
While some studies indicate that derivatives
may be useful to banks because they give firms a
chance to hedge their exposure to interest rate risk,
others have found that derivatives can impose a
significant amount of risk on an institution, resulting
in large financial losses. It is the goal of this study
to determine if banks use derivatives to lessen their
exposure to interest rate risk or to gamble
speculatively in derivative markets.
IV. THEORY
This paper argues that banks use derivatives
to minimize risk exposure, assuming that banks
maximize profits subject to a risk constraint. In
theory, a bank’s exposure to interest rate risk should
have an effect on the size of its derivative holdings
if the financial instruments are used for hedging
purposes. Furthermore, it is argued that derivative
use will vary according to bank size, balance sheet
composition, total risk exposure, profitability and
appetite for assuming risk. I will discuss each of
these characteristics below.
A. Risk Exposure
Interest Rate Risk Exposure
In theory, banks can benefit from derivative
markets because derivatives, like insurance, can be
used to hedge against risk. Carefully chosen
derivative deals can reduce interest rate risk inherent
in banking activities because the preexisting interest
rate risk can sometimes be offset by a
counterbalancing derivative risk. Therefore, if
derivatives are used to hedge against interest rate
risk, then the volume of derivatives held by a bank
should be negatively related to the current interest
rate risk experienced by the bank.
Credit Risk Exposure
The ratios of loan loss reserves to loans and non-
current loans to loans are indications of the quality
of assets held by a bank. Each bank must maintain
an allowance for loan and lease losses that is
adequate to absorb estimated credit losses associated
with its loan and lease portfolio. A bank with
relatively risky assets would be required to hold a
relatively larger loan loss reserve balance.
Loans are considered non-current if they are 90
days or more past due or if they are in non-accrual
status. Thus a bank with a relatively greater
proportion of non-current loans would be considered
relatively riskier. It can be argued that investors
would view a bank with a relatively high loan loss
reserve or a bank with a relatively high balance of
non-current loans as one of high risk. Thus the bank
might have a difficult time raising additional capital
as needed to manage interest rate risk in the
traditional manner. Furthermore, a riskier loan
portfolio may be an indication of management’s
predilection for risk that might be carried over into
derivative dealings. If management has greater
tendencies towards risk then they might be more
likely to assume the risk involved in speculating
with derivatives. Banks in either situation would
theoretically be more likely to use derivatives.
However, it would be difficult to discriminate among
those that are using derivatives prudently to manage
interest rate risk and those that are speculating. On
the other hand, it has been argued that banks that
hold a relatively risky portfolio of assets would avoid
using derivatives in order to avoid regulatory
scrutiny. (Simmons 100) Therefore, the direction
of the relationship between derivative use and bank
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credit risk is ambiguous.
B. Balance Sheet Characteristics
Capitalization
Banks are required to hold a percentage of
capital based on the risk embedded in their asset
holdings. Profit maximizing banks have an
incentive to increase their assets given the size of
their capital balance. Such banks would tend to
purchase assets until their capital to asset ratio
reaches its minimum as required by regulators.
Once in that position, the banks are better off using
derivatives to manage interest rate risk because they
do not require additional capital. Therefore, a
negative relationship should exist between
derivative use and the banks’ risk weighted capital
to asset ratio.
Size of Asset Portfolio
In theory, large banks are more likely to be
involved in derivative use for several reasons. First,
derivatives are very complex instruments and
require careful management and analysis. Smaller
banks may not have the resources to devote to
understanding the complexities of these instruments.
Furthermore, transaction fees involved in trading
derivatives decrease with increased volume of
purchases. Thus larger banks that can afford to
make larger transactions pay relatively smaller
transactions fees. Finally, larger banks are more
likely to have greater exposure to market risk
particularly because of the differences in their
borrowing sources. Large banks tend to use
instruments, such as jumbo CDs, whose price and
yields vary with the market on a day-to-day basis.
Therefore, the relationship between derivative use
and asset size is expected to be positive.
C. Other Characteristics—Bank Profitability
Recalling the work of Deshmukh,
Greenbaum, and Kanatas (1983), banks who can
manage interest rate risk using derivatives will be
less constrained in their lending activities and will
thus be able to invest in higher risk/higher yielding
assets. Derivatives free banks from the restrictions
imposed by traditional internal hedging by allowing
the bank to separate its choice of assets or sources
of funding from considerations of market risk.
Therefore, derivative use is expected to have a
positive relationship with bank profitability.
V. EMPIRICAL MODEL
This section analyzes the determinants of
derivative use among commercial banks with more
than $500 million in assets. The independent
variables which are described below include: net
interest margin, return on assets, capital to total
assets unweighted for risk, non-current loans to
loans, loan loss allowance to loans, total assets, and
a trend variable based on quarterly real GDP. The
dependent variable is the ratio of derivatives to total
assets. The regression equation is presented below.
Two regressions will be run. The first lags net
interest margin one quarter, and the second is
identical to the first, except that the lag is removed.
Derivative Volume = C + ? ?? ??Exposure to
Interest Rate Risk + ? ?? ??Non-Current Loans +
? ?? ??Loan-Loss Allowance + ? ?? ??Profit + ? ?? ??Bank
Size + ? ?? ??Capital to Assets + ? ?? ??GDP + ? ?? ??
Exposure to interest rate risk is measured
as net interest margin, the difference of interest
income and interest expense relative to assets. This
index measures the sensitivity of the return on assets
to changes in market yields. Wright and Houpt
(1995) used net interest margin to trace the threat
of interest rate risk to commercial banks over a
nineteen year period. They found that from 1976
to 1995, net interest margins of the banking industry
have shown a fairly stable upward trend while
savings and loan institutions exhibited highly
volatile margins. (Wright 115) If derivatives are,
in fact, used to hedge interest rate risk then banks
that use derivatives will be less exposed to interest
rate risk and have a lower net interest margin.
However, in the first model, which lags net interest
margin, the coefficient on net interest margin is
expected to be positive. This would indicate that
banks that faced a high net interest margin in the
previous quarter would increase their derivative
holdings in the current quarter to hedge this exposure
to risk. The coefficient on net interest margin in the
second model would be expected to be negative
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because if derivatives are used to hedge interest rate
risk then the more intensely a bank uses derivatives,
the less exposed they should be to interest rate risk.
