Interest rate derivatives and asset-liability management by commercial banks

New England Economic Review, Jan-Feb, 1995 by Katerina Simons

Alternatively, the liability-sensitive bank can buy a cap on LIBOR, so that if LIBOR rises above a certain predetermined level, the seller will pay the bank the difference between LIBOR and that level. A similar approach is a "costless" collar on LIBOR, where the bank buys a LIBOR cap from the dealer and at the same time sells a LIBOR floor to the dealer, with the premium on the bought cap exactly offsetting the premium on the sold floor. In this way, the bank reduces the cost of buying protection from a rise in LIBOR by giving up a potential benefit to its earnings from a fall in LIBOR.

Derivatives can also be used to create synthetic loan and deposit products. For example, a bank can transform a floating-rate loan into a fixed-rate loan by coupling new floating-rate financing with a plain-vanilla swap where the bank pays a floating rate in return for receiving a fixed rate.

The advantage of derivatives over more traditional methods of asset-liability management, such as adjusting one's securities portfolio, is that derivatives can transform the duration of the balance sheet while neither increasing it nor incurring significant additional capital requirement.(1)

As a result of these advantages, the use of interest rate derivatives by banks has exploded in recent years. Table 1 illustrates the growth of interest rate contracts at commercial banks with more than $100 million in assets. The table shows that futures and forwards grew from $98 billion in 1985 to almost $2.5 trillion, a growth rate of nearly 2,500 percent. Interest rate swaps grew from $186 billion of notional principal in 1985 to almost $3 trillion in 1993, a growth rate of almost 1,500 percent. Options contracts (including caps, floors, and collars, described above), first reported on Call Reports in 1990, have since more than doubled in notional principal from $697 billion to $1.77 trillion in 1993.

Table 1
Interest Rate Contracts at Large Commercial Banks(a)

The vector of independent variables, X, consists of the following variables: the logarithm of assets, the ratio of equity to assets, the ratio of nonperforming assets to assets, the ratio of loan-loss reserves (LLR) to nonperforming loans,(4) the ratio of loan-loss reserves to loans and leases, and four "gap" variables measured as the difference between bank assets and liabilities maturing or repricing in a given time interval (0 to three months, three to 12 months, one to five years, and over five years). Following Kim and Koppenhaver (1993), the gap is expressed as the absolute value between assets and liabilities repricing within a given interval, divided by total assets.

The presence of the equity-to-asset ratio and the standard measures of asset quality such as the ratios of nonperforming assets to assets, loan-loss reserves to nonperforming loans, and loan-loss reserves to total loans and leases, are meant to capture the regulatory environment. An important reason why managing interest rate risk through derivatives may be preferable to on-balance-sheet management is that off-balance-sheet contracts entail lower capital requirements. Thus, banks with lower capital ratios may be expected to be bigger users of derivatives, other things being equal. Similarly, banks with relatively poor asset quality (as measured by high levels of nonperforming assets relative to total assets or low levels of loan loss reserves relative to nonperforming loans) will need to conserve capital and might find derivatives to be a more desirable, capital-efficient way to manage the balance sheet. On the other hand, the use of derivatives may be perceived by regulators as risky, and poorly capitalized banks and banks with weak asset quality or low loan-loss reserves would be subject to more scrutiny or restrictions by regulators when they attempt to use derivatives, thus discouraging the use of derivatives by such banks.