Interest rate derivatives and asset-liability management by commercial banks

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

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To summarize, while these results do not explain much of the variation in bank derivative use, particularly for small banks, certain patterns emerge. First, the study found a positive relationship between bank size and the use of swaps for the small-bank subsample. Second, well-capitalized banks appear to use swaps more intensively, but not futures. This is not surprising given that creditworthiness of swap counterparties is an important consideration for market participants, while it is not a concern for futures, where the exchange stands behind the transactions. Third, large banks with weaker asset quality are bigger users of swaps and futures than banks with stronger asset quality, possibly because they are more capital-constrained or have more taste for risk. Fourth, derivative use had no consistent relationship to the bank's gap profile. While hedging is consistent with a positive relationship, even if such a relationship were found, it could not be considered to be explicit evidence of hedging. The available data are not, in fact, sufficient to determine if a bank uses derivatives to reduce the interest rate risk inherent in its balance sheet position, or to increase it.

V. Conclusion

This study has used the quarterly Call Report data to shed some light on the pattern of derivative use by U.S. commercial banks. The study has found that [TABULAR DATA FOR TABLE 6 OMITTED] for banks with less than $5 billion in assets, larger banks tend to use interest rate swaps more intensively, while there was no clear relationship between size and other interest rate derivatives. In addition, the study has found that for banks with more than $5 billion in assets, those with weaker asset quality tend to be more intensive users of derivatives than banks with better asset quality. These results, while intriguing, do not give a clear indication of how derivatives are used to manage interest rate risk, particularly whether they are used to increase or reduce that risk. Given that banks and the federal regulatory agencies spend time and effort to collect and process financial data through the Call Report system, it is disappointing that Call Report data are not more revealing. Call Reports are changed periodically to make the information in them more relevant, and a few modifications to the way derivative activities currently are reported would allow a clearer assessment of bank derivative activities and their risk.

First, Call Reports should distinguish the short and the long positions in futures and forwards, call and put options written and bought, and fixed versus floating sides in interest rate swaps. In addition, swaps and forward contracts should be broken down into the same maturity brackets currently used for loans and securities. This would allow one to adjust gap analysis for derivatives and gain a clearer picture of the relationship between interest rate risk and derivative use.

Rather than providing a definitive measure of risk, the purpose of the Call Report is to give analysts and supervisors a screening mechanism that might point to the need to gather more detailed information. Expanding the reporting of off-balance-sheet derivatives mentioned above would go further in making the risk of derivative activities more transparent and highlighting potential problems requiring the supervisors' attention. It is important to emphasize, however, that the Call Report is not a substitute for a bank examination, and gap analysis is not a meaningful measure of interest rate risk in any but the simplest of cases. Large banks active in derivative trading have developed more sophisticated models to gauge the risk exposure arising from their trading activities. Even smaller banks' balance sheets are usually too complex to be amenable to a simple gap analysis. This is because even banks that do not use the derivative contracts discussed here, namely swaps, futures, and options, have assets on their balance sheets that have imbedded derivative characteristics. In particular, certain mortgage securities and "structured notes," that is, debt securities whose cash flow characteristics depend on one or more indices and/or that have embedded forwards or options, have risks not reflected in their maturities and have proved especially volatile in the current interest rate environment.