Research Problem

Research Problem

Over the past two decades, financial markets across numerous countries have undergone significant transformations and development. Within the United States, banks’ conventional business has significantly declined, and the primary activities of the current commercial banks have turned to the fee-producing company as well as charge fees as the main source of the organizations’ profit.  The bond and stock market have dramatically grown in size.  Financial innovations have stimulated the development of financial instruments markets. There has been an introduction of new financial products like derivative instruments and mortgage-backed securities. There also seems to be some changes when it comes to financial options, futures as well as other derivative securities. The growth in utilization of financial derivatives by the conventional banks has been subject to various academic discussions.

Some of the questions being asked regarding derivatives include: Does the utilization of derivatives have an effect on the banks’ exposure to risks? Why do commercial banks utilize derivatives? In previous literature, the studies failed when it came to controlling for current risks in use of derivatives.  These studies also failed to take account of various macro-economic factors and did not control for risk and size capital. Since there has been a significant increase in use of derivatives in the financial sector since the mid-1990s, most of the previous studies directly linking risk exposure to use of bank derivatives only looked into sample periods, which came to an end in early 2005. On top of that, none of the previous research took into consideration the effects of level of derivatives that are held for trading in relation to total usage of derivatives. These studies also failed to examine the purpose and existing link between bank attributes and other propensities for these derivatives.

The study will focus on investigations to gain some insights into the use of various derivatives by financial organizations. It will employ a research design, statistical, and data tests which correct for any limitations as follows: the effect of bank derivatives usage on overall bank risk will be examined through the simultaneous inclusion of interest rate risk, credit risk, as well as liquidity risk. On top of that, improvements of the following in research sampling and design are expected: (a) improved mode of sampling to overcoming definition changes will be used; (b) recent and highly representative data will be implemented; (c) differentiation between use of derivatives for the purposes of trading versus other than trading activities;  (d) examination of the motivations of derivatives use for basic risk exposure control;  (d) taking into account the macro-economic conditions as well as the impacts of the level of derivatives held for trading in relation to total usage of derivatives.

Hypothesis

H₁: The sensitivity of a financial organization’s stock return to interest rate, market, exchange rate, as well as basis exposures, is similar for most organizations irrespective of the companies’ size.

H_2: There is no difference in the utilization of derivatives by financial organizations due to the influence of the various related macroeconomic factor.

Based on information on derivatives that are retrieved from quarterly bank holding company performance information from the Federal Deposit Insurance Corporation or FDIC, the use of financial derivatives by bank holding organizations serves two essential purposes. The first one of these purposes is trading, an activity that would increase the bank holding companies’ profits while increasing exposures. Other than trading, making use of the financial derivatives to hedge risks that is exposed to the bank holding companies.

Literature Review

In previous studies, most of the research assessed the Bank Holding Companies’ risk and found the utilization of derivatives has had the effect of shifting the risks faced by banking institutions.  Several of these studies found the increased use of derivatives by the banks often leads to an increase of such risks.  For example, Rosen and Gorton (1995) studies interest rate swaps, and their empirical results showed that the position of banking systems had a strong significance to changes in interest rates. The study points out that whenever the bank institutions make use of derivatives, they will end up facing two main issues. The first issue is that it is difficult for the banks to know-how subject to the interest rate as well as other banks the entire organization would be. The other issue is that the bank’s bankruptcy had external effects as well. The collapse of big banks could lead to a severe breakdown of the entire banking system, not to mention the economy’s eventual collapse.

Gorton and Rosen (1995) restrict attention on the bank’s organizations whose assets were much greater than five hundred million dollars since the smaller banking institution generally do not utilize swaps and have insignificant activities on the derivatives’ market. By exploring the reasons as to why a few big banks account for a big proportion of the derivatives market. The study concluded that one of the reasons is the issue of the interest rate risk faced by large banking institutions.  The study indicates that banks in particular are exposed to significant interest rate risks. Still, the banking system can hedge most of the risk, and the banking institutions pay very little concern about the swaps’ systemic risk. Geczy, Schrand, and Minton (1997) uses the currency derivatives information of American banking organizations and examines the utilization of these derivatives as a means of finding the differences within the existing theories that touch on hedging behavior. They front the argument that incentives directed at banking institutions to hedge are critical but not enough conditions for the bank holding companies to utilize derivatives instruments. The bank holding companies are also required to take into consideration the risk level that they face are faced with, the overall cost of hedging and managing risk as well as capital market regulation.  The study explores the determinants of corporate utilization of currency derivatives drawn from various perspectives, and the resultant empirical results showed organizations that have more growth chances. Still, low accessibility to finances often turn their attention to using currency derivatives.

Choi and Elyasiani (1997) initially explain the differences that exist between the derivatives activities and conventional off balance sheets activities. They thereafter study the two issues that are a public concern. Concentrating on the foreign exchange exposure and interest rates exposure, the research explored the impact of off-balance sheets as well as on-balance sheets exposure through employing monthly information. As the initial formal estimate of the joint impact of derivatives’ exposure on exchange and interest rates, the empirical result highlights the fact that exchange rates risk is much more significant than the interest rate risk. The conventional financial statement variable as well as derivative variables have significant importance on what determines bank-specific exchange rate exposure and interest rates. Utilization of derivative contracts have ended up creating yet another notable systemic risk that is beyond the issue of financial statement exposure. The study got to the conclusion that exchange rate exposure risks are notably more than interest rate risks exposure with the bigger banks having much higher exposure risk than the smaller ones.

