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FRBSF WEEKLY lETTEA Number 95-17, April 28, 1995 Western Banks and Derivatives Financial derivatives have made the headlines in the past year or so, as some companies and local government authorities have suffered spectacular losses related to them. With the headlines has come increasing concern about the riskiness of these instruments. However, investors' successes in using derivatives to hedge against risk have received less attention. To provide some balance to the picture, this Weekly Letter presents an example of how one type of derivative, an interest rate swap, can be used to reduce risk. The Letter also profiles the use of interest rate swaps by Twelfth District and banks, pointing out how some aspects of this profile can be consistent with a general strategy of using swaps to reduce overall bank risk or to pursue banks' roles as financial intermediaries. u.s, Swaps and risk Derivatives are financial contracts whose payment terms are derived from the performance of some underlying asset or assets. The payment terms of one type of derivative contract, the simplest type of interest rate swap, depend on the level of an interest rate that remains fixed over the life of the contract and the level of a short-term rate that varies with the market. A bank can use swaps to hedgeagainstinterest rate risk. For example, say a bank has a loan paying a fixed rate of interest and deposits on which it pays a variable rate of interest. The bank faces interest rate risk in that its net return will fall when interestrates rise because it will pay more for deposits but will not receive more on its loan. If the bank wants to reduce this risk, it can engage in an interest rate swap. In particular, the bank can arrange to paya counterparty (such as another bank) at regular intervals a given "notional principal" times a fixed interest rate equal to the interest rate on the loan. (The notional principal simply is a base for calculating the pay- WESTERn BAnKinG ments and is not itself exchanged.) In exchange, the bank.can receive from the counterparty the same notional principal times an interest rate that varies in the same way as the interest rate on the bank's deposits. With the swap, the bank's fixed rate payments can better match its fixed rate receipts, and its variable rate payments can better match its variable rate receipts. Of course, swaps; aswell as other derivatives, can be used to enhance yield instead of to reduce risk. Usually, when a swap is originated, the reciprocal interest payments more or less offset each Other, in present value terms. Therefore, if a bank thinks that interest rates will fall more than the market as a whole predicts, it can enter an interest rate swap agreement in which it makes the variable interest payments. Then, if interest rates fall enough, and the bank does not have other investments offsetti ng the swap payments and receipts in its portfolio, it will make a profit. Some of the very largest banks also serve as dealers in swaps by taking the opposite sides of swaps agreements for fees, often for their own business customers. The risk exposure to the dealer bank depends in part on whether it has taken offsetting sides of swaps agreements and in part on the risk of counterparty default. Characteristics of swaps users The notional value of interest rate swaps at all U.s. banks totaled about $4.4 trillion at the end of 1994. Banks in the Twelfth District accounted for 8.7 percent of the total notional amount, less than their 13.7 percent share of banking assets. The most striking feature of the swaps profile of banks is the dominance of the very