The variables used to measure credit risk
are the ratios of non-current loans relative to loans
and loan loss reserves to loans. If a bank has more
credit risk, it would have less access to additional
capital and may therefore be more likely to use
derivatives. Thus the coefficient on non-current
loans to loans is predicted to be positive and the
coefficient on loan loss reserves to total loans is also
predicted to be positive. On the other hand, the use
of derivatives may be perceived by regulators as
risky, and banks with weak asset quality might be
subject to more scrutiny or restrictions by regulators
when they attempt to use derivatives, thus
discouraging the use of derivatives by such banks.
(Simmons 101) This might indicate a negative sign
on both coefficients. Therefore the sign on this
variable is ambiguous.
The return on assets ratio is used to measure
the profitability of a bank. A bank with higher
profits would be more likely to have used derivatives
because derivatives can be used to hedge loss in
income associated with interest rate risk exposure
allowing banks to take on more profitable
investments.
The capital to assets unweighted for risk
ratio is also included in the model. It can be argued
that a bank that is not well capitalized may be more
likely to use derivatives because derivatives can
transform the duration of the balance sheet without
incurring additional capital charges. Thus the sign
on this variable would be negative. However, since
I used a ratio unweighted for risk, it will increase
with riskiness. Therefore the sign on this variable
is expected to be positive.
Bank size is measured by the amount of total
assets. The coefficient on this variable is expected
to be positive because a larger bank is more likely
to use derivatives than a smaller bank, as discussed
in the theoretical section.
A measure of quarterly real GDP was
included in the model as a trend variable to control
c i t s i r e t c a r a h C e l b a i r a V t n e i c i f f e o C
) c i t s i t a t s - T (
d e t c e p x E
n g i S
e t a R t s e r e t n I
e r u s o p x E k s i R
n i g r a M t s e r e t n I t e N
) r e t r a u q e n o d e g g a l (
* * 1 2 5 0 4 0 . 0 -
) 8 6 7 . 2 - (
+
n o i t a z i l a t i p a C s t e s s A o t l a t i p a C * * * 7 7 4 3 8 0 . 0
) 8 7 1 . 5 (
+
k s i R t i d e r C s n a o L o t e c n a w o l l A s s o L
s n a o L o t s n a o L t n e r r u C - n o N
2 3 5 5 2 0 . 0 -
) 7 2 9 . 0 - (
* 7 3 4 4 1 0 . 0
) 3 0 7 . 1 (
?
?
y t i l i b a t i f o r P s t e s s A n o n r u t e R 8 1 2 7 0 0 . 0
) 7 9 1 . 0 (
+
e z i S k n a B s t e s s A * * * 8 0 - e 2 . 3
) 0 6 4 . 9 (
+
*significant to the .10 level **significant to the .01 level ***significant to the .001 level
Table 1
Dependent Variable: Derivatives Relative to Assets
Sample Size: 304
Adjusted R-Square: .311157
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for cyclical economic changes that might affect all
banks’ incomes.
This model estimates the determinants of
derivative use by commercial banks based on pooled
time series, cross sectional quarterly data for 38
banks for the period 1995:IV to 1997:III. A total
of 304 cases were observed. The data were taken
from the Federal Deposit Insurance Corporation’s
(FDIC) Institutional Directory System, which
provides financial information on banks based on
quarterly Call Reports. The sample selected for this
study included banks with assets over $500 million.
The sample banks are diversified geographically and
by size with large dealer banks excluded from the
study because their derivative trading accounts are
not representative of the typical commercial bank.
VI. RESULTS
A. Model I
In the first regression, the independent
variable, net-interest margin, was lagged one quarter
in order to test if derivatives were being used to
reduce interest rate risk exposure present in the
previous quarter. Overall this model performed
fairly well with all but two variables being
significant. (See Table 1) However, the coefficient
on the net interest margin variable has a negative
sign indicating that banks that use derivatives tend
to have lower interest rate risk in previous quarters.
This result may be due to the fact that the data in
this study are based on quarterly measurements of
derivative holdings. Since derivative positions are
adjusted more frequently then quarterly, quarterly
data might not truly reflect the effect of the previous
quarters’ net interest margin on derivative use.
Three of the five remaining independent
variables were significant in this first model. Bank
asset size was positive and significant at the .001
level indicating that larger banks tend to use
derivatives to a greater extent than smaller banks.
Banks that hold more capital relative to assets also
tend to be more frequent users of derivatives
according to this model. The capital to asset variable
was positive and significant at the .001 level also.
Because banks are required to hold a percentage of
capital based on the riskiness of their assets, this
result may indicate that banks with greater
tendencies towards risk are more likely to use
derivatives. However, since the variable used in
this study was the ratio of capital to total assets
unweighted for risk, it is difficult to distinguish
among those banks that are well capitalized and
those whose large capital holdings are a result of a
risky asset portfolio. But, well-capitalized low risk
banks would have a greater proportion of their asset
portfolio weighted at zero risk, therefore the ratio
of capital to total assets as measured in this study
would be lower for such banks. On the other hand,
banks with riskier assets would have a lower
proportion of their assets at zero risk, therefore their
capital to total asset ratios will be higher. And since
the results show a positive coefficient on the captial-
to-asset variable which indicates banks with a higher
capital to assets ratios tend to be more intensive users
of derivatives, the risky asset view of derivative use
seems to hold true. Future studies might consider
the ratio of capital to risk weighted assets which
would indicate if a bank was well capitalized or if a
bank’s capital was necessary because of its risky
assets.
The coefficient on the variable, non-current
loans relative to total loans, was positive and
significant at the .10 level. This result indicates
that banks with a relatively greater proportion of
credit risk would be more likely to use derivatives
to a greater extent. There are two possible
arguments supporting this result. First, it could be
assumed that banks with riskier tendencies in
lending activities may be more likely to take on risk
in other areas as well, including derivative dealings.
This result could perhaps suggest that banks use
derivatives to speculate because of the
management’s appetite for risky activities. On the
other hand, banks with relatively greater credit risk
may find it more difficult to raise capital in the
marketplace, thus making it more difficult to adjust
their balance sheets in the traditional way of
managing interest rate risk. Derivatives would seem
to be the likely solution for banks in this type of
situation because they do not require additional
capital and can be used to hedge interest rate risk
exposure.
The variables, return on assets and loan loss
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90
reserves to loans, were not significant in this model.
B. Model II
The second model, removing the lag on net
interest margin and including all of the previously
explained variables, slightly improved the results.
(See Table 2) The adjusted R-square value for
model II increased to .32777 from .311157 in model
I. The signs on the variables remained the same
and their individual significance improved slightly.
