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FEDERAL RESERVE BANK OF DALLLAS
JULY 1995
FINANCIAL INDUSTRY
Who's Capitalizing on Derivatives?
Jeffery W. Gunther
Senior Economist and Policy Advisor
Thomas F. Siems
Senior Economist
Interesting Times
For Banks Since Basle
Kenneth J. Robinson
Senior Economist and Policy Advisor
This publication was digitized and made available by the Federal Reserve Bank of Dallas' Historical Library (FedHistory@dal.frb.org)
Financial Industry Studies
Federal Reserve Bank of Dallas
Robert D. McTeer, Jr.
President and Chief Executive Officer
Tony J. Salvaggio
First Vice President and Chief Operating Officer
Robert D. Hankins
Senior Vice President
Genie D. Short
Vice President
Economists
Jeffery W. Gunther
Kenneth J. Robinson
Robert R. Moore
Thomas F. Siems
Financial Analysts
Howard C. "Skip" Edmonds
Karen M. Couch
Kelly Klemme
Susan P. Tetley
Wendy W. Zea
Research Programmer Analyst
Olga N. Zograf
Graphic Designer
Lydia L. Smith
Editors
Rhonda Harris
Judith Finn
Monica Reeves
Financial Industry Studies
Graphic Design
Gene Autry
Laura J. Bell
Patrice Mozelewski, PM Design
Financial Industry Studies is published by the
Federal Reserve Bank of Dallas. The views expressed
are those of the authors and should not be attributed
to the Federal Reserve Bank of Dallas or the Federal
Reserve System.
Articles may be reprinted on the condition that
the source is credited and a copy of the publication
containing the reprinted article is provided to the
Financial Industry Studies Department of the Federal
Reserve Bank of Dallas.
Financial Industry Studies is available free of charge
by writing the Public Affairs Department, Federal Reserve Bank of Dallas, P.O. Box 655906, Dallas, Texas
75265-5906, or by telephoning (214) 922-5254 or
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Contents
Who's Capitalizing
On Derivatives?
Jeffery W. Gunther and Thomas F. Siems
Page 1
Interesting Times
For Banks Since Basle
Kenneth J. Robinson
Page 9
Are banks using derivatives to hedge financial risks or to make
speculative gambles? While data are not available to answer this
question fully and directly, the relationship between bank capital
and derivatives activities may provide an important clue. This study
provides evidence that those banks with the highest capital cushion
with which to absorb losses and potentially the lowest risk-taking
incentives are the ones with the highest derivatives participation. This
finding is consistent with the view that either financially strong
institutions are using derivatives to hedge, or regulatory and market
discipline have made higher capital levels a prerequisite for derivatives activities. Either way, a positive relationship between derivatives activities and capitalization should help ease concerns regarding
bank derivatives activities.
Unanticipated increases in interest rates are often viewed as
harmful to banks. This assumption arises partly from the fact that
banks are frequently viewed as institutions that borrow short and
lend long. Because the implementation of the Basle risk-based
capital standards did not include a capital charge for interest-rate risk,
banks may have been encouraged to substitute interest-rate risk for
credit risk in their portfolios. Here, two approaches are used to
estimate whether interest-rate risk at banks has increased significantly since the implementation of risk-based capital standards. One
method relies on bank stock price data to judge the effects of interestrate increases on banks' market value, while the other approach uses
bank accounting data to infer long-run effects of interest-rate movements on bank profitability. Overall, the results provide some
evidence that interest-rate risk is higher after the Basle capital
standards took effect.
Who's
Capitalizing
On Derivatives?
Jeffery W. Gunther
Senior Economist and Policy Advisor
Thomas F. Siems
Senior Economist
Financial Industry Studies Department
Federal Reserve Bank of Dallas
ire banks using derivatives
to hedge financial risks or to
make speculative gambles? This
study provides evidence that
those banks with the highest
capital cushion with which to
absorb losses and potentially the
lowest risk-taking incentives are
the ones with the highest
Financial derivatives activity at U.S. banks,
as measured by the notional value of derivatives contracts, has increased dramatically in
recent years, more than doubling from roughly
$7 trillion in the first quarter of 1991 to about
$16 trillion by year-end 1994 (Chart 1). This
tremendous growth, coupled with recent highly
publicized derivatives-related losses, has led
bank regulators and policymakers to question
the potential impact of derivatives activities on
the safety and soundness of the banking system.
One view of these issues emphasizes the
benefits of derivatives activities in helping
banks manage risks and serve their financial
customers. Under this view, regulatory capital
standards, disclosure requirements, and supervisory guidelines are seen as sufficient controls
over the generally beneficial use of derivatives
instruments.1
But an alternative view characterizes
derivatives activities as highly speculative endeavors that greatly jeopardize financial safety
and soundness. The focus is placed on the
potential for weak or ill-managed institutions
to suffer large losses through derivatives trading, thereby endangering the safety of both the
banking system and the fund that backs federally insured deposits. In this regard, some have
favored restricting, or even banning, derivatives
activities at insured commercial banks. In this
way, the nature of proposals for the appropriate regulatory response to the recent growth
in derivatives activities depends on assessments
of the motivations and actions of derivatives
users.2
The regulatory policy debate over derivatives has been accompanied by a search for
evidence on the nature of the derivatives activi-
derivatives participation.
Chart 1
Growth of Financial Derivatives Activities
At U.S. Insured Commercial Banks
Notional value, trillions of dollars
See Siems (1994), Abken (1994), and
Becketti (1993) for studies that conclude that banks can safely manage and
H Commodities and equities
Interest rate
• Foreign exchange
regulators can effectively supervise
bank participation in derivatives markets. Also, the Group of Thirty (1993),
an international policy organization
made up of representatives of central
banks, international banks, securities
firms, and academia, emphasizes the
positive economic benefits associated
with derivatives and has published a set
of recommendations for users and dealers of financial derivatives.
See the General Accounting Office
(1994) for recommendations calling for
stiffer government regulation of financial derivatives markets.
FEDERAL RESERVE BANK OF DALLAS
1
FINANCIAL INDUSTRY STUDIESDECEMBER1995
total bank assets, is higher for banks with relatively high capital levels.
These findings have important implications
for the supervision of the derivatives activities of
commercial banks. If banks are using financial
derivatives in a speculative or risky fashion, then
the finding of a positive relationship between
derivatives activities and capitalization is consistent with the view that regulatory measures have
offset the incentive for thinly capitalized banks to
take on increased risk. Those banks with the
highest capital cushion with which to absorb
losses and, as a result, the lowest risk-taking
incentives, are the ones with the highest derivatives participation. These findings cast considerable doubt on the view that banks are placing
large financial bets through derivatives.
ties actually conducted by banks. Are derivatives
being used to hedge or to speculate? And to
what extent are banks acting in the capacity of
a dealer, as opposed to taking net positions
themselves?
Unfortunately, the information banks submit quarterly in regulatory financial statements
does not specify the nature of derivatives activities at individual institutions. As a result, it often
is difficult to distinguish empirically hedging
from speculative activities, and a bank's derivatives involvement as a dealer also is not directly
identifiable.
Nevertheless, it may be possible to address
some of the concerns currently facing policymakers through an analysis of the relationship
between derivatives activities and bank capital.
Bank capital long has played a prominent role
in the supervisory process. And that role was
enhanced further with the enactment of the
Federal Deposit Insurance Corporation Improvement Act of 1991, which established new
policies and procedures designed to control
tightly the activities of thinly capitalized banks,
while expanding the options and activities open
to banks that maintain relatively high capital
levels. The basic philosophy underlying the
capital-based supervisory approach is that banks
with relatively low capital ratios have a smaller
cushion with which to protect the Bank Insurance Fund from potential losses and a
greater incentive to engage in high-risk activities.