largest banks. As Figure 1 shows, the percent of banks reporting interest rate swaps increases dramaticallywith Western Banking is a quarterly review of banking developments in the Twelfth Federal Reserve District. It is published in the Weekly Letter on the fourth Friday of January, April, July, and October. FABSF Figure 1 Percentage of District Banks with Interest Rate Swaps in 94.Q4 The larger the maturity gap, the greater the sensitivity of the bank's net income to movements in interest rates. Ifbanks are using swaps to hedge this interest rate risk, then banks with larger gaps may have larger swaps positions. Kim and Koppenhaver find that, after controlling for various other factors that affect swaps usage, banks with larger maturity gaps have larger notional amounts of interest rate swaps. Percent i 00 80 60 40 20 o +-----i-<$.5 $.5-$1 $1-$10 >$10 Bank Size (billions of dollars in assets) bank size. In fact, only 8.1 percent of District banks report swaps. Moreover, banks with assets of over $10 billion account forover95 percent of the notional value of swaps in the District, compared with less than 1 percent at banks with less than $500 million in assets. Some of this difference likely is due to the largest banks acting as swaps dealers. However, the contrast also suggests that there may be fixed costs associated with swaps activity, such as the cost of trained staff to manage swaps and other derivatives instruments. Pinning down how the banks with swaps are using them is more problematic. Kim and Koppenhaver(1993) look at the relationship between one indicator of interest rate risk, the maturitY gap, and the use of swaps by all U.S. banks. The maturity gap is the absolute value of the difference between a bank's assets that will mature or be repriced within a certain time period and its liabilities that will mature or be repriced within the same time period, with this difference diyided bytotal assets. (Th~calc~latio9 ofthe maturity gap excludes swaps and other derivatives.) These authors also investigate the importance of some characteristics that may be linked with banks' role as dealers in interest rate swaps. They find that banks with higher ratios of business loans to assets have higher notional amounts of interest rate swaps, indicating the possibility that banks that are especially active in business lending are more apt to act as intermediaries for their business customers' swaps transactions. In addition, they find that banks with positions in interest rate futures have higher notional amounts of interest rate swaps than those without such instruments. Interest rate futures also can be used to hedge against interest rate risk, and it is possible that banks that tend to take on interest rate risk by acting as swaps dealers tend to use futures to hedge that risk. Conclusion Interest rate swaps activity among District banks is dominated by the very largest institutions, and most District banks do not have swaps. Evidence on the national level suggests that banks with swaps tend to have larger maturity gaps than banks without swaps. This association and the positive correlation between interest rate futures and swaps activity may be consistent with using swaps .as part of a general strategy of hedging interest rate risk. Moreover, the positive correlation between business lending and swaps activity suggests that swaps activity at banks in part is an extension of the traditional intermediation services provided by banks. Elizabeth S. laderman Economist Reference Kim, Sung-Hwa, and G. D. Koppenhaver. 