Return on assets and loan loss reserves remained
insignificant.
The improvement in this model could be due
to the fact that banks can adjust derivatives on a
very frequent basis and the results of these
adjustments may be better represented by the net
interest margin in the current quarter rather than
the previous quarter.
VII. CONCLUSION
The major results of this project support the
notion that financial derivatives are used to hedge
interest rate risk. The results indicate that the lower
a bank’s exposure to interest rate risk, as measured
by net interest margin, the more likely the bank is
to use derivatives. The study also found that larger
banks tend to use derivatives to a greater extent than
smaller banks and that banks with a greater
proportion of credit risk are more likely to use
derivatives. It was also found that banks that utilize
derivatives typically have a higher capital to asset
ratio. This result might indicate that banks with
relatively more credit risk are more likely to use
derivatives. This study found no relationship
between bank profitability and derivative use.
In order to understand how these results
relate to those of previous studies they will be
compared with those covered in the literature review
section. The findings of the present study agree with
that of Brewer, Jackson, Moser and Saunders who
found a negative correlation between interest rate
risk and derivative usage for savings and loan
institutions. On the other hand, these results are at
odds with a previous study by Deshmukh,
c i t s i r e t c a r a h C e l b a i r a V t n e i c i f f e o C
) c i t s i t a t s - T (
d e t c e p x E
n g i S
e t a R t s e r e t n I
e r u s o p x E k s i R
n i g r a M t s e r e t n I t e N * * * 8 7 1 0 4 0 . 0 -
) 1 0 9 . 2 - (
-
n o i t a z i l a t i p a C s t e s s A o t l a t i p a C * * * 2 4 4 3 9 0 . 0
) 1 9 1 . 6 (
+
k s i R t i d e r C s n a o L o t e c n a w o l l A s s o L
s n a o L o t s n a o L t n e r r u C - n o N
9 0 2 3 3 0 . 0 -
) 9 4 2 . 1 - (
* 9 2 4 4 1 0 . 0
) 4 2 7 . 1 (
?
?
y t i l i b a t i f o r P s t e s s A n o n r u t e R 9 5 2 3 1 0 . 0
) 7 8 3 . 0 (
+
e z i S k n a B s t e s s A * * * 8 0 - e 4 4 . 3
) 1 9 1 . 6 (
+
*significant to the .10 level **significant to the .01 level ***significant to the .001 level
Table 2
Dependent Variable: Derivatives Relative to assets
Sample Size: 304
Adjusted R-Square: .32777
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Greenbaum and Kanatas (1983) which found that
banks that use derivatives are more profitable than
banks that do not. The results of the present study
also contradict the results of Jason and Taylor (1994)
which indicated derivative trading is risky and may
expose firms to large losses. The results of this study
can also be compared to a study done by Simmons
(1995). She found no significant relationship
between interest rate risk exposure and derivative
use, yet her results concerning capital to assets
agreed with those of the present study.
Although the results of this study support
the major hypothesis that derivatives are used to
reduce banks’ exposure to interest rate risk, the field
of study remains fruitful for further research. First
of all, it would be interesting to trace the data farther
back in history when the use of derivatives first
began to accelerate. A greater number of
observations would give a better indication of profit
and risk variability over time which may show some
changes in the way derivatives have been used over
time. It would also be interesting to evaluate the
changes in banks use of derivatives as a result of
the new interest-rate risk based capital standards that
were enacted in January of this year. Furthermore,
the question of causation between derivative use and
risk exposure might be addressed in future research.
While this study explored the determinants of
derivative use by banks, it would be interesting to
test whether or not overall bank risk depends on the
use of derivatives. Finally, the data used in this study
did not separate the various types of derivatives,
further studies might utilize data on specific types
of derivatives to analyze the determinants of swap
use, an inherently riskier derivative, versus the less
risky use of futures and options.
Financial markets have responded to
increasing interest rate risk with new products that
allow banks to transform the duration of their
balance sheets without incurring additional capital
charges. While some argue that derivatives are too
risky to be used by commercial banks, the results of
this study support the argument that derivatives can
be used to effectively lower market risk exposure
for banks. As pointed out earlier, the question of
how banks use derivatives remains an interesting
topic for further research. Furthermore, it is of no
doubt that the soundness of the banking system is
an issue of primary concern to society. Thus
continued careful monitoring of banks’ derivative
activities by regulators is essential to ensure that
the increasingly popular instruments are utilized in
ways that contribute to the objective of a safe and
sound banking system.
References
Becketti, Sean. “Are Derivatives Too Risky for
Banks?” Federal Reserve Bank of
Kansas City, 3
rd
Quarter, pp. 27-42.
Brewer, Elijah; William Jackson, James Moser,
Anthony Saunders. “Alligators in the
Swamp.” Journal of Money, Credit and
Banking. Aug. 1996, pp.482-502.
Deshmukh, Sudhakar, Stuart Greenbaum,
George Kanatas. “Interest Rate
Uncertainty and the Financial
Intermediary’s Choice of Exposure.”
Journal of Finance 38 (Mar 1983), pp. 141-
47.
Fabozzi, Frank; Franco Modigliani; Micheal
Ferri. Foundations of Financial Markets
and Institutions. Prentice Hall: Upper
Saddle River, NJ. 1998.
Fisher, Ray. “Use Derivatives to Manage Rate
Risk.” Bank Management. March-April
1996, pp.44-48.
Hanwek, Gerald and Bernard Shull. Interest Rate
Volatility. Bankline Publication:
Chicago. 1996.
Jagannathan, Ravi. “The CAPM Debate.”
Federal Reserve Bank of Minneapolis,
Quarterly Review, Fall 1995, pp. 3-17.
Jason, Georgette and Jeffrey Taylor.
“Derivatives Force First Closure of Money
Fund.” The Wall Street Journal, 28
Hundman Hundman Hundman Hundman Hundman
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92
September 1994, pp. C1.
Lopez, Jose. “Regulatory Evaluation of Value-At-
Risk Models.” Federal Reserve Bank of
New York Staff Reports, no. 33. November,
1997.
Maher, Matt. “Bank Holding Company Risk from
1976-1989 with a Two Factor Model.”
Financial Review. August 1989, pp.431-
55.
Mitchell, Karlyn. “Interest Rate Risk at
Commercial Banks: An Empirical
Investigation.” Financial Review. August
1989, pp.431-55.
Satoris, William. “The Term Structure of Interest
Rates and the Asset and Liability
Decisions of a Financial Intermediary.”