Such considerations suggest that tighter restrictions on thinly capitalized institutions may
be appropriate.
If, on the other hand, banks use derivatives
primarily to hedge, or reduce risk, then our
findings are consistent with the view that, because well-capitalized banks have relatively low
risk-taking incentives, they are more likely to
hedge. Either way, the finding of a positive
relationship between derivatives activities and
capitalization should ease concerns that additional regulatory restrictions on bank derivatives
activities are necessary at this time.
Factors potentially influencing
derivatives usage
What are the determining factors that
motivate banks to use derivatives? This question
is complicated by the multiple uses of derivatives instruments. Individual banks can use derivatives not only to hedge, but also to speculate
on changes in interest rates or exchange rates in
anticipation of expected market movements.
And banks can trade derivatives by serving as
a dealer in helping other organizations meet
their specific risk management objectives. Moreover, an additional complicating factor in analyzing bank derivative usage is the influence of
regulatory and market discipline on a bank's decision to use derivatives in any of these alternative capacities.
The question then arises of whether
derivatives activities, which often are more
complex and somewhat more difficult for regulators to monitor than bank lending activities,
have tended to be associated with high or low
capital levels. If derivatives activities were concentrated at thinly capitalized banks, then that
would reinforce concerns over the possible motivations and potential losses of derivatives
players. Conversely, a positive capital-derivatives relationship would help ease such concerns, since greater derivatives participation at
least would be associated with stronger capital
positions.
Hedging. Perhaps one of the strongest motivations for using derivatives is their potential
effectiveness in hedging financial risks. For corporations, Nance, Smith, and Smithson (1993)
argue that the use of derivatives to hedge risks
can increase the value of firms by reducing
expected taxes, the costs associated with financial distress, and the likelihood of bond defaults.
Sinkey and Carter (1994) build on this theory of
hedging behavior—together with contemporary
theories of banking, as discussed in Bhattacharya and Thakor (1993)—to examine em-
To date, much of the evidence submitted on
this issue has suggested an association of derivatives activities with low capitalization. However,
in this article, we offer substantial evidence in
the other direction. Specifically, we find that, for
most size classes of banks, the intensity of
derivatives activities, as measured by the notional value of derivatives contracts relative to
2
Table 1
The Capital-Derivatives Relationship
pirically the determinants of the hedging and
derivatives activities of U.S. commercial banks.
Sinkey and Carter find that the use of derivatives
is associated with smaller maturity gaps, greater
liquidity, lower net interest margins, higher dividends, greater use of subordinated debt, and
lower capital ratios.
Speculation. In addition to the types of
motivating factors related to hedging, the existence of the federal safety net for bank deposits
may give banks special reasons for using derivatives. In particular, mispriced deposit insurance
can lead to risk-taking incentives.3 When deposit
insurance premiums do not fully reflect the risk
of individual institutions, a bank's incentive for
risk-taking tends to increase as its level of capitalization falls. Such risk-taking incentives are a
particular manifestation of the general moral
hazard problem, which occurs when the method
of insurance alters the behavior of the insured.
Because of this incentive structure, banks may
attempt to exploit government subsidies by taking on increased risk during times of financial
stress. Such considerations have helped generate
concern among regulators and policymakers
over the potential for speculative derivatives
activities.
Derivatives usage
Hedging
Speculating
£
Box A
Moral hazard
Box B
Regulatory and
market discipline
BoxC
Regulatory and
market discipline
Box D
Moral hazard
Positive
Negative
Market discipline. Although the existence of
federal deposit guarantees reduces the potential disciplinary role of depositors, certain peculiarities of derivatives instruments suggest that
market forces may still play a role in disciplining
bank derivatives activities. In particular, since
many derivatives contracts are made over the
counter without the benefit of a third-party
guarantee, low capital levels may reduce access
to the derivatives markets. Perhaps more
importantly, to the extent that banks use derivatives to speculate, the monitoring and disciplining activities of uninsured bank creditors
also would be expected to result in a positive
relationship between bank capitalization and
derivatives participation.
Dealing. Finally, as financial intermediaries, banks can use derivatives to help financial
customers manage their own risk positions. In
this capacity, banks manage an entire derivatives
portfolio, with specific contracts linked to the
special needs of individual customers. However,
while derivatives are easily accessible, successful
derivatives trading requires a substantial investment in intellectual and reputational capital.4
The time and resources required to understand
and monitor derivatives activities may make
some banks reluctant to participate in the derivatives markets, particularly in the capacity of a
dealer. Typically, large banks are able to develop
derivatives expertise and exploit innovations
more efficiently because of size and technical
efficiencies. 5 In particular, Booth, Smith, and
Stolz (1984) and Block and Gallagher (1986)
assert that informational and transactional scale
economies can promote increased derivatives
usage for dealing.
To the extent that derivatives are used to
speculate, the moral hazard hypothesis would
predict that derivatives usage should increase
as capitalization falls. Conversely, if derivatives
are used mainly to hedge, the moral hazard hypothesis would suggest that derivatives activities
should be greater at relatively well-capitalized
institutions. Intuitively, such banks should be
more likely to hedge unwanted risks because
more of the banks' own capital is at stake.
Regulatory discipline. The existence of
federal deposit insurance is a key motivating
factor behind the existence of federal bank
supervision and regulation. Because the government has guaranteed the safety of most bank
deposits, the responsibility for monitoring and
disciplining bank behavior essentially has devolved from depositors to the regulatory agencies. Under this type of system, Buser, Chen, and
Kane (1981) describe the way in which regulatory and supervisory restrictions might increase
as bank capital levels fall. Similarly, Merton and
Bodie (1992) argue that the appropriate regulatory response to potentially excessive bank risktaking might include monitoring, risk-based
deposit insurance premiums, cash-asset reserve
and capital requirements, portfolio restrictions,
and limits on discount window borrowing.
1
See, for example, Merton (1978,1977);
Kareken and Wallace (1978); Buser,
Chen, and Kane (1981); Marcus (1984);
Kane (1989,1985); and Short (1987).
See Hu (1993) for a review essay that
traces the history of the development of
derivatives and the emergence of the
new "financial science," which
integrates mathematical sophistication
and economics into finance and raises
Implications of the capital-derivatives
relationship
In light of these arguments, the relationship between bank capital ratios and derivatives
activities is particularly important, as shown in
Table 1. If banks use derivatives to hedge against
unwanted risks and to maintain their capital
base, then, under the moral hazard hypothesis,
To the extent that these regulatory measures are effective, the negative relationship be-
FEDERAL RESERVE BANK OF DALLAS
tween bank capital levels
and risk-taking predicted by moral hazard
considerations might be
offset or even reversed.
If derivatives are used
for speculative purposes,
then these considerations suggest derivatives
participation should fall
as capital levels decline.
3
FINANCIAL INDUSTRY STUDIESDECEMBER1995
the level of conceptualization in financial methodologies. In addition,
Bernstein (1992) provides a comprehensive history of modern finance
recounted with wit and elegance that
should be useful to academics and
interested lay readers alike.
Hunter and Timme (1986) argue that
large banks have used their operating
efficiencies as a means of remaining
competitive in deposit markets.
Chart 2
capital levels should be positively associated
with derivatives usage, as shown in Box A.
Conversely, if derivatives are used primarily to
speculate, then the moral hazard hypothesis
would predict a negative relationship between
bank capital levels and derivatives activities, as
shown in Box D.