1993. "An Empirical Analysis of Bank Interest Rate Swaps," JOllfnal of Financial Services Research 7 Uanuary) pp.57--72. REGIONAL BANK DATA DECEMBER 31.1994 (NOT SEASONALLY ADJUSTED. PRELIMINARY DATA) DISTRICT ALASKA ARIZ. CALIF. HAWAII IDAHO NEVADA OREGON UTAH WASH. FOREIGN DOMESTIC LOANS TOTAL FOREIGN DOMESTIC REAL ESTATE COMMERCIAL CONSUMER AGRICULTURAL OTHER LOANS INV. SECURITIES TOTAL U.S. TREASURIES U.S, AGENCIES, TOTAL U.S. AGENCIES, MBS OTHER MBS OTHER SECURITIES 368.529 3.1,614 3'36,915 172,106 65.339 65,303 6,581 27,586 2,759 6 2.754 1,299 779 509 3 164 29,173 0 29.173 9,582 3.149 12.572 412 3,457 Z29,988 30,074 199,914 118,111 39,383 20,277 3,441 18,702 '14,913 1,477 13,435 8,113 3.419 , ,1,141 33 730 8,858 0 8.858 Z.930 1.781 2,781 913 454 16.353 0 16.353 3.154 929 11,906 14 350 20.883 17 20,866 8,569 5.410 4.458 489 1.939 10,823 0 10,823 4.695 1.899 3,527 176 527 34.780 40 34,740 15.652 8.592 8.132 1,101 1,264 81.116 23,024 22,809 15,130 4,027 31,255 2,060 1,044 459 363 137 421 8,547 1,783 2,619 2,229 252 3,893 49.011 14.042 13.601 9,016 3,258 18,110 4,651 1.918 1.390 878 17 1,326 1,746 462 543 236 38 704 3,840 1.141 928 S54 62 1,709 3.529 934 1,013 7S0 14 1.568 3,537 627 1.445 710 80 1,386 4,194 1,073 813 394 168 2,140 11.297 11,297 20,862 20,862 26.354 26.340 15,608 15,608 40,800 40,757 LIABILITIES TOTAL DOMESTIC 496,625 452.961 4,635 4.634 39.356 39.356 317,166 275,851 20,547 18,255 DEPOSITS TOTAL FOREIGN DOMESTIC IilEMAND NOW MMDA & SAVINGS SMALL TIME LARGE TIME OTHER DEPOSITS 410,809 42,770 368,039 100.196 42,609 132.562 64.260 28.005 406 4,044 0 4.044 1,179 392 1,395 517 495 66 30.894 0 30.894 7.036 3,763 11.194 7.446 1,455 0 275,039 40,249 234,790 67,942 24.728 86.059 36.705 19.098 258 13,972 2,221 11,751 2,415 1,397 4,365 1,974 1,595 5 8;878 0 8,878' 1,869 ;,102 2,580 2,392 934 0 9.952 0 9.952 3,175 1,518 3.722 972 564 0 21.346 1 21,345 5,151 3,351 7,097 4,970 764 13 11,956 139 11.817 2,543 1.637 3,970 2.517 '1.145 4 34,729 161 34,568 8,885 4,721 12,180 6,768 1,954 61 OTHER BORROWINGS EQUITY CAPITAL LOAN LOSS RESERVE LOAN COMMITMENTS 30,53B 45,660 9.518 258.174 520 681 42 807 1.164 3.586 627 51.887 13,983 28.011 6.845 118,925 3.295 1,844 251 7,969 1,789 926 122 3,936 534 2,494 385 25,199 2,933 2,539 388 16,169 2.224 1.534 226 13,941 4,115 4,045 633 19,340 TIERl CAPITAL RATIO TOTAL CAPITAL RATIO LEVERAGE RATIO 0.094 0.122 0.078 0.188 0.199 0.126 0.100 0.121 0.080 0.090 0.121 0.074 0.103 0.121 0.080 0.095 0.113 0.077 0.117 0.137 0.106 0.095 0.112 0.084 0.120 0.135 0.086 0.089 0.112 0.082 9.579 783 99 6 756 62 5.889 508 398 13 221 17 519 f8 521 56 339 25 837 79 9,591 3,392 2,362 446 3,390 88 35 26 1 26 923 260 172 176 315 5,816 2.069 1.575 226 1.945 402 167 84 18 134 203 96 34 8 65 492 160 63 ·9 278 471 179 139 -39 192 368 137 72 20 140 828 290 198 45 295 TAXES NET INCOME 952 1,797 9 20 10 34 546 1,042 27 39 20 38 160 294 BO 136 29 49 72 146 ROA (% ANNUALIZED) ROE (% ANNUALIZED! NET INTEREST MARGIN (% ANNUALIZED) 1.36 15.75 4.68 1.45 11.52 4.78 0.34 3.78 5.03 1.23 14.88 4.50 0.71 8.45 4.20 1.27 16.22 4.23 5.52 47.12 6.76 1.94 21.49 4.88 1.12 12.73 4.64 1.32 14.46 4.94 0.51 0.38 0.13 2.32 0.54 0.18 -0.01 0.11 0.76 0.00 0.57 -0.09 0.06 1.28 0.05 0.50 0.52 0.19 4.25 0.40 0.34 0.24 0.53 0.81 -0.01 0.22 .0.05 -0.06 0.58 0.75 1.85 -0.35 -0.89 2.58 -0.07 0.24 0.29 -0.37 1.02 -0.16 0.24 0.00 0.04 0.82 -0.02 0.29 0.04 0.02 0.90 1.47 2.67 3.76 11.82 4.71 4.29 1.30 2.36 10.52 1.85 2.43 2.35 2.31 2.13 8.46 2.27 0.00 0.74 1.47 1.16 2.49 2.10 0.00 1.85 1.95 2.58 4.81 8.97 0.80 U9 0.66 1.01 2.43 1.51 3.09 4.62 18.74 5.96 4.12 1.37 2.75 14.93 1.96 2.28 1.58 2.38 2.30 2.36 2.28 6.37 1.56 2.78 1.37 2.94 2.72 24.72 1.61 1.29 1.24 U7 5.87 0.40 1.53 0.00 1.78 1.67 2.79 3.54 2.52 0.74 4.09 0.00 1.58 1.41 0.04 2.07 3.93 2.39 1.40 1.60 3.52 2.59 3.86 0.39 0.95 0.48 1.37 1.28 1.39 1.56 1.21 1.32 1.17 11.79 0.82 . 