Journal of Economics and Business.
May 1993, pp. 129-43.
Simmons, Katerina. “Interest Rate Derivatives
and Asset-Liability Management by
Commercial Banks.” Federal Reserve Bank
of Boston. Jan-Feb. 1995, pp. 17-28.
Stern, Gabriella and Steven Lipin. “Proctor and
Gamble to Take a Charge to Close Out Two
Interest Rate Swaps.” The Wall Street
Journal, 13 April 1994, pp. A3.
Stout, Lynn. “Insurance or Gambling? Derivatives
Trading in a World of Risk and
Uncertainty.” Brookings Review. Winter
1996 pp. 38-42.
Wright, James. “An Analysis of Commercial Bank
Exposure to Interest Rate Risk.”
Federal Reserve Bulletin. Feb. 1996,
pp.115-129.
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doc_562094694.pdf
Derivatives, namely, futures, options and swaps, are off-balance sheet instruments that allow banks to transform the duration of their balance sheets in order to manage market risk without incurring additional capital requirements. Banks' use of derivatives has been growing rapidly in recent years due, in part, to regulatory changes concerning the amount of capital banks are required to hold as well as an increase in market risk exposure.
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An Analysis of the Determinants of Financial
Derivative Use By Commercial Banks
By Katie Hundman
I. INTRODUCTION
Derivatives, namely, futures, options and
swaps, are off-balance sheet instruments that allow
banks to transform the duration of their balance
sheets in order to manage market risk without
incurring additional capital requirements. Banks’
use of derivatives has been growing rapidly in recent
years due, in part, to regulatory changes concerning
the amount of capital banks are required to hold as
well as an increase in market risk exposure. The
use of future and forward contracts grew from $95
billion in 1985 to nearly $2.5 trillion in 1993 — a
growth rate of almost 2500%. (Simmons 95) The
increasing popularity of financial derivatives has
brought about much concern regarding the potential
risks and complexities involved in derivative
trading. This paper will explore the determinants
of the use of such instruments by commercial banks
to ascertain whether they increase or decrease banks’
exposure to risk.
Section Two will provide background
information defining financial derivatives and
discussing their increasing popularity among
commercial banks. A summary of recent regulatory
developments surrounding capital requirements and
derivative use will also be presented. Section Three
will describe previous research that has been done
on derivative use in the financial services industry.
A theoretical model will be developed in Section
Four, and an empirical model will be presented in
Section Five. The results and future implications
of the study will be presented in Section Six and
Seven, respectively.
II. BACKGROUND INFORMATION
Derivatives are financial contracts whose
values are derived from the values of other
underlying assets, such as foreign exchange, bonds,
equities or commodities. For example, a Treasury
bond futures contract commits the parties to
exchange a Treasury bond at a future date for a
predetermined price. The value of the futures
contract depends on the value of the underlying
Treasury bond. If, for instance, the price of Treasury
bonds increases then the value of the futures contract
will increase because the buyer of the futures
contract is now entitled to receive a more valuable
asset.
Banks typically participate in derivatives
markets because their traditional lending and
borrowing activities expose them to financial market
risk. Interest rate risk, or market risk, is, in general,
the potential for changes in rates to reduce a bank’s
earnings or value. As financial intermediaries,
banks encounter interest rate risk in several ways.
The primary source of interest rate risk stems from
timing differences in the repricing of bank assets,
liabilities, and off-balance-sheet instruments. These
repricing mismatches are fundamental to the
business of banking and generally occur from either
borrowing short term to fund long-term assets or
borrowing long term to fund short-term assets.
Financial derivatives provide banks with an effective
way to manage interest rate risk without incurring
additional capital charges. Derivatives can be used
to hedge asset and liability positions by allowing
banks to take a position in the derivatives market
that is equal and opposite to a current or planned
future position in the spot or cash market. Therefore,
regardless of the movement in prices, losses in one
market will be offset by gains in the other. Banks
can also take a derivative position uncovered by
potential earnings or losses. In this case they are
speculating on interest rate changes that the market
doesn’t anticipate.
It has been argued that federal deposit
insurance held by banks provides an incentive to
use derivatives in a speculative manner in order to
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increase the value of shareholder equity by
expanding into activities that shift risk onto the
deposit insurer. (Jason and Taylor 1994)
Speculating with derivatives involves gambling on
the future performance of the underlying assets in
an attempt to reap trading profits. However, as has
been the case in several instances, using derivatives
in such a manner subjects banks to higher, rather
than lower, risk exposure and can lead to significant
financial losses. (Jason and Taylor 1994)
It is important from a policy perspective to
determine how banks are using derivatives. If used
properly as hedging instruments
then derivatives can be quite
useful as explained previously.
Yet, speculating with
derivatives would seem to be
unacceptable from a safety and
soundness standpoint. It is my
hypothesis that banks engage in
derivatives to hedge their
exposure to interest rate risk
rather than to increase it by
speculating.
The acceleration of
bank derivative use began in the
late 1970s and 1980s, when
banks’ market risk exposure
proved fatal to many institutions. During this period,
interest rates were extremely volatile — mortgage
rates rose to over 15 percent while the prime rate
surpassed 20 percent. Banks found themselves in a
more vulnerable position. Further, because
Regulation Q was being phased out, banks’ costs
of borrowing rose significantly. Many banks
experienced a dramatic drop in their market values,
and as a result 1000 insured banks with
approximately $92 billion in deposits failed over
the decade. (Hanwek 3)
Because of the rapidly rising number of
bank failures during the 1980s, the Federal
Regulatory Agencies became concerned about the
amount of capital held by commercial banks. At
the time capital requirements for a bank were based
solely on its total assets. No consideration was given
to the risk embedded in the assets. The Committee
assigned to investigate the problem formulated the
Federal Deposit Insurance Corporation
Improvement Act (FDICIA), passed in 1991. In an
effort to develop formal capital charges that
conformed more closely to banks’ true risk exposure
regulators implemented risk-based capital
requirements through FDICIA in accordance with
the Basel Accord of 1988. The new risk-based
capital requirements took into account the amount
of credit risk of the assets held by a particular bank
in determining the level of capital required for that
bank. The requirements called for assets to be
divided into four categories according to their
riskiness. Cash and its
equivalents, including short term
Treasury securities, were
assigned a zero weight, municipal
general obligation bonds and
mortgage-backed securities a 20
percent weight. Moderate risk
assets and assets in a bank’s loan
portfolio, including residential
mortgages, carried a 50 percent
weight and commercial loans,
loans made to developing
countries (LDC loans) and
corporate bonds held a 100
percent weight. A required
minimum ratio of total capital to
risk-weighted assets was established at 7.25 percent.