The regulatory and market discipline hypotheses produce the opposite predictions. If
banks use derivatives to speculate, regulatory
discipline, and possibly market forces, might
counter any existing moral hazard incentives
and give rise to a positive capital-derivatives
relationship, as shown in Box B. On the other
hand, to the extent that derivatives are used to
hedge, regulatory and market discipline might
motivate thinly capitalized banks to make the
greatest use of derivatives instruments, as
shown in Box C.6
1
This prediction is complicated, however, by the frequent lack of precise
information on the nature of banks'
derivatives activities. For example, if
derivatives were used to hedge and
reduce overall risk, regulatory factors
may still work to restrict derivatives
activities if the risk-reducing nature of
the activities was not revealed.
Sinkey and Carter (1994) find that
banks using derivatives have weaker
capital positions, smaller maturity gaps,
lower net interest margins, more notes
and debentures in their capital structures, higher dividend payout rates, and
greater liquidity. Kim and Koppenhaver
(1992) provide evidence that the ratio of
the notional value of interest-rate swaps
to total assets is reduced for banks with
capital close to or below regulatory
minimums. However, for banks in
general, they find that swap exposure
is negatively related to capita! ratios.
Only a small proportion of banks
actually engage in derivatives activities.
Of the 10,432 insured commercial
banks in the United States at the end of
1994, only 624, or 6 percent, reported
any derivatives-related activities.
The notional value of derivatives
contracts is an imprecise measure of
derivatives activities. For example, the
notional value of an interest-rate swap
represents the principal upon which the
traded interest payments are calculated,
and a bank that serves merely as an
intermediary in a swap transaction
reports the same notional value twice,
once for each side of the swap. However, due to data limitations, most
previous studies of derivatives activities
also are based on notional values.
Distribution of Derivatives Activities Across
U.S. Insured Commercial Banks
(Notional value, fourth-quarter 1994)
Largest five
banking organizations
70.1%
Next
largest five
17.7%
The rest
12.2%
From a policy perspective, the finding of
a positive relationship between bank capitalization and derivatives activities would be the
most comforting, since such a result would rule
out the combination of speculation and moral
hazard shown in Box D.
tives contracts are divided into five asset size
groups and also three capitalization groups.8
Each asset size group contains 20 percent of
the banks, with the first group containing the first
20 percent of the banks, as ranked from the
smallest to largest, while the fifth asset size group
contains the largest banks. Similarly, each capitalization group contains one-third of the banks,
with the first group containing the first third of
the banks, as ranked from the weakest to the
strongest capitalization, while the banks with
the highest capital ratios are placed in the third
capitalization group. For each asset size group,
we calculate, by level of capitalization, the
median value of the intensity of derivatives participation, which is measured by the notional
value of derivatives contracts relative to total
bank assets.9
Evidence from the early 1990s
Currently, regulatory financial statements
give little information to identify directly the
nature of derivatives activities at individual institutions. However, despite the interpretative
difficulties inherent in current derivatives data,
several researchers have attempted to infer the
motivations for derivatives usage by analyzing
the relationships between derivatives participation and various potential explanatory variables.
Clear evidence exists to support the notion
that scale economies in derivatives activities
favor large banks. Based on the reported notional
value of derivatives contracts at year-end 1994,
the ten largest commercial banks account for
more than 87 percent of total derivatives activity
in the U.S. banking industry {Chart 2). The high
market share of these large institutions mostly
reflects their dominance as derivatives dealers.
Based on data for the period from 1991
through 1994, Chart 3 shows the median notional
value of derivatives relative to total assets for
each asset size category and capitalization level.
In each of the four years, the largest banks are
the most active derivatives participants, as expected. Informational and transactional scale
economies allow the largest institutions to exploit most efficiently the newest innovations
and establish extensive dealer activities.
But beyond such obvious factors, relatively
little is known concerning the nature of bank
derivatives activities. The few studies conducted
to date have tended to suggest a negative relationship between bank capitalization and derivatives.7
In this study, we examine the year-end
financial reports submitted to regulators by individual banks over the period from 1991 through
1994 to assess the relationship between bank
capitalization and derivatives activities. For each
time period, banks that reported having deriva-
More importantly, the figures also reveal a
strong relationship between bank capital levels
and derivatives activity. For virtually every size
group and year, derivatives participation increases with capitalization, as measured by the
ratio of equity capital to total assets. In particular,
the highly capitalized banks have a greater intensity of derivatives participation than banks
with low capital for eighteen of the twenty
4
combinations of time period and size. The only
exceptions occur for the largest group of banks,
which exhibits a negative relationship between
capitalization and derivatives activities in 1991
and 1994. These departures from the general
positive capital—derivatives relationship represent a source of concern, since they occur at the
largest banks, which tend to dominate smaller
banks in terms of derivatives participation.
However, the mixed results for the group
of largest banks may simply reflect the greater
participation of large banks in dealing activities. Because dealers oversee large portfolios of
derivatives and manage the net risk, or residual
risk, of their overall derivatives positions, the
relationship between capital and total derivatives
activities may be muted. For dealers, derivatives
activities may be much more a function of a
bank's size, its trading expertise, and its reputation than of its capital level. Moreover, capital
levels increased over the time period examined
here, so that the median capital-to-asset ratio for
the large banks categorized as having low capitalization was 6.07 percent in 1994, versus 5-34
percent in 1991. Viewed in the context of dealing activities, for which reputational capital is
particularly important, the lack of a consistently
positive relationship between capitalization and
derivatives activities at the large banks may have
few implications for the motivations and potential losses of derivatives participants.10
Overall, the positive association between
bank capital and derivatives activities is comforting from a regulatory perspective. To the extent
that derivatives are used primarily to hedge, then
the related policy concerns are minimal in any
case. And the positive capital—derivatives relationship shown here provides evidence against
the view that banks are pursuing moral hazard
incentives through derivatives speculation,
since, under moral hazard, it is thinly capitalized
banks that have the greatest incentive to take on
risk. If derivatives are being used for speculative
purposes, at least regulatory discipline, and possibly market forces, have required additional
capital as a prerequisite for increased derivatives participation.
Gunther and Siems (1995) report similar
findings on the capital—derivatives relationship.
Gunther and Siems employ a general statistical
framework to analyze the separate relationships
between capitalization, a bank's participation in
derivatives (or lack of it), and the extent of
participation. After controlling for the potential
Chart 3
Equity-to-Asset Ratio and Derivatives Activity
M e d i a n n o t i o n a l v a l u e of d e r i v a t i v e s
M e d i a n n o t i o n a l v a l u e of d e r i v a t i v e s
r e l a t i v e t o t o t a l a s s e t s , 1991 ( P e r c e n t )
relative t o t o t a l a s s e t s , 1 9 9 2 ( P e r c e n t )
35 - »
Equity-to-asset ratio
• Low
S Medium
• High
First
Second
Third
Fourth
First
Fifth
Second
Third
Fourth
Asset size group
Asset size group
M e d i a n n o t i o n a l v a l u e of d e r i v a t i v e s
M e d i a n n o t i o n a l v a l u e of d e r i v a t i v e s
relative t o t o t a l a s s e t s , 1 9 9 3 ( P e r c e n t )
relative t o t o t a l a s s e t s , 1 9 9 4 ( P e r c e n t )
35 -,
35
Equity-to-asset ratio
•
•
•
10
Low
Medium
High
In addition, analyzing the five asset size
groups separately only partly controls
for the influence of size on derivatives
activities. In particular, the fifth, or largest, asset size group includes a wide
range of asset sizes, and the two cases
of a seemingly negative relationship
between capitalization and derivatives
activities partly reflect relatively high
derivatives participation by the very
First
Second
Third
Fourth
Fifth
First
Asset size group
FEDERAL RESERVE BANK OF DALLAS
Second
Third
Asset size group
5
FINANCIAL INDUSTRY STUDIESDECEMBER1995
Fourth
largest banks in the group, which often
tend to manage their capital levels relatively close to regulatory minimums.
high at highly capitalized banks, it is difficult
to assess whether the observed higher capital
levels fully compensate for the potential risks of
derivatives activities. However, some evidence is
available to address this issue in the form of the
risk-based capital requirements. To the extent
that the risk-based capital requirements effectively categorize banking activities according
to risk, the amount of regulatory capital per
dollar of risk-weighted assets should indicate
whether banks with extensive derivatives activities are more or less adequately capitalized than
banks with relatively low levels of derivatives
participation.
influence of a number of additional variables,
capital levels are found not to influence banks'
decision to participate in derivatives activities.