1.18 0.29 1.79 1.35 1.98 1.65 1.77 5.80 1.57 2.66 1.52 0.97 0.00 1.08 1.71 4.64 674 N/A 8 2,718 34 20,632 401 N/A 16 8,427 19 4,960 22 7,918 44 15,486 44 8,593 86 20,557 INTEREST FEES & CHARGES EXPENSES TOTAL INTEREST SALARIES LOAN LOSS PROVISION OTHER REAL ESTATE COMMERCIAL CONSUMER AGRICULTURAL PAST DUE & NON-ACCRUAL, TOTAL REAL ESTATE CONSTRUCTION COMMERCIAL FARM HOME EQUITY LINES MORTGAGES MULTI-FAMILY COMMERCIAL CONSUMER AGRICULTURAL NUM8ER OF BANKS NUM8ER OF EMPLOYEES Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco, or of the Board of Governors of the Federal Reserve System. Editorial comments may be addressed to the editor or to the author. ... Free copies of Federal Reserve publications can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O, Box 7702, San Francisco 94120. Phone (415) 974-2246, Fax (415) 974-3341. Research·Department· Federal Reserve Bank of San Francisco P.O. Box 7702 San Francisco, CA 94120 Printed on recycled paper Q ..t. with ~oybean ink~. W ~ PERCENT OF COMBINED MARKET TOTAL FOR FEBRUARY 1995. BY REGiON ~ DEPOSIT TYPE CB TOTAL DEPOSITS S7 35 91 6 66 2. 63 26 32 63 .7 44 OEMAND NOW SAVINGS & MMOAS SMALL TIME LARGE TIME ~ ~ SL ev eB SL ev eB 8 3 9 11 5 10 72 97 62 57 25 3 33 39 19 4 92 9B 8B 8B 93 91 75 9. CB ;;; COMMERCIAL BANKS; SL ev 1 0 0 0 ~ 1 B 2 12 11 5 8 ~ eB ~ SL ev 50 .3 90 7 60 32 60 31 23 72 38 51 7 3 8 9 5 11 SL = SAVINGS & LOANS AND SAVING BANKS; TYPE OF RETAIL DEPOSIT ACCOUNT OR LOAN ~ eB SL ev eB 68 95 69 61 56 7. 23 1 26 2S 39 "5 17 9 92 98 89 91 89 94 9 3 5 SL ev CU - CREDIT UNIONS; ~ ~ ~ eB SL cv eB SL ev eB 78 97 7B 76 '2 B9 18 3 13 15 52 11 78 92 80 7' 72 7' 13 10 5 3 10 10 13 13 19 10 18 B 80 92 B2 75 77 78 S 0 8 9 6 0 SL ev 5 16 1 2 10 8 17 • • 23 13 14 ~ e8 SL ev S7 90 67 55 41 45 33 9 20 27 52 53 MAY NOT SUM TO 100% DUE TO ROUNDING NOV 1992 FEB 1993 MAY 1993 1993 NOV 1993 FEB 1994 MAY 1994 AUG 1994 NOV 1994 FEB 1995 SAVINGS ACCOUNTS AND MMOAS U.S DISTRICT 2.90 :3.05 2.80 2.96 2.65 2.78 2.55 2.67 2.48 2.58 2.43 2.56 2.50 2.65 2.83 2.81 2.80 2.88 3.09 2.96 92 TO 182 DAYS CERTIFICATES U.S DISTRICT 3.14 3.14 3.08 3.01 2.98 2.88 2.96 2.85 2.92 2.81 2.93 2.83 3.28 3.03 3.81 3.34 4.22 3.84 4.83 4.47 2-112 YEARS AND OVER CERTIFICATES U.S DISTRICT 4.70 4.49 4.59 4.41 4.45 4.27 4.40 4.19 4.28 4.09 4.35 4.13 4.89 4.5B 5.33 4.96 6.0B 5.52 6.52 6.02 COMMERCIAL SHORT TERM FIXED U.S DISTRICT 4.17 4.79 4.16 4.2B 3.91 4.19 4.02 4.75 3.95 4.43 4.03 4.95 4.6B 6.7B 5.2B 5.39 5.67 6.32 6.B9 6.39 COMMERCIAL SHORT TERM FLOATING U.S DISTRICT 5.91 6.59 5.B5 6.36 5.5B 5.40 5.53 6.48 5.56 6.46 5.49 6.36 6.32 6.38 6.83 7.34 7.36 7.78 8.50 9.17 COMMERCIAL LONG TERM FIXED U.S DISTRICT 5.97 6.44 6.43 9.19 6.02 10.86 6.21 8.05 5.38 6.62 5.41 6.58 6.17 N/A 6:66 9.82 7.30 8.20 N/A N/A COMMERCIAL LONG TERM FLOATING U.S DISTRICT 6.53 8.09 6.38 8.43 6.47 8.55 6.05 8.77 5.70 7.68 5.98 8.16 6.61 N/A 6.99 N/A 7.59 9.00 N/A N/A CONSUMER. AUtOM081LE U.S DISTRICT 8.60 8.76 8.57 8.98 8.17 8.23 7.98 8.09 7.63 7.70 7.54 7.68 7.76 7.86 8.41 8.15 8.75 8.41 9.70 9.63 CONSUMER, PERSONAL U.S DISTRICT 13.55 12.83 13.57 12.67 ·'3.63 13.87 13.45 12.69 13.22 "13:00 12.89 12.02 "2.96 12.26 13.33 13.37 13.59 12.87" 14.10 "4.55 U.S QISTRICT 17.38 18.29 17.26 17.76 17.15 17.60 16.59 17.58 16.30 17.00 16.06 17.17 16.15 17.61 16,25 17.34 15.91 16.33 16.24 15.60 CONSUMER, CREDIT CARD SOURCES: MONTHLY SURVEY OF SELECTED DEPOSITS. SURVEY OF TERMS OF BANK LENDING. AND TERMS OF CONSUMER CREDIT MOST COMMON INTEREST RATES ON RETAIL DEPOSITS. WEIGHTED AVERAGE INTEREST RATE ON LOANS 11 1 13 lB 7 2
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