Hirtle (1997) explores the role that was being played by interest rates derivatives on the returns on stock on banking organization from a different point. By using the bank holding companies’ financial information, the analysis’ result showed the use of derivatives has played a notable role in the interest rates exposure management of the bank holding company. From the empirical research, the sample’s bank holding organizations have higher interest rates risks that are consistent with the heightened utilization of derivatives. The relationship is much stronger for the banking organizations which use derivatives compared to the smaller end user ones.

In order to come up with the relationship that exists between market-based risk measures and the U.S. commercial banks’ use of foreign currency, Chaudhry, et. al. (2000) explores the utilization of four distinct kinds of currency claims by the bank holding companies and explores the market’s perception of the bank’s risk concerning different degrees of use. Banking institutions use derivatives for different reasons. Some of them use them as the end-users in a bid to hedge the risks while the others are dealers who provide risk management services to their clients. The empirical result end up getting different conclusions for four kinds of foreign currency derivatives.  Mostly speaking, the utilization of options tends to heighten all types of bank risks.

Research Design

The multifactor design has been used by numerous papers and offers a significant and useful approach when measuring the relationship between the utilization of derivatives and the risks involved. For this paper, a two-stage four-factor design or model will be conceptualized to enable the researchers analyze how the capital market reacts to the activities within the derivatives market. In the first stage, interest rate, market return, liquid betas as well as exchange rates are regressed with the help of quarterly stock returns over the separate quarterly periods. When it comes to the second stage, the cross-sectional regressions will get estimated so as to determine how the Bank Holding company derivative activity affects the four separate measures of capital risk.

When it comes to the second step, the foreign exchange rate, interest rate as well as basis risk betas that were generated during the first stage will get regressed against bank-specific on as well as off-balance sheet exposure variables. In order to make adjustments for likely biases owing to cross-equation dependencies, the equation when it comes to every single Bank Holding Company gets estimated as a simultaneous equation system with the help of a modified seemingly unrelated technique or SUR. The modified SUR technique is a variation of the standard SUR method and generates asymptotically efficient estimates without trying to impose either conditional homoscedasticity or serial independence restrictions on the disturbances term.

Measurement Issues

The variables and data that will be obtained from the schedule RC-L of the quarterly call reports is supported by other sources like the FR Y-9C. The American commercial banks are always required to separately report the use of derivatives. As previously discussed, banks make use of derivatives as trader, end-user, or even both. As traders, the role of derivative contacts is used for trading as well as making profits from the transactions. When banks used them as end-users, the derivatives are employed when the banks are hedging risks. Banks report their derivative activities in the case of trading as contracts held for trading purposes. The derivatives contract that is used for the purposes of hedging purposes is reported as being a contract held for non-trading purpose.  Considering the characteristics of the activities of the commercial banks, the variables get constructed using interest rate exposure and exchange rate exposure.

Net interest-sensitive assets repricing in less than twelve months will affect the level of interest rate exposure. The specific impact will be dependent on the funding gap and repricing as well as whether the rate-sensitive assets are more or even less likely than the rate-sensitive liabilities. During the period when interest rates were increasing, the variable would be positively related to the banks’ interest rate exposure. Industrial and commercial loans are critical measures of lending activities and consequently have a direct effect on interest rate exposure and interest sensitivities. It was expected that such a variable will be similarly positively related to interest rate exposure. CIL refers to the commercial and industrial loans that are expressed as a fraction of the bank holding corporation’s total asset. When it comes to exchange rate exposure, assets in foreign offices, or FOA highlight whether the bank holding corporation is susceptible to movements in exchange rates. Deposits that are denominated in foreign currencies will end up having a negative relationship to the exchange rate exposure since an increase in the value of the U.S. dollar ends up reducing the exposure to exchange rate risks.

Scientific Contribution

Previously studied theories on banking and risk management have primarily concentrated on the traditional role of the banking industry and similarly traditional risk management methods. However, both the role played by banking and the tools that are available to be used for managing risks have substantially changed over the past decade with a significant part of this change taking place in just the past few years. The shift from conventional time tested banking to the much newer and untested one has been studied in both regulatory and academic publications.

Initial measurements and the subsequent controls of the various exposures that are facing financial firms are crucial for bank customers, regulators as well as the wider public. They are also crucial for the banks themselves since exposures do have the likelihood to negatively affect a banking institution through converting mere exposures to actual high levels of risk. Such exposures may be disadvantageous or even advantageous for a particular bank depending on the various factors which are unique to each one of the banks and to the specific time. Adverse levels of exposure usually arise whenever the Bank Holding Company’s financial success could be adversely affected by changed within the underlying factors like exchange rates, interest rates, the quality of the bank loans as well as the liquidity position of the bank.

References

Chaudhry, M., Christie‐David, R., Koch, T., & Reichert, A. (2000). The risk of foreign currency

contingent claims at US commercial banks. Journal of Banking & Finance, 24(9), 1399

1417.

Choi, J., & Elyasiani, E. (1997). Derivative exposure and the interest rate and exchange rate risks

of US banks. Journal of Financial Services Research, 12(2), 267‐286.

Géczy, C., Minton, B., & Schrand, C. (1997). Why firms use currency derivatives. Journal of

            Finance, 52(4), 1323‐1354.

Gorton, G., & Rosen, R. (1995). Banks and derivatives. NBER Macroeconomics Annual, 10,

299‐339.

Hirtle, B. (1997). Derivatives, portfolio composition, and bank holding company interest rate

risk exposure. Journal of Financial Services Research, 12(2), 243‐266.