However, in agreement with the results reported
here, Gunther and Siems find capitalization to
be positively associated with the magnitude of
derivatives activities for those banks participating in the derivatives markets.
The treatment of off-balance-sheet activities under risk-based capital guidelines may be
one regulatory force contributing to the positive
association between derivatives usage and capitalization. Wall, Pringle, and McNulty (1990)
describe the treatment of derivatives activities
under the international risk-based capital standards established by the 1988 Basle Accord.
These standards set forth a framework for measuring capital adequacy under which riskweighted assets are calculated by assigning
assets to broad categories of activities based
primarily on their perceived credit risk. Offbalance-sheet transactions are included in riskweighted assets by converting each transaction
item into a credit-equivalent amount, which is
then assigned to a particular credit-risk category.
Based on data from 1991 through 1994,
Chart 4 shows the median notional value of
derivatives relative to total assets for each asset
size category and total risk-based capital level.
The statistics are obtained in exactly the same
manner as those presented in Chart 3, with the
exception that the three capitalization categories
now are based on the total risk-based capital
ratio, rather than the equity-to-asset ratio.
In Chart 4, no clear relationship emerges
between risk-based capital and derivatives
participation, with one half of the twenty combinations of time period and asset size suggest-
While the results presented so far indicate
that derivatives activities tend to be relatively
Chart 4
Total Risk-Based Capital Ratio and Derivatives Activity
Median notional value of derivatives
Median notional value of derivatives
relative to total assets, 1991 (Percent)
relative to total assets, 1992 (Percent)
35 - i
35
j
Total risk-based capital ratio
30 -
•
Low
Medium
• High
First
Second
Third
Fourth
Fifth
First
Second
Third
Fourth
Asset size group
Asset size group
Median notional value of derivatives
relative to total assets, 1993 (Percent)
Median notional value of derivatives
Me
relc
relative to total assets, 1994 (Percent)
35 -i
55 -i
Second
Third
First
Fourth
Second
Third
Asset size group
Asset size group
6
Fourth
ing a positive relationship and the other half
showing a negative one. These results suggest
that, to the extent that the risk-based capital
requirements accurately reflect risk, the relatively
high equity-to-asset ratios of banks with extensive derivatives activities do compensate, in general, for the associated risks.
References
Abken, Peter A. (1994), "Over-the-Counter Financial
Derivatives: Risky Business?" Federal Reserve Bank of
Atlanta Economic
Review 79, 1 - 2 2 .
Becketti, Sean (1993), "Are Derivatives Too Risky for
Banks?" Federal Reserve Bank of Kansas City
Economic
Review, Third Quarter, 2 7 - 4 2 .
Conclusion
Derivatives usage among U.S. banking
organizations is surprisingly low, given the flexibility and adaptability derivatives offer in managing risk exposures. A primary reason for the low
participation rate seems to be the large amount
of intellectual and reputational capital required
to develop and maintain a comprehensive and
knowledgeable derivatives trading function.
Typically, only the largest institutions can gather
the necessary resources to produce extensive
derivatives trading operations, and the available
data confirm that the largest banks are the
dominant players in the derivatives industry.
But for banks involved with derivatives, our
results indicate that derivatives participants with
the greatest derivatives usage as a percentage
of assets in general have the highest capital
levels. And this finding of a positive relationship
between derivatives and capital has important
policy implications. From a regulatory perspective, the speculative use of derivatives by
relatively weak banks would represent the
worst-case scenario. However, our finding of a
positive capital-derivatives relationship argues
against the view that banks are pursuing moral
hazard incentives through derivatives speculation. If derivatives are being used for speculative
purposes, at least regulatory discipline, and possibly market forces, have tended to require
additional capital as a prerequisite for increased
derivatives participation. These results reflect a
general tendency in the banking industry, and
we cannot rule out the possibility that some
institutions may have speculated heavily with
derivatives. Nevertheless, our finding of a positive capital-derivatives relationship is consistent
with the view that banks generally have used
derivatives in a prudent fashion.
Improbable
Origins of Modern Wall Street (New York: The Free Press).
Bhattacharya, Sudipto, and Anjan V. Thakor (1993),
"Contemporary Banking Theory," Journal of Financial
Intermediation
3, 2 - 5 0 .
Block, Stanley B., and Timothy J. Gallagher (1986), "The
Use of Interest Rate Futures and Options by Corporate
Financial Managers," Financial Management,
Autumn,
73-78.
Booth, James R., Richard L. Smith, and Richard W. Stolz
(1984), "Use of Interest Rate Futures by Financial Institutions," Journal of Bank Research
15 (Spring): 1 5 - 2 0 .
Buser, Stephen A., Andrew H. Chen, and Edward J. Kane
(1981), "Federal Deposit Insurance, Regulatory Policy,
and Optimal Bank Capital," Journal of Finance
35
(March): 51-60.
General Accounting Office (1994), Financial
Derivatives:
Actions Needed to Protect the Financial System, Report
to Congressional Requesters, G A O / G G D - 9 4 - 1 3 3 , May.
Group of Thirty (1993), Derivatives:
Practices
and Prin-
ciples, Washington, D.C., July.
Gunther, Jeffery W., and Thomas F. Siems (1995), "The
Likelihood and Extent of Bank Participation in Derivatives
Activities," Financial Industry Studies Working Paper no.
1 - 9 5 , Federal Reserve Bank of Dallas.
Hu, Henry T. C. (1993), "Misunderstood Derivatives: The
Causes of Informational Failure and the Promise of
Regulatory Incrementalism," The Yale Law Journal
102,
1457-1513.
The results reported here favor the view
that regulatory efforts to monitor the derivatives
activities of U.S. commercial banks should emphasize supervisory guidelines and marketoriented incentives as opposed to an overly
restrictive legislative response that might impair
the ability of banks to manage risk effectively.
FEDERAL RESERVE BANK OF DALLAS
Bernstein, Peter L. (1992), Capital Ideas: The
Hunter, William C., and Stephen G. Timme (1986),
"Technical Change, Organizational Form, and the
Structure of Bank Production," Journal of Money,
Credit,
and Banking 18 (May): 1 5 2 - 6 6 .
Kane, Edward J. (1989), The S&L Insurance Mess: How Did
It Happen?
7
(Washington, D.C.: The Urban Institute Press).
FINANCIAL INDUSTRY STUDIESDECEMBER1995
(1985), The Gathering
Insurance
Crisis in Federal
Nance, Deana Ft., Clifford W. Smith, Jr., and Charles W.
Deposit
Smithson (1993), "On the Determinants of Corporate
(Cambridge, Mass.: The MIT Press).
Hedging," Journal of Finance 48 (March): 2 6 7 - 8 4 .
Kareken, John H., and Neil Wallace (1978), "Deposit
Insurance and Bank Regulation: A Partial-Equilibrium
Short, Genie D. (1987), "Bank Problems and Financial
Exposition," Journal of Business
Safety Nets," Federal Reserve Bank of Dallas
51 (July): 4 1 3 - 3 8 .
Economic
Review, March, 17-28.