(Hanwek 49)
The risk-based capital requirements
discussed above are based solely on credit risk;
however, in developing FDICIA, regulators realized
the need to establish guidelines for protecting banks
against interest-rate risk as well. From the
regulatory perspective in a risk-based capital
environment, interest-rate risk should be
incorporated into existing capital requirements as
well as credit risk. Thus, as outlined in FDICIA,
regulators set out to incorporate interest rate risk
into capital charges based on the interest rate
sensitivity of the assets and liabilities of the bank.
Specifically, assets, liabilities and off-balance sheet
instruments are divided into seven maturity groups:
0 to 3 months; 3 months to 1 year; 1 year to 3 years;
3 to 5 years; 5 to 10 years; 10 to 20 years; and more
than 20 years. Each group is then assigned a
The acceleration of
bank derivative use
began in the late
1970s and 1980s
when banks’ market
risk exposure proved
fatal to many
institutions.
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duration based on a benchmark instrument
representative of the assets and the liabilities in that
group. Duration is the measure of the approximate
change in the value of an asset or liability for a
change of 100 basis points in interest rates. Once
the durations are computed, they are multiplied by
the balances in each of the respective groups, and
the net balance sheet duration is calculated.
(Fabozzi 71) The results provide an estimate of the
amount by which the surplus or equity position, (the
difference between a bank’s assets and liabilities) is
expected to change as a result of a given change in
interest rates. According to
the proposal, if the surplus
changes by more than one
percent of assets, the bank
must hold additional capital
in an amount equal to the
excess. (Fabozzi 71)
Although the
recommendation was part of
the 1991 proposal, the
incorporation of interest rate
risk into capital requirements
was not immediately
implemented by the
regulatory agencies. It was
subjected to further study as regulators struggled to
devise a method to measure the effects of interest
rate changes as well as a method to model the effects
of such changes on the market value of a bank’s
portfolio or net worth. (Hanweck 150) Finally, in
1996, an amendment to the Basel Capital Accord
proposed that commercial banks with significant
trading activities set aside capital to cover the market
risk exposure in their trading accounts. The U.S.
bank regulatory agencies have adopted this
amendment and began enforcing it in 1998.
Beginning on January 1, 1998, any bank or bank
holding company whose trading activity equals
more than 10 percent of its total assets or whose
trading activity is equal to more than $1 billion must
hold regulatory capital against their market risk
exposure. These capital charges are based on value
at risk estimates generated by banks’ own internal,
risk measurement models using the standardizing
regulatory parameters of a 10-day (k = 10) holding
period and 99 percent (alpha = 1) coverage. Thus,
as described previously, a bank’s market risk capital
charge is based on its estimate of the potential loss
that would not be exceeded with 99 percent certainty
over the subsequent 2-week period. (Lopez 4)
Although the capital charges against market
risk exposure were not implemented until January
of 1998, the credit risk-based capital requirements
outlined in FDICIA have changed the way banks
manage market risk. Traditional interest rate risk
management techniques involved simply changing
the maturity structure of the bank’s assets and
liabilities to minimize
exposure to changes in
interest rates. However, the
new regulations left many
banks with a short supply of
capital thus, making it more
difficult for banks to
increase asset holdings to
change balance sheet
duration while maintaining
an adequate level of capital.
Banks often needed a way
to manage interest rate risk
without additional capital
on their balance sheet.
Financial derivatives seemed to be the solution.
III. LITERATURE REVIEW
Several studies examined the use of
derivatives by banks. Deshmukh, Greenbaum, and
Kanatas (1983) argue that an increase in interest
rate uncertainty encourages depository institutions
to decrease their lending activities, which entail
interest rate risk, and to increase their fee for service
activities, which do not. Therefore, they argue that
if interest rate risk can be controlled by derivatives,
then perhaps banks that use derivatives would
experience less interest rate uncertainty and can
increase their lending activities which result in
greater returns relative to the return on fixed fee for
service activities. Thus their overall profitability
would be higher compared to those banks that do
not use derivatives to control for interest rate
uncertainty. (Brewer 482)
Brewer, Jackson, Moser and Saunders found
Banks often need a way
to manage interest rate
risk without additional
capital on their balance
sheet. Financial deriva-
tives seem to be a rela-
tively common solution.
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that there is a negative correlation between risk and
derivative usage for savings and loan institutions.
In fact, it was found that S&Ls that used derivatives
experienced relatively greater growth in their fixed-
rate mortgage portfolios. (Brewer 481) These
results indicate that financial institutions use
derivatives for hedging purposes, which would
explain the reduction in the volatility risk with an
increase in derivative use. Jason and Taylor (1994),
and Stern and Linan (1994) found that trading
derivatives for profit is risky and may expose firms
to large losses. (Brewer 482)
In an earlier study, Katerina Simmons used
quarterly Call Report data to examine the pattern
of derivative use by banks between 1988 and 1993.
She found that banks with weaker asset quality tend
to use derivatives more intensely than banks with
better asset quality. Simmons found no relationship
between duration gap measures and derivative use.
Thus, her study provided no indication as to whether
banks use derivatives to increase or reduce interest
rate risk. (Simmons 104)
While some studies indicate that derivatives
may be useful to banks because they give firms a
chance to hedge their exposure to interest rate risk,
others have found that derivatives can impose a
significant amount of risk on an institution, resulting
in large financial losses. It is the goal of this study
to determine if banks use derivatives to lessen their
exposure to interest rate risk or to gamble
speculatively in derivative markets.
IV. THEORY
This paper argues that banks use derivatives
to minimize risk exposure, assuming that banks
maximize profits subject to a risk constraint. In
theory, a bank’s exposure to interest rate risk should
have an effect on the size of its derivative holdings
if the financial instruments are used for hedging
purposes. Furthermore, it is argued that derivative
use will vary according to bank size, balance sheet
composition, total risk exposure, profitability and
appetite for assuming risk. I will discuss each of
these characteristics below.
A. Risk Exposure
Interest Rate Risk Exposure
In theory, banks can benefit from derivative
markets because derivatives, like insurance, can be
used to hedge against risk. Carefully chosen
derivative deals can reduce interest rate risk inherent
in banking activities because the preexisting interest
rate risk can sometimes be offset by a
counterbalancing derivative risk. Therefore, if
derivatives are used to hedge against interest rate
risk, then the volume of derivatives held by a bank
should be negatively related to the current interest
rate risk experienced by the bank.
