Summary: The relationship between risk and derivatives is especially important in banking since banks dominate most derivatives markets and, within banking, derivative holdings are concentrated at a few large banks. If large banks are using derivatives to increase risk, then recent losses on derivatives, such as those of Procter and Gamble and Orange County, may seem small in comparison to the losses by banks. If, in addition, the major banks are all taking similar gambles, then the banking system is vulnerable. This paper is the first to estimate the market value and interest rate sensitivity of bank derivative positions. The authors focus on interest rate swaps in the analysis, because interest rate risk is non-diversifiable and because banks naturally are repositories of interest rate risk.
Difficulty in monitoring risk is especially important when the party entering into a derivative transaction is an agent managing money for outside principals. Since derivatives are opaque, a realized loss by one organization may be viewed as information about the portfolio positions of other organizations. The problems from derivative transactions thus come from information problems. This points out the need for changes in the accounting rules or investment regulations.
When banks use derivatives, the problems are more severe. First, even knowing more about the derivatives position of a bank may not allow outside stakeholders to determine the overall riskiness of the bank. Banks invest in many non-derivative instruments that are illiquid and opaque. Thus, even if the value of their derivative positions were known, it would be hard to know how subject to interest rate and other risks the entire bank would be. This makes them different from most other organizations that invest in derivatives.
Second, bank failures can have external effects. The failure of several large banks can lead to the breakdown of the payments system and the collapse of credit markets for firms. It is clear that if banks have similar positions, the failure of one bank is likely to mean the failure of many. Because derivatives are opaque, even if banks have different positions, outside principals may not be able to determine whether the failure of one bank signals trouble at other banks.
The authors first estimate interest rate sensitivity using the Call Reports of Income and Condition published by the FDIC. Since the data are insufficient to calculate interest rate sensitivity, or even market value of the derivative position, interest rate, they make simple assumptions that allow them to go from the data available to estimates of market value and interest rate sensitivity.
The authors estimates of interest rate sensitivity show that the banking system has a large net swap position. An increase in interest rates reduces the value of bank swap positions. This sensitivity is due to the positions of large banks. Small banks tend to have only minor exposure to interest rates in their swap positions. While these estimates show that large banks have highly interest rate sensitive swap positions, this does not mean that the banks equity positions are interest rate sensitive to the same extent. The banks may use swaps to hedge on-balance sheet interest rate risk or they could use other derivatives markets, such as the futures market, to hedge their swap exposure. The authors found that large banks have mostly hedged swap interest rate risk.
The authors suggest that these conclusions may be premature because banks can quickly alter their positions in ways that are hard to monitor. Swaps are opaque so such changes may not be evident to regulators and market participants until it is too late.