Kim, Sung-Hwa, and G. D. Koppenhaver (1992), "An
Siems, Thomas F. (1994), "Financial Derivatives: Are New
Empirical Analysis of Bank Interest Rate Swaps," Journal
of Financial Services Research
Regulations Warranted?" Federal Reserve Bank of Dallas
6 (February): 57-72.
Financial Industry Studies, August, 1-13.
Marcus, Alan J. (1984), "Deregulation and Bank Financial
Policy, "Journal of Banking and Finance
Sinkey, Joseph F., Jr., and David Carter (1994), "The
8 (December):
557-65.
Derivatives Activities of U.S. Commercial Banks," in The
Merton, Robert C. (1978), "On the Cost of Deposit Insur-
Chicago, proceedings of the 30th Annual Conference on
ance When There Are Surveillance Costs," Journal of
Bank Structure and Competition, May, 165-85.
(Declining?)
Business
Role of Banking, Federal Reserve Bank of
51 (July): 4 3 9 - 5 2 .
Wall, Larry D., John J. Pringle, and James E. McNulty
(1990), "Capital Requirements for Interest-Rate and
(1977), "An Analytic Derivation of the Cost of
Deposit Insurance and Loan Guarantees: An Application
Foreign-Exchange Hedges," Federal Reserve Bank of
of Modern Option Pricing Theory," Journal of Banking
Atlanta Economic
and
Finance 1 (June): 3 - 1 1 .
, and Zvi Bodie (1992), "On the Management of
Financial Guarantees," Financial Management
21
(Winter): 87-109.
8
Review, May/June, 14-28.
Interesting Times
For Banks
Since Basle
The potential impact of changes in market
interest rates on commercial banks' revenues,
costs, and profitability has long been a concern
of policymakers and bankers. A fairly traditional
view of banks is that they borrow short and lend
long. That is, banks engage in financial intermediation activities such that the maturity structure of their assets may exceed the maturity
structure of their liabilities. If so, then bank
earnings and net worth could be negatively
affected by unanticipated increases in interest
rates. The exposure of bank profitability and net
worth to unanticipated changes in interest rates
is what is meant by the term interest-rate risk.
Kenneth J. Robinson
Senior Economist and Policy Advisor
Financial Industry Studies Department
Federal Reserve Bank of Dallas
u
nanticipated increases in interest
rates are often viewed as harmful
to banks. Here, two approaches
are used to estimate whether
interest-rate risk at banks has
increased significantly since
the implementation of
A number of studies have examined the
extent of banks' exposure to interest-rate risk.
Most of these studies use data on how bank
stock prices react to interest-rate movements.
Bank stock returns that respond to unexpected
changes in interest rates indicate that banks
are exposed to interest-rate risk. Other studies
use bank accounting data to infer the average
maturity structure of assets and liabilities and to
judge the long-run effect on banks' profitability
from changes in interest rates. The empirical
evidence is mixed, with several studies finding
that bank stock prices react negatively to interestrate increases. But results using accounting data
provide little evidence of a maturity mismatch
or a negative effect on bank profitability arising
from interest-rate movements.
Recently, concerns about banks' exposure
to interest-rate risk have increased with the introduction of risk-based capital standards. These
standards, known as the Basle Accord, were
approved in mid-1988 with the purpose of requiring banks that undertake more risky activities to hold more capital. The focus of these
requirements, however, is on the credit risk, or
risk of default, of banks' assets and off-balancesheet positions. The Basle Accord does not
currently impose capital requirements on banks'
exposure to interest-rate risk. As a result, banks
may have an incentive to alter their portfolios
to substitute interest-rate risk for credit risk.1
risk-based capital standards.
Here, the two alternative approaches are
used to judge whether interest-rate risk at U.S.
banks has increased since the adoption of the
risk-based capital standards. The first approach
uses bank stock price data to estimate whether
interest-rate risk has increased significantly since
the Basle Accord. As a check on the robustness
of these results, bank accounting data are used
to analyze the long-run effects of interest-rate
movements on banks' revenues, costs, and profitability. Overall, the results provide some support
for the notion that interest-rate risk has increased
FEDERAL RESERVE BANK OF DALLAS
9
FINANCIAL INDUSTRY STUDIESDECEMBER1995
Modifications to the risk-based capital
requirements have been proposed to
address the problem of interest-rate
risk (Federal Register 1993).
a cushion to absorb losses during economic
downturns. This cushion also helps shield the
deposit insurance fund from losses that might
be incurred from bank failures. Until recently,
bank capital regulations were not explicitly
linked to banks' risk profile. On July 11, 1988,
the Basle Committee on Banking Regulations
and Supervisory Practices—meeting under the
auspices of the Bank for International Settlements in Basle, Switzerland—reached what has
come to be known as the Basle Accord. Under
this agreement, which covers banks in the United
States, Canada, Europe, and Japan, banks' minimum capital requirement now depends on the
perceived credit-risk exposure of their assets
and off-balance-sheet positions. This assessment
is made by assigning different risk weights to
various categories of assets and off-balancesheet items to reflect their risk of default. The
Basle Accord is structured to reflect that riskier
banks are more likely to fail and, therefore,
should be required to hold more capital. Interim
requirements became effective at the end of
1990, with final implementation occurring at
the end of 1992.
since the implementation of the Basle Accord
and its emphasis on credit risk.
Before presenting these two approaches, a
more formal discussion of interest-rate risk and
its relationship with the Basle risk-based capital
requirements will be offered. Next will come a
brief look at some aggregate bank data that
might give some indication of banks' exposure
to interest-rate risk. Then, the results using both
bank stock prices and bank accounting data to
estimate interest-rate-risk exposure are presented, followed by some conclusions.
Interest-rate risk in more detail
In principle, the most straightforward
method of evaluating the effects of changes in
market interest rates on banks' economic wellbeing is to calculate the changes' effects on bank
net worth. The change in bank net worth resulting from a change in interest rates is equal to the
change in the present value of current and expected revenues minus the change in the present
value of current and expected costs.
A related concept to estimating interestrate risk is the calculation of the duration of
bank assets and liabilities. Duration is defined as
the weighted average maturity of the cash flows
in present value terms. Duration measures the
sensitivity of net worth to changes in interest
rates by assessing the effects of interest-rate
changes on the discounted value of future earnings. Calculating the duration of assets and liabilities, though, requires major assumptions
about maturity structures and interest rates.2
2
For more on the concept of duration,
see Houpt and Embersit (1991) and
However, the Basle Accord only covers
banks' credit-risk exposure. Calculation of the
risk-based capital standards does not include
interest-rate-risk exposure. A regulatory system
that favors some types of assets over others
could create incentives for banks to alter the
composition of their portfolios. Under the current Basle risk-based capital requirements, then,
banks may be tempted to reallocate their portfolios to substitute interest-rate risk, which has
no explicit capital charge, for credit risk.3 A look
at banks' exposure to increases in interest rates
The borrow short and lend long view of
banks and the view's role in interest-rate risk are
easy to understand in terms of revenue and cost.
Under this type of portfolio mismatch, an unanticipated increase in interest rates would raise
costs relative to revenues for some time. As a
result, the bank's market value would decline in
response to the increase in interest rates. A gap,
or mismatch, in the asset/liability maturity structure is not the only factor that can expose banks
to interest-rate movements, however. If unanticipated changes in interest rates affect the rate at
which market participants discount the present
value of banks' future profit streams, then banks'
vulnerability to unexpected interest-rate movements would also increase. Also, bank revenues
and costs may be affected by the level of interest
rates and the variability or predictability of interest rates within each period.
Chart 1
U.S. Insured Commercial Bank Loans
And Debt Securities
P e r c e n t of t o t a l l o a n s a n d d e b t s e c u r i t i e s
Santoni (1984).
J
See Houpt and Embersit (1991) Also,
see Neuberger (1992) for a description
of some other problems associated with
the current Basle Accord.
