The Economic Consequences of Banks’ Derivatives Use in Good Times and Bad Times (original) (raw)
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The Risks of Off-Balance Sheet Derivatives in U.S. Commercial Banks
SSRN Electronic Journal, 2009
This study employs both contingent and non-contingent claim models to test for the existence of market discipline hypothesis for derivative contracts in U.S. banking industry. In addition to the Capital Asset Pricing Model (CAPM) measure of systematic risk and standard deviation of a bank's equity return, we apply Ronn-Verma option pricing model to assess whether market participants incorporate derivatives positions when they price banks' market risk. The benefit of using the contingent claim model is that the traditional linear models seem to be inadequate in estimating the non-linear relation between derivatives and bank risks. In order to capture the differences in marginal propensity to risk (MPR) across banks, we divide our bank holding company (BHC) sample into three groups: big, medium, and small. The conclusions are as follows. First, among the derivatives contracts, swaps are the major contracts that are incorporated in market risk valuation. They are viewed as risk reducing tools according to the three risk measures (Beta, equity return risk, and implied asset volatilities) for both big and medium BHCs. Second, futures, forwards, and options do not seem to have a major effect in valuation of bank market risk for all the three BHCs groups. However, we find a significant positive relationship between these three types of derivatives and market systematic risk (Beta). Third, generally, market participants view swaps positions as more of potential risk diversification tools. Fourth, small BHCs have the highest MPR while big banks have the lowest MPR. Finally, more capital and regulations on bank derivatives activities are required to minimize the impact of derivatives on banks' market risk.
Evidence on the financial characteristics of banks that do and do not use derivatives
The Quarterly Review of Economics and Finance, 2000
While the use of derivatives by U.S. commercial banks has exploded in recent years, the growth has not been evenly distributed. At present, only about five percent of banks are involved in the market for derivatives. Although the concentration of derivatives activities in the largest banks is well known, we know less about other factors underlying a bank's decision to use derivatives. This article investigates the financial characteristics of banks that use derivatives and those that do not. We find that user banks, compared to nonusers, are associated with riskier capital structures (more notes and debentures and less equity capital), larger maturity mismatches between assets and liabilities, greater net loan charge-offs, and lower net interest margins. We also find that banks, especially smaller ones, benefit from being associated with bank-holding companies. Finally, our evidence does not support a regulatory hypothesis in which banks must have stronger capital positions to engage in derivative activities.
Derivatives and Interest Rate Risk Management by Commercial Banks
SSRN Electronic Journal, 2015
How do derivatives markets affect corporate decisions of financial intermediaries? I introduce interest rate swaps into the capital structure model of a bank. First, derivatives are a substitute to financial flexibility for risk management. Second, I show the existence of three distinct motives to engage in interest rate risk management. Together, they imply that both increases and decreases in the short rate can be optimally hedged. Third, the use of derivatives induces a "procyclical but asymmetric" lending policy. Derivatives users are better able to exploit transitory lending opportunities in good times, but do not cut lending proportionally more during either monetary contractions or real recessions. Finally, despite attractive insurance properties of derivative contracts, not all banks take derivative positions, as in the data. The model's predictions jointly match a number of yet unexplained stylized facts. New testable predictions are obtained.
The Use of Financial Derivatives and Risks of U.S. Bank Holding Companies
2014
This article examines the impact of financial derivatives on systematic risk of publicly listed U.S. bank holding companies (BHCs) from 1997 to 2012. We find that the use of financial derivatives is positively and significantly related to BHCs’ systematic risk exposures. Higher use of interest rate derivatives, exchange rate derivatives, and credit derivatives corresponds to greater systematic interest rate risk, exchange rate risk, and credit risk. The positive relationship between derivatives and risks persists for derivatives for trading as well as for derivatives for hedging. We also analyze the role of BHCs’ size and capital and the impact of the global financial crisis on the relationship between derivatives and risks.
