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File Name : Banks and Derivative Market


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Running Head: A Real Crisis
Banks and the Derivative Market
[Your Name]
[Your Class]
[Your University]
[Professor Name]
Opioid Pandemic
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.
The first part of the work 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. The
second part will describe previous research that has been done on derivative use in the financial
services industry. And the results and future implications of the study will be presented in last
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Banks and the Derivative Market
Part I: Introduction
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 offbalance-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.
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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 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)
Part II: Literature Review
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 for 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)
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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 mortgagebacked 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
The risk-based capital requirements discussed above are based solely on credit rislc;
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
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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 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 US bank regulatory agencies have adopted this
amendment and began enforcing it inl998. 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
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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 estimates1 generated by banks’
own internal, risk measurement models using the standardizing regulatory parameters of a 10day (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 needed a way to manage interest rate risk without additional capital on their balance
sheet. Financial derivatives seemed to be the solution.
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, if interest rate risk can be
controlled by derivatives then perhaps banks that use derivatives 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
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compared to those banks that do not use derivatives to control for interest rate uncertainty.
(Brewer 482)
Brewer, Jackson, Moser and Saunders found 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 Stem 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.
Part III: Methodology
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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 in Figure 1. 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.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 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 noncurrent 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.
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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 measures 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 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
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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.
Part IV: Results
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. 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 factthat 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
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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 torisk 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 reserves to loans, were not significant in this model.
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Part V: Discussion
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, 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
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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
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Part VI: Conclusion
In the last ten to fifteen years financial derivative securities have become an important,
and controversial, product for commercial banks. The controversy concerns whether the size,
complexity, and risks associated with these securities; the difficulties with accurately reporting
timely information concerning the value of firms’ derivative positions; and the concentration of
activity in a small number of firms has substantially increased the risk of collapse of the world
banking system. Despite the widespread attention to derivatives, there has been little systematic
analysis. We estimate market values and interest-rate sensitivities of interest-rate swap positions
of U.S. commercial banks to empirically address the question of whether swap contracts have
increased or decreased systemic risk in the U.S. banking system. We find that the banking
system as a whole faces little net interest-rate risk from swap portfolios.
Banks play double roles in derivatives markets. Banks are intermediaries in the OTC
(over the counter) market, matching sellers and buyers, and earning commission fees. However,
banks also participate directly in derivatives markets as buyers or sellers; they are end-users of
derivatives.An important difference between banks and non-financial firms is that banks have to
abide by capital regulations. Banks cannot lend all their capital; they are required to hold a
proportion of the bank’s total capital (eg, 8%) to sustain operational losses and to honour
withdrawals. What is the significance of this? On the one hand, banks are motivated to operate in
the derivatives market to compensate for the regulatory capital. On the other hand, losses on
derivatives may cause a bank not to have sufficient regulatory capital, which means the bank is
not well prepared to deal with shocks in the financial system. This happened in the 2007–08
global financial crisis.

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