Where do capital requirements fit in?
1989
Capital requirements have been imposed
on banks for some time. Bank capital represents
I
1990
1991
Maturing in more than one year
1992
1993
D A T A S O U R C E : R e p o r t of C o n d i t i o n a n d I n c o m e .
10
1994
N Maturing in one year or less
Chart 2
since the Basle Accord was adopted would shed
light on whether banks have altered their portfolios toward greater interest-rate-risk exposure.
Deposits at U.S. Insured Commercial Banks
Proportion of total deposits
A look at some aggregate bank data
Before turning to the two alternative
approaches to estimating banks' exposure to
interest-rate risk, a cursory review of aggregate
bank data might reveal whether banks have
altered the composition of their portfolios. Chart
1 shows how the maturity structure of banks'
loans and securities holdings has changed since
1989—the first year after the Basle Accord was
approved—through the end of 1994. Asset structure lengthened somewhat over this period.
Loans and debt securities with a maturity of more
than one year represented 41 percent of the total
in 1989, increased to 46 percent in 1992, and
fell slightly to 44 percent in 1994. Alternatively,
loans and debt securities at commercial banks
with a maturity of one year or less declined from
59 percent in 1989 to 56 percent in 1994.
1989
1991
1992
1993
1994
to changes in interest rates. Alternatively, bank
revenues, costs, and income are all affected by
changes in interest rates. Estimates of the longrun effect of interest-rate movements on these
variables would provide another view of banks'
interest-rate-risk exposure since the adoption of
risk-based capital requirements.
Because interest-rate risk can arise from
a mismatch between the maturity structure of
assets and liabilities, the liability side of banks'
balance sheets must also be examined. Chart 2
reveals how the maturity structure of deposits at
banks has changed from 1989 to 1994. What
stands out in this chart is how the proportion of
core deposits has increased by 11 percentage
points, from 54 percent of total deposits in 1989
to 65 percent in 1994.4 Meanwhile, time deposits
of less than one year decreased from 37 percent
of total deposits to 24 percent. To the extent
that core deposits represent a relatively stable
funding source, the liability side of banks' balance sheets shows some lengthening in the maturity structure.'' Thus, while loans and securities
may have shown an increase in their maturity
composition, deposits at U.S. banks have also
probably lengthened in their maturity as well.
Can the stock market tell us anything?
When using stock price data to estimate
banks' exposure to interest-rate changes, a
model of the determination of stock prices is
needed. The so-called market model is a widely
used and relatively simple model of stock prices.
To some degree, all stocks are affected by general economic conditions or overall economic
activity. This relationship implies a fairly close
connection between an individual security's return and the return on a broad-based, marketwide
index of stocks. Therefore, the market model
describes an individual security's return over a
certain period as a function of the returns generated over that period on a market index of
stocks. In this model, how an individual stock's
return is affected by marketwide returns is
widely referred to as the stock's beta. For example, if beta equals one, the security's return
moves one-for-one with the overall market. If
beta is less than one, the security's return would
change by a smaller amount than overall market
returns, and if beta exceeds one, the change in
the security's return would exceed the change
in overall market returns. A stock with a beta
greater than one implies that the security's return
exhibits more cyclical movements than the overall market does.
Examining aggregate bank data, though,
may not reveal the extent of banks' exposure to
interest-rate risk. Changes in interest rates alter
the present value of bank assets and liabilities.
This correlation implies that the market value of
the firm changes,, depending on assets and liabilities' sensitivity to changes in interest rates. This
change in market value is reflected in the stock
prices of publicly traded firms.
Measuring interest-rate risk—
two approaches
If some banks have undertaken portfolio
reallocations that increased their sensitivity to
interest-rate movements, then this might be reflected in an increased sensitivity of share prices
FEDERAL RESERVE BANK OF DALLAS
1990
DATA SOURCE: Report of Condition and Income.
When examining banks' interest-rate risk,
an augmented-market model is used. The model
11
FINANCIAL INDUSTRY STUDIESDECEMBER1995
Core deposits are defined as the sum
of demand deposits, MOW and ATS
accounts, MMDA savings, and other
savings deposits.
Uncertainty over the effective maturity
of core deposits represents a significant
obstacle to measuring the gap between
asset and liability maturity structures
and also to measuring the duration of
assets and liabilities.
Table 1
Estimates of Interest-Rate Sensitivity of Bank Stock Returns Using ARIMA Residuals
Pre- and Post-Basle 1989 Periods
Variable
1973:1-94:3
1973:1-88:4
1989:1-94:3
Interest-Rate Variable: TBILL
CONSTANT
.1184**
.1401"
.1446**
(.0118)
(.0114)
(.0327)
1.0509**
1.0016**
1.4766**
(.0310)
(.0273)
(.1200)
-.0759**
-.0685**
-.1354**
(.0087)
(.0075)
(.0432)
R2 = . 2 5
R2 = . 3 6
R2 = . 1 4
BETA
INTEREST-RATE
SENSITIVITY
Interest-Rate Variable: TBOND
.1467**
CONSTANT
(.0112)
1.0166**
BETA
-.1212**
SENSITIVITY
1.8166**
(.0276)
-.1547**
(.0133)
TE
(.0328)
.9420**
(.0320)
INTEREST-RA
.1364**
.1303**
(.0118)
(.0115)
R2
(.1322)
.2201**
(.0538)
fl2
R2 = . 3 7
= .26
= .14
" = Statistically significant at t h e 1 - p e r c e n t level.
N O T E S : S t a n d a r d errors a r e in p a r e n t h e s e s .
T h e m o d e l e s t i m a t e d is RETURN\
= a „ + P , • MARKETt
+
• RATE, + <;„, w h e r e RETURNit
(annualized) rate of return o n b a n k ts s t o c k in t i m e p e r i o d f ; MARKET'ts
of s t o c k s at t i m e f ; RATE
is a m e a s u r e of the c h a n g e in interest rates f r o m t-1
points), a n d eh is a n error t e r m to c a p t u r e all other factors. CONSTANT
e s t i m a t e d e r i v e d for p, a n d INTEREST-RATE
variation in RETURN
An F-test was used to assess whether a
single augmented-market model applied
to all the banks, as opposed to fortyeight separate bank-specific models.
For both interest-rate variables, the
tests were insignificant at the 5-percent
level, indicating that the data can be
pooled and a single regression equation
estimated.
ARIMA stands for autoregressive integrated moving average, ARIMA models
forecast a particular time series, say
interest rates, by using prior movements in the series. In effect, ARIMA
models are linear combinations of the
series' own past values and, perhaps,
past errors or innovations in the series.
For TBILL, one lag of the series was
used in the forecasting equation, while
for TBOND, two lags of the series were
used. Both of these models produced
white noise residuals that are then used
as proxies for unanticipated interestrate movements.
SENSITIVITY
that is e x p l a i n e d b y MARKET
and
is d e f i n e d a s t h e
t h e rate of return o n a b r o a d m a r k e t index
to t ( m e a s u r e d a s p e r c e n t a g e
is t h e estimate d e r i v e d for a , BETA is the
is t h e e s t i m a t e of
R z is the proportion of t h e
RATE.
organizations whose stocks traded continuously
over the entire period are included in the analysis,
for a total of forty-eight banks. 6 Data for bank
stock prices and dividends are for the last trading
day of the quarter, are obtained from Compustat,
and are adjusted for dividend and stock splits.