Winners and losers from financial derivatives use: evidence from community banks
Applied Economics, 2018
This article provides empirical evidence on how profitability of small community banks was affected by derivatives use before and after the 2008 crisis. We use an endogenous switching regressions model to estimate the sensitivity of bank profitability to risks and control for the endogenous choice to use or not to use derivatives. We then compute counterfactual effects and show how profitability would have looked without derivatives use for banks that used derivatives and how it would have looked with derivatives for banks that did not use derivatives. The results show that derivatives helped reduce the sensitivity of profitability to credit risks and improved profitability for most specialists. However, for the largest number of banks which are non-user non-specialists, devivates use would have resulted in lower return on assets had they used derivatives post 2008. Therefore, our evidence suggests that implementation of the Volcker Rule, imposing high compliance costs on community banks and, thus, discouraging hedging, may have a negative impact on profits of specialists banks but, overall, a neutral effect on profits in the community banks industry as a whole.
This paper provides empirical evidence on how profitability of small community banks was affected by derivatives use before and after the 2008 crisis. We use an endogenous switching regressions model to estimate the sensitivity of bank profitability to risks and control for the endogenous choice to use or not to use derivatives. We then compute counterfactual effects and show how profitability would have looked without derivatives use in banks that used derivatives and how it would have looked with derivatives in banks that did not use derivatives. The results show that derivatives helped reduce the sensitivity of profitability to credit risks and improved profitability for most specialists banks but that the much larger group of non-user non-specialists would have had lower ROA had they used derivatives post 2008. Therefore, our evidence suggests that the implementation of the Volcker Rule, imposing high compliance costs for community banks and, thus, discouraging hedging, would be associated with negative impact on profits in specialists banks. Since the vast majority of community banks are non-specialists, the overall industry effect is likely neutral.
The Determinants of Derivatives Activities in U.S. Commercial Banks
SSRN Electronic Journal, 2009
This paper aims to test the extent to which the tax regulatory and market discipline hypotheses determine derivative activities of U.S. commercial banks for the period starting 1992 through 2008. We employ Mansfield's (1961) logistic diffusion model and we consider derivative activities as real financial innovation following a time trend diffusion curve. The model is modified to include regulator, non-regulatory/bankspecific factors and macroeconomic factors. The results reveal that derivative activities are real financial innovations that are increasing over time. Another major finding is that the regulatory tax hypothesis is not a major factor in determining derivative activities by U.S. commercial banks. The results also suggest that derivatives activities do not follow business cycle and economic conditions. However, derivatives are prevalently used where economies of scale is a viable outcome since they require highly specialized and qualified staff and are more likely available to large banks. The substitution effect is dominant between derivatives and loan ratio factor. Diminishing credibility of the bank will reduce derivatives activities. While derivatives are more likely to be an innovation, they are also determined by other factors such as technology and learning.
Financial Derivatives at Community Banks
2013
Recent financial regulation changes have brought many challenges to community banks. The Volcker Rule, section 619 of the Dodd-Frank Financial Reform Act of 2010, prohibits banks from engaging in proprietary trading in derivatives. Banning proprietary trading will deter smaller banks, especially community banks, from the permissible risk management derivative activities. This paper provides empirical evidence on how profitability at community banks was affected by derivatives before and after the 2008 crisis and estimates the potential effects of the Volcker Rule on profitability of these small banks if they had to operate under such rule. Contrary to the premises of the Volker Rule, we find derivatives helped reduce the sensitivity of profitability to credit risks and improve the profitability at community banks.
The reaction of bank stock prices to news of derivatives losses by corporate clients
Journal of Banking and Finance, 1999
From March through May of 1994, several large non®nancial ®rms announced millions of dollars in losses from derivatives deals, especially those arranged by Bankers Trust. Accompanying these announcements and related news stories were allegations that Bankers Trust had either misrepresented, lied, or deceived its clients. Using SUR methods, we investigate how these announcements aected Bankers Trust and three portfolios of banks: dealers, nondealers, and nonusers. Our results indicate signi®cant cumulative abnormal returns of À12.14% (Bankers Trust), À5.56% (13 dealer banks), and À2.45% (32 nondealer, user banks). The evidence suggests an intra-industry, information-transfer eect consistent with rational pricing. The replacement cost of derivative contracts is an important factor in explaining the variation in abnormal returns across banks.