Credit Risk Exposure
The ratios of loan loss reserves to loans and non-
current loans to loans are indications of the quality
of assets held by a bank. Each bank must maintain
an allowance for loan and lease losses that is
adequate to absorb estimated credit losses associated
with its loan and lease portfolio. A bank with
relatively risky assets would be required to hold a
relatively larger loan loss reserve balance.
Loans are considered non-current if they are 90
days or more past due or if they are in non-accrual
status. Thus a bank with a relatively greater
proportion of non-current loans would be considered
relatively riskier. It can be argued that investors
would view a bank with a relatively high loan loss
reserve or a bank with a relatively high balance of
non-current loans as one of high risk. Thus the bank
might have a difficult time raising additional capital
as needed to manage interest rate risk in the
traditional manner. Furthermore, a riskier loan
portfolio may be an indication of management’s
predilection for risk that might be carried over into
derivative dealings. If management has greater
tendencies towards risk then they might be more
likely to assume the risk involved in speculating
with derivatives. Banks in either situation would
theoretically be more likely to use derivatives.
However, it would be difficult to discriminate among
those that are using derivatives prudently to manage
interest rate risk and those that are speculating. On
the other hand, it has been argued that banks that
hold a relatively risky portfolio of assets would avoid
using derivatives in order to avoid regulatory
scrutiny. (Simmons 100) Therefore, the direction
of the relationship between derivative use and bank
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87
credit risk is ambiguous.
B. Balance Sheet Characteristics
Capitalization
Banks are required to hold a percentage of
capital based on the risk embedded in their asset
holdings. Profit maximizing banks have an
incentive to increase their assets given the size of
their capital balance. Such banks would tend to
purchase assets until their capital to asset ratio
reaches its minimum as required by regulators.
Once in that position, the banks are better off using
derivatives to manage interest rate risk because they
do not require additional capital. Therefore, a
negative relationship should exist between
derivative use and the banks’ risk weighted capital
to asset ratio.
Size of Asset Portfolio
In theory, large banks are more likely to be
involved in derivative use for several reasons. First,
derivatives are very complex instruments and
require careful management and analysis. Smaller
banks may not have the resources to devote to
understanding the complexities of these instruments.
Furthermore, transaction fees involved in trading
derivatives decrease with increased volume of
purchases. Thus larger banks that can afford to
make larger transactions pay relatively smaller
transactions fees. Finally, larger banks are more
likely to have greater exposure to market risk
particularly because of the differences in their
borrowing sources. Large banks tend to use
instruments, such as jumbo CDs, whose price and
yields vary with the market on a day-to-day basis.
Therefore, the relationship between derivative use
and asset size is expected to be positive.
C. Other Characteristics—Bank Profitability
Recalling the work of Deshmukh,
Greenbaum, and Kanatas (1983), banks who can
manage interest rate risk using derivatives will be
less constrained in their lending activities and will
thus be able to invest in higher risk/higher yielding
assets. Derivatives free banks from the restrictions
imposed by traditional internal hedging by allowing
the bank to separate its choice of assets or sources
of funding from considerations of market risk.
Therefore, derivative use is expected to have a
positive relationship with bank profitability.
V. EMPIRICAL MODEL
This section analyzes the determinants of
derivative use among commercial banks with more
than $500 million in assets. The independent
variables which are described below include: net
interest margin, return on assets, capital to total
assets unweighted for risk, non-current loans to
loans, loan loss allowance to loans, total assets, and
a trend variable based on quarterly real GDP. The
dependent variable is the ratio of derivatives to total
assets. The regression equation is presented below.
Two regressions will be run. The first lags net
interest margin one quarter, and the second is
identical to the first, except that the lag is removed.
Derivative Volume = C + ? ?? ??Exposure to
Interest Rate Risk + ? ?? ??Non-Current Loans +
? ?? ??Loan-Loss Allowance + ? ?? ??Profit + ? ?? ??Bank
Size + ? ?? ??Capital to Assets + ? ?? ??GDP + ? ?? ??
Exposure to interest rate risk is measured
as net interest margin, the difference of interest
income and interest expense relative to assets. This
index measures the sensitivity of the return on assets
to changes in market yields. Wright and Houpt
(1995) used net interest margin to trace the threat
of interest rate risk to commercial banks over a
nineteen year period. They found that from 1976
to 1995, net interest margins of the banking industry
have shown a fairly stable upward trend while
savings and loan institutions exhibited highly
volatile margins. (Wright 115) If derivatives are,
in fact, used to hedge interest rate risk then banks
that use derivatives will be less exposed to interest
rate risk and have a lower net interest margin.
However, in the first model, which lags net interest
margin, the coefficient on net interest margin is
expected to be positive. This would indicate that
banks that faced a high net interest margin in the
previous quarter would increase their derivative
holdings in the current quarter to hedge this exposure
to risk. The coefficient on net interest margin in the
second model would be expected to be negative
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88
because if derivatives are used to hedge interest rate
risk then the more intensely a bank uses derivatives,
the less exposed they should be to interest rate risk.
The variables used to measure credit risk
are the ratios of non-current loans relative to loans
and loan loss reserves to loans. If a bank has more
credit risk, it would have less access to additional
capital and may therefore be more likely to use
derivatives. Thus the coefficient on non-current
loans to loans is predicted to be positive and the
coefficient on loan loss reserves to total loans is also
predicted to be positive. On the other hand, the use
of derivatives may be perceived by regulators as
risky, and banks with weak asset quality might be
subject to more scrutiny or restrictions by regulators
when they attempt to use derivatives, thus
discouraging the use of derivatives by such banks.
(Simmons 101) This might indicate a negative sign
on both coefficients. Therefore the sign on this
variable is ambiguous.
The return on assets ratio is used to measure
the profitability of a bank. A bank with higher
profits would be more likely to have used derivatives
because derivatives can be used to hedge loss in
income associated with interest rate risk exposure
allowing banks to take on more profitable
investments.
The capital to assets unweighted for risk
ratio is also included in the model. It can be argued
that a bank that is not well capitalized may be more
likely to use derivatives because derivatives can
transform the duration of the balance sheet without
incurring additional capital charges. Thus the sign
on this variable would be negative. However, since
I used a ratio unweighted for risk, it will increase
with riskiness. Therefore the sign on this variable
is expected to be positive.