The market index used is Standard & Poor's
stock price index and dividend index (S&P 500),
based on the last trading day of the quarter. Two
interest-rate variables are used: the three-month
Treasury bill rate, last trading day of the quarter
{TBILL)-, and the rate on ten-year Treasury bonds,
last trading day of the quarter {TBOND). The
interest-rate series were obtained from the HI5
release of the Board of Governors of the Federal
Reserve System.
is augmented by a variable that proxies for
unanticipated interest-rate movements. If this
interest-rate factor is negative and statistically
significant, it suggests that banks' market value
is adversely affected by increases in interest rates.
A number of previous studies have used an
augmented-market model to judge the sensitivity
of bank security returns to unexpected interestrate movements. Flannery and James (1984),
Aharony, Saunders, and Swary (1986), Sweeney
and Warga (1986), Saunders and Yourougou
(1990), and Yourougou (1990) all find evidence
that bank stock returns are negatively related to
interest-rate changes. Chance and Lane (1980),
however, do not find much evidence that the
stock prices of financial firms exhibit sensitivity
to interest-rate fluctuations.
Because the interest-rate sensitivity variables TBILL and TBOND are proxies for unanticipated changes in interest rates, the models are
estimated using the residuals from an ARIMA
model of these interest-rate series.7 Table 1 shows
In estimating the augmented-market model
to determine if interest-rate risk has increased
since the Basle Accord, quarterly data from the
1973:1-94:3 period are used. Only banking
12
I H I m
Table 2
Estimates of Interest-Rate Sensitivity of Bank Stock Returns
Using Interest-Rate-Spread
Variable
Pre- arid Post-Basle 1989 Periods
Variable
1973:1-94:3
1973:1-88:4
1989:1-94:3
Interest-Rate Variable: TBOND-TBILL
CONSTANT
.1016"
.1268**
.1121"
(.0119)
SENSITIVITY
1.0698**
1.7043**
(.0303)
INTEREST-RATE
(.0342)
1.1250**
BETA
(.0114)
(.0267)
(.1223)
.0329**
.0222**
(.0092)
(.0108)
R2
R2 = . 2 5
= .34
.2834**
(.0682)
R2 =
.14
" = Statistically significant at the 1 -percent level.
NOTES: See notes to Table 1.
the results of estimating the two versions of the
augmented-market model over the entire period,
1973:1-94:3, and over the pre- and post-Basle
time periods, here defined as 1973:1-88:4, and
1989:1—94:3, respectively.8 Over the entire period,
all of the variables are statistically significant in
both versions of the model. The results indicate that bank stock returns tend to move fairly
closely with the overall stock market, with beta
close to 1. Both interest-rate sensitivity factors
are negative and statistically significant, indicating that bank stock returns are negatively correlated with changes in interest rates. These results
provide some evidence that banks were exposed
to interest-rate risk over the entire period.
as favorable developments for bank stock
returns in the post-Basle period. A 100-basispoint increase in long-term rates is associated
with a 22-percent increase in bank stock returns,
compared with a negative effect in the pre-Basle
period.9
The combination of a negative coefficient
for short-term interest rates and a positive coefficient for long-term rates in the post-Basle period
could indicate that market participants viewed
increases in the yield spread as more important
in determining bank profitability in the late 1980s
and early 1990s. During this time, the yield
spread between short- and long-term interest
rates increased dramatically. At the same time,
banks restructured their portfolios toward more
holdings of government securities, perhaps in
an attempt to increase current profits (Short,
Gunther, and Moore 1993). Table 2 shows the
results of estimating the augmented-market
model using the difference between TBOND and
TBILL as the interest-rate factor. This spread
variable is statistically significant over the entire
period, as well as in the pre- and post-Basle
periods. But, comparing the results before and
after the approval of risk-based capital requirements, the coefficient on the spread variable
increases dramatically in the later period, from
0.022 to 0.28. 10 These results suggest that the
yield spread was viewed as a much more important determinant of bank profitability in the
post-Basle period.
Examining the results over the pre- and
post-Basle periods provides some insight into
whether interest-rate risk has increased significantly since the Basle Accord was approved. In
the pre-Basle period, both models indicate that
bank stock returns were negatively correlated
with unanticipated interest-rate changes. However, the results reveal a slightly different picture
in the period after the risk-based capital requirements were approved. Bank stock returns are
now more sensitive to unanticipated increases in
short-term interest rates. In the pre-Basle period,
a 100-basis-point increase in short-term interest
rates reduces bank stock returns by 6.85 percent
(holding the overall effect of the stock market
constant), while in the post-Basle period, a
100-basis-point increase in short-term interest
rates reduces bank stock returns by 13.54 percent.
The evidence also indicates, though, that the
stock market viewed increases in long-term rates
FEDERAL RESERVE BANK OF DALLAS
If the introduction of risk-based capital
requirements for banks provided incentives for
banks to substitute interest-rate risk for credit
13
FINANCIAL INDUSTRY STUDIESDECEMBER1995
' Because the Basle capital standards
were approved in July 1988, partially
implemented at the end of 1990, and
fully effective at the end of 1992,
several break points were used in the
estimation of the model. The first break
point chosen was the end of 1988, and
these results are reported in the text.
Even though the Basle Accord was not
in effect at the beginning of 1989, this
break point was chosen because banks
could have been forward looking, and
anticipating the Basle requirements,
could have chosen to take on more
interest-rate risk at this time. Similarly,
the Basle Accord began to be implemented at the end of 1990, making that
a potential break point. The results are
not affected if the models are estimated
using a break point of the fourth quarter
of 1990. While the Accord was fully
implemented at the end of 1992, too
few data points are available for each
bank to place much faith in estimates of
the models that began in 1993
9
Tests for differences in the coefficients
across these two periods are statistically significant at the 1-percent level.
These procedures involved testing the
hypothesis that the interest rate factors
are significantly different across the two
periods. The test statistic is distributed
as standard normal and for TBILL is
52.18 and for TBOND is 234.10, both
highly significant. Furthermore, Chow
tests for a structural change in the
regression equations across these two
time periods are also statistically
significant, with a value for the F-test
statistic of 56.99 for the model containing TBILL and 42.0 for the model
containing TBOND.
10
This difference is statistically significant
at the 1 -percent level, with a value of
the test statistic of 128.74.
Table 3
Estimates of the Long-Run Impact of a Change in Market Interest
Rates on Banks' Operating ROA
long-lasting interest-rate effects are on bank
revenues, costs, and earnings.
Flannery begins by recognizing that banks
can reallocate only a portion of their earning
assets and their liabilities in the short run in
response to changing market conditions. This
constraint primarily arises from the limitations
imposed by prior portfolio decisions that cannot be changed instantaneously. As a result,
Flannery employs a partial-adjustment model to
account for the lagged response of bank portfolio decisions to changing market conditions.
For comparison's sake, the sample of banks
consists of the same forty-eight banks that were
used in estimating the market models. Two
different interest rates are used, this time the
quarterly average of the three-month T-bill rate
and the ten-year T-bond rate.
Separate Specifications for Revenues and Costs
(Average for all banks)
Period
1973:1-94:3
1973:1-88:4
TBILL
-.068"
-.046"
-.056*
TBOND
-.051"
-.034"
-.067**
Interest rate
1989:1-94:3
** = Significant at the 1 -percent level.
* = Significant at the 5-percent level.
The partial adjustment framework for revenues and costs includes the following equations:
(1)
JL
TA,-TA,_
+ cy, +<x3<?, + a 4
TA, ,
TA.,
+ E, ,
where: R: = total operating revenues in period t,
TA, = total assets in period t,
r;
= the current market interest rate,
of
= intraperiod variability in rr
The first four terms incorporate a partial adjustment framework for revenue to its equilibrium level
The partial-adjustment framework allows
estimates of the long-run impact of interest-rate
changes to be obtained. Table 3 shows estimates
of the effect of a permanent change in interest
rates on the ratio of banks' net operating earnings to total assets, or operating ROA. These
estimates are based on separate specifications
for revenues and costs in the partial-adjustment
framework. To conserve space, the results reported are the mean responses for the entire
sample of banks. The long-run mean responses
of operating ROA to an increase in interest rates
are all negative and statistically significant. For
example, a (permanent) 100-basis-point increase
in TBILL is, on average, estimated to reduce
banks' operating ROA by almost 7 (6.8) basis
points over the entire period. Estimates comparing the pre- and post-Basle periods show an
increase in the long-run impact associated with
an increase in both TBILL and TBOND. Moreover, these differences in interest-rate sensitivities
are statistically significant across the pre- and
post-Basle periods at the 1-percent significance
level. 13 These results provide some evidence
that increases in interest rates do have a negative
effect on profitability and that this interest-rate
sensitivity increased after the introduction of the
risk-based capital standards.
if all investable funds are placed in assets earning the current market rate. The term associated
with aa represents the return on net new assets. The expected signs on the coefficients are a 0 , a 2 ,
a ( > 0; 0 < a, < 1; a 3 < > 0. Current operating expenses are modeled as
(2)
= &
+
+
M
+
TA, - TA,_
TA,,
where C, = total current operating expense in time f. The coefficients' expected signs and interpretations in equation 2 are analogous to those in equation 1. The dependent variables are
expressed in basis points. The volatility measure is the standard deviation of the weekly interest
rate series over the quarter.
The long-run effect of a (permanent) change in market interest rates on operating ROA, or the
difference between revenues and costs as a percent of assets, is defined as
"
"a
1-ci,
P2
1-P,
risk, then the interest-rate factors should have
been negative and greater in absolute value in
the post-Basle period. Using different measures
of unanticipated interest-rate changes, evidence
Because the sample of banks used in
from bank stock returns provides some proof
the analysis covers only those instituthat banks altered their portfolios such that
tions whose stocks traded continuously
their stock returns were more sensitive to interestover the entire period, the results
obtained could suffer from survivorship
rate movements in the post-Basle period. Morebias. To test this possibility, the
over, the stock market seemed to view moveaugmented-market model was
ments in the interest-rate spread as a much more
estimated using data for all banks in the
Compustattlle that reported data for at
important factor in the post-Basle period. 11 An
least four years. This sample produces
alternative approach that uses bank accounting
134 banks. After expanding the sample
data can offer additional insights into the extent
ot banks the results are substantially
unaffected, which indicates the absence
of banks' exposure to interest-rate risk.
Finally, the partial-adjustment framework
can supply another estimate of the effect of
interest-rate changes on bank profitability.
Table 4 contains additional estimates of the
long-run impact of changes in interest rates
on banks' operating ROA. These estimates are
based on results from a single-equation estimation that uses the ratio of net current operating earnings to assets as the dependent variable.
Again, the results are the average for all banks
in the sample. Over the entire time period, (per-
of any survivorship bias.
Flannery (1981) argues that net current
operating earnings are a more appropriate measure than net income because
extraordinary income items and realized
gains or losses on securities are often
tax-related in their timing, which would
obscure the true impact of interest-rate
changes on bank profitability.
13
These significance tests are based on
the Wilcoxon rank tests for testing
hypotheses about shifts in location
parameters.
Bank accounting data: What do they reveal?
To judge the robustness of the results
obtained with stock market data, estimates of
the relationship between market conditions and
bank revenues, costs, and net current operating
earnings are obtained to assess the overall
impact of interest-rate fluctuations on bank
profitability.12 This approach was developed by
Flannery (1981, 1983) to judge how large and
14
Table 4
Estimates of the Long-Run Impact of a Change in Market Interest Rates
On Banks' Operating ROA
Single-Equation Estimation of Operating ROA
(Average for all banks)
Period
1973:1-94:3
1973:1-88:4
1989:1-94:3
TBILL
-.015"
.002
-.032**
TBOND
-.006*
.006**
-.075**
Interest rate
** = Significant at the 1-percent level.
* = Significant at the 5-percent level.
NOTE: See notes to Table 3.
Net earnings are given as
(3)
EA,
(EA
+
+
+Y4
TA,-TAm
TA,,
+ <i,
where EAt = net current operating earnings. The coefficients' expected signs and interpretations in equation 3 are analogous
to those in equation 1. The volatility measure is the standard deviation of the weekly interest-rate series over the quarter.
Equations 1, 2, and 3 were estimated using techniques described in Flannery (1983, 1981). Similar to Flannery, the volatility
measure is not statistically significant in most of the equations estimated.
The long-run impact ot a change in market interest rates on banks' operating ROA is defined from equation 3 as
ment was implemented. Only four years' worth
of data are available since the initial phase-in of
the risk-based capital standards. A longer period
for analysis would provide more evidence of
any heightened interest-rate risk associated with
the Basle agreements.
manent) increases in both TBILL and TBOND
result in declines in banks' operating ROA. In
the pre-Basle period, this effect is statistically
insignificant for TBILL and positive and significant for TBOND. However, in the post-Basle
period, increases in interest rates—for both
interest-rate measures—exert a negative and
statistically significant effect on net current operating earnings to assets. These coefficients are
statistically different across the two periods at
the 1-percent significance level. The results also
suggest that the effect of interest-rate changes
on earnings is greater in the post-Basle time
period and in a direction that suggests greater
exposure to interest-rate risk. However, the
effect is not very large. A permanent 100-basispoint increase in TBILL reduces operating ROA
by slightly more than 3 basis points in the postBasle period, while a 100-basis-point increase
in TBOND gives rise to a 7.5-basis-point decline
in the ratio of net current operating earnings
to assets.
Conclusions
In mid-1988, major industrial countries
agreed to a set of international capital guidelines
for banks that are based on the perceived riskiness of the individual institutions. These capital
charges recognize that banks with higher risk
profiles are more likely to fail. To enhance financial safety and soundness and to protect the
deposit insurance fund, riskier institutions are
now required to hold a greater capital cushion
to absorb losses. It is important to note that
such risk-based capital requirements consider
only the credit risk of banks' portfolios. This
type of regulatory system could encourage
banks to alter their portfolios in such a way
that interest-rate risk, which is not explicitly
accounted for, may increase.
Some caveats
Despite the robustness of the results, some
caution should be used in interpreting their
meaning. First, the interval associated with the
p o s t - B a s l e period exhibits s o m e unusual
interest-rate movements. In particular, the yield
spread averaged 222 basis points in the postBasle period, compared with an average spread
of 158 basis points in the pre-Basle period.
Another potential factor behind the results
could be the brief period since the Basle agree-
FEDERAL RESERVE BANK OF DALLAS
T2
MO '
Estimates presented here using data from
the stock market as well as data from banks'
balance sheets and income statements provide
some support for this hypothesis. Since the
Basle Accord was agreed upon, bank stock returns appear to be more negatively correlated
with unanticipated short-term interest rates,
while the stock market views increases in longterm rates positively. Moreover, banks' market
values are more sensitive to changes in interest-
15
FINANCIAL INDUSTRY STUDIESDECEMBER1995
rate spreads in the post-Basle period. Estimates
of the long-run impact of interest-rate changes
on interest margins are greater after the approval
of the Basle Accord, with evidence that net
earnings at banks have become more adversely
affected by permanent increases in interest
rates, although this effect is not very large.
Houpt, James V., and James A. Embersit (1991),
"A Method for Evaluating Interest Rate Risk in U.S.
Commercial Banks," Federal Reserve Bulletin 77
(August): 6 2 5 - 3 7 .
Neuberger, Jonathan A. (1992), "Risk-Based Capital
Standards and Bank Portfolios," Federal Reserve Bank of
San Francisco Weekly Letter, no. 9 2 - 0 2 , January 10.
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@FedFRASER