Bank size is measured by the amount of total
assets. The coefficient on this variable is expected
to be positive because a larger bank is more likely
to use derivatives than a smaller bank, as discussed
in the theoretical section.
A measure of quarterly real GDP was
included in the model as a trend variable to control
c i t s i r e t c a r a h C e l b a i r a V t n e i c i f f e o C
) c i t s i t a t s - T (
d e t c e p x E
n g i S
e t a R t s e r e t n I
e r u s o p x E k s i R
n i g r a M t s e r e t n I t e N
) r e t r a u q e n o d e g g a l (
* * 1 2 5 0 4 0 . 0 -
) 8 6 7 . 2 - (
+
n o i t a z i l a t i p a C s t e s s A o t l a t i p a C * * * 7 7 4 3 8 0 . 0
) 8 7 1 . 5 (
+
k s i R t i d e r C s n a o L o t e c n a w o l l A s s o L
s n a o L o t s n a o L t n e r r u C - n o N
2 3 5 5 2 0 . 0 -
) 7 2 9 . 0 - (
* 7 3 4 4 1 0 . 0
) 3 0 7 . 1 (
?
?
y t i l i b a t i f o r P s t e s s A n o n r u t e R 8 1 2 7 0 0 . 0
) 7 9 1 . 0 (
+
e z i S k n a B s t e s s A * * * 8 0 - e 2 . 3
) 0 6 4 . 9 (
+
*significant to the .10 level **significant to the .01 level ***significant to the .001 level
Table 1
Dependent Variable: Derivatives Relative to Assets
Sample Size: 304
Adjusted R-Square: .311157
An Analysis of the Deter An Analysis of the Deter An Analysis of the Deter An Analysis of the Deter An Analysis of the Determinants of Derivative Use By Commer minants of Derivative Use By Commer minants of Derivative Use By Commer minants of Derivative Use By Commer minants of Derivative Use By Commercial Banks cial Banks cial Banks cial Banks cial Banks
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for cyclical economic changes that might affect all
banks’ incomes.
This model estimates the determinants of
derivative use by commercial banks based on pooled
time series, cross sectional quarterly data for 38
banks for the period 1995:IV to 1997:III. A total
of 304 cases were observed. The data were taken
from the Federal Deposit Insurance Corporation’s
(FDIC) Institutional Directory System, which
provides financial information on banks based on
quarterly Call Reports. The sample selected for this
study included banks with assets over $500 million.
The sample banks are diversified geographically and
by size with large dealer banks excluded from the
study because their derivative trading accounts are
not representative of the typical commercial bank.
VI. RESULTS
A. Model I
In the first regression, the independent
variable, net-interest margin, was lagged one quarter
in order to test if derivatives were being used to
reduce interest rate risk exposure present in the
previous quarter. Overall this model performed
fairly well with all but two variables being
significant. (See Table 1) However, the coefficient
on the net interest margin variable has a negative
sign indicating that banks that use derivatives tend
to have lower interest rate risk in previous quarters.
This result may be due to the fact that the data in
this study are based on quarterly measurements of
derivative holdings. Since derivative positions are
adjusted more frequently then quarterly, quarterly
data might not truly reflect the effect of the previous
quarters’ net interest margin on derivative use.
Three of the five remaining independent
variables were significant in this first model. Bank
asset size was positive and significant at the .001
level indicating that larger banks tend to use
derivatives to a greater extent than smaller banks.
Banks that hold more capital relative to assets also
tend to be more frequent users of derivatives
according to this model. The capital to asset variable
was positive and significant at the .001 level also.
Because banks are required to hold a percentage of
capital based on the riskiness of their assets, this
result may indicate that banks with greater
tendencies towards risk are more likely to use
derivatives. However, since the variable used in
this study was the ratio of capital to total assets
unweighted for risk, it is difficult to distinguish
among those banks that are well capitalized and
those whose large capital holdings are a result of a
risky asset portfolio. But, well-capitalized low risk
banks would have a greater proportion of their asset
portfolio weighted at zero risk, therefore the ratio
of capital to total assets as measured in this study
would be lower for such banks. On the other hand,
banks with riskier assets would have a lower
proportion of their assets at zero risk, therefore their
capital to total asset ratios will be higher. And since
the results show a positive coefficient on the captial-
to-asset variable which indicates banks with a higher
capital to assets ratios tend to be more intensive users
of derivatives, the risky asset view of derivative use
seems to hold true. Future studies might consider
the ratio of capital to risk weighted assets which
would indicate if a bank was well capitalized or if a
bank’s capital was necessary because of its risky
assets.
The coefficient on the variable, non-current
loans relative to total loans, was positive and
significant at the .10 level. This result indicates
that banks with a relatively greater proportion of
credit risk would be more likely to use derivatives
to a greater extent. There are two possible
arguments supporting this result. First, it could be
assumed that banks with riskier tendencies in
lending activities may be more likely to take on risk
in other areas as well, including derivative dealings.
This result could perhaps suggest that banks use
derivatives to speculate because of the
management’s appetite for risky activities. On the
other hand, banks with relatively greater credit risk
may find it more difficult to raise capital in the
marketplace, thus making it more difficult to adjust
their balance sheets in the traditional way of
managing interest rate risk. Derivatives would seem
to be the likely solution for banks in this type of
situation because they do not require additional
capital and can be used to hedge interest rate risk
exposure.
The variables, return on assets and loan loss
Hundman Hundman Hundman Hundman Hundman
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90
reserves to loans, were not significant in this model.
B. Model II
The second model, removing the lag on net
interest margin and including all of the previously
explained variables, slightly improved the results.
(See Table 2) The adjusted R-square value for
model II increased to .32777 from .311157 in model
I. The signs on the variables remained the same
and their individual significance improved slightly.
Return on assets and loan loss reserves remained
insignificant.
The improvement in this model could be due
to the fact that banks can adjust derivatives on a
very frequent basis and the results of these
adjustments may be better represented by the net
interest margin in the current quarter rather than
the previous quarter.
VII. CONCLUSION
The major results of this project support the
notion that financial derivatives are used to hedge
interest rate risk. The results indicate that the lower
a bank’s exposure to interest rate risk, as measured
by net interest margin, the more likely the bank is
to use derivatives. The study also found that larger
banks tend to use derivatives to a greater extent than
smaller banks and that banks with a greater
proportion of credit risk are more likely to use
derivatives. It was also found that banks that utilize
derivatives typically have a higher capital to asset
ratio. This result might indicate that banks with
relatively more credit risk are more likely to use
derivatives. This study found no relationship
between bank profitability and derivative use.
In order to understand how these results
relate to those of previous studies they will be
compared with those covered in the literature review
section. The findings of the present study agree with
that of Brewer, Jackson, Moser and Saunders who
found a negative correlation between interest rate
risk and derivative usage for savings and loan
institutions. On the other hand, these results are at
odds with a previous study by Deshmukh,
c i t s i r e t c a r a h C e l b a i r a V t n e i c i f f e o C
) c i t s i t a t s - T (
d e t c e p x E
n g i S
e t a R t s e r e t n I
e r u s o p x E k s i R
n i g r a M t s e r e t n I t e N * * * 8 7 1 0 4 0 . 0 -
) 1 0 9 . 2 - (
-
n o i t a z i l a t i p a C s t e s s A o t l a t i p a C * * * 2 4 4 3 9 0 . 0
) 1 9 1 . 6 (
+
k s i R t i d e r C s n a o L o t e c n a w o l l A s s o L
s n a o L o t s n a o L t n e r r u C - n o N
9 0 2 3 3 0 . 0 -
) 9 4 2 . 1 - (
* 9 2 4 4 1 0 . 0
) 4 2 7 . 1 (
?
?
y t i l i b a t i f o r P s t e s s A n o n r u t e R 9 5 2 3 1 0 . 0
) 7 8 3 . 0 (
+
e z i S k n a B s t e s s A * * * 8 0 - e 4 4 . 3
) 1 9 1 . 6 (
+
*significant to the .10 level **significant to the .01 level ***significant to the .001 level
Table 2
Dependent Variable: Derivatives Relative to assets
Sample Size: 304
Adjusted R-Square: .32777
An Analysis of the Deter An Analysis of the Deter An Analysis of the Deter An Analysis of the Deter An Analysis of the Determinants of Derivative Use By Commer minants of Derivative Use By Commer minants of Derivative Use By Commer minants of Derivative Use By Commer minants of Derivative Use By Commercial Banks cial Banks cial Banks cial Banks cial Banks
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91
Greenbaum and Kanatas (1983) which found that
banks that use derivatives are more profitable than
banks that do not. The results of the present study
also contradict the results of Jason and Taylor (1994)
which indicated derivative trading is risky and may
expose firms to large losses. The results of this study
can also be compared to a study done by Simmons
(1995). She found no significant relationship
between interest rate risk exposure and derivative
use, yet her results concerning capital to assets
agreed with those of the present study.
Although the results of this study support
the major hypothesis that derivatives are used to
reduce banks’ exposure to interest rate risk, the field
of study remains fruitful for further research. First
of all, it would be interesting to trace the data farther
back in history when the use of derivatives first
began to accelerate. A greater number of
observations would give a better indication of profit
and risk variability over time which may show some
changes in the way derivatives have been used over
time. It would also be interesting to evaluate the
changes in banks use of derivatives as a result of
the new interest-rate risk based capital standards that
were enacted in January of this year. Furthermore,
the question of causation between derivative use and
risk exposure might be addressed in future research.
While this study explored the determinants of
derivative use by banks, it would be interesting to
test whether or not overall bank risk depends on the
use of derivatives. Finally, the data used in this study
did not separate the various types of derivatives,
further studies might utilize data on specific types
of derivatives to analyze the determinants of swap
use, an inherently riskier derivative, versus the less
risky use of futures and options.
Financial markets have responded to
increasing interest rate risk with new products that
allow banks to transform the duration of their
balance sheets without incurring additional capital
charges. While some argue that derivatives are too
risky to be used by commercial banks, the results of
this study support the argument that derivatives can
be used to effectively lower market risk exposure
for banks. As pointed out earlier, the question of
how banks use derivatives remains an interesting
topic for further research. Furthermore, it is of no
doubt that the soundness of the banking system is
an issue of primary concern to society. Thus
continued careful monitoring of banks’ derivative
activities by regulators is essential to ensure that
the increasingly popular instruments are utilized in
ways that contribute to the objective of a safe and
sound banking system.
References
Becketti, Sean. “Are Derivatives Too Risky for
Banks?” Federal Reserve Bank of
Kansas City, 3
rd
Quarter, pp. 27-42.
Brewer, Elijah; William Jackson, James Moser,
Anthony Saunders. “Alligators in the
Swamp.” Journal of Money, Credit and
Banking. Aug. 1996, pp.482-502.
Deshmukh, Sudhakar, Stuart Greenbaum,
George Kanatas. “Interest Rate
Uncertainty and the Financial
Intermediary’s Choice of Exposure.”
Journal of Finance 38 (Mar 1983), pp. 141-
47.
Fabozzi, Frank; Franco Modigliani; Micheal
Ferri. Foundations of Financial Markets
and Institutions. Prentice Hall: Upper
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Fisher, Ray. “Use Derivatives to Manage Rate
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Hanwek, Gerald and Bernard Shull. Interest Rate
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Jagannathan, Ravi. “The CAPM Debate.”
Federal Reserve Bank of Minneapolis,
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Jason, Georgette and Jeffrey Taylor.
“Derivatives Force First Closure of Money
Fund.” The Wall Street Journal, 28
Hundman Hundman Hundman Hundman Hundman
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September 1994, pp. C1.
Lopez, Jose. “Regulatory Evaluation of Value-At-
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1997.
Maher, Matt. “Bank Holding Company Risk from
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55.
Mitchell, Karlyn. “Interest Rate Risk at
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Satoris, William. “The Term Structure of Interest
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Simmons, Katerina. “Interest Rate Derivatives
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Stern, Gabriella and Steven Lipin. “Proctor and
Gamble to Take a Charge to Close Out Two
Interest Rate Swaps.” The Wall Street
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Stout, Lynn. “Insurance or Gambling? Derivatives
Trading in a World of Risk and
Uncertainty.” Brookings Review. Winter
1996 pp. 38-42.
Wright, James. “An Analysis of Commercial Bank
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Federal Reserve Bulletin. Feb. 1996,
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An Analysis of the Deter An Analysis of the Deter An Analysis of the Deter An Analysis of the Deter An Analysis of the Determinants of Derivative Use By Commer minants of Derivative Use By Commer minants of Derivative Use By Commer minants of Derivative Use By Commer minants of Derivative Use By Commercial Banks cial Banks cial Banks cial Banks cial Banks
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