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Purnanandam, Amiyatosh

Commercial Banks Benefit by Using Derivatives for Hedging Risk

9/19/2005 --

Federal monetary policy-makers need to consider derivatives when making rate changes and gauging the economic impact.

ANN ARBOR, Mich.—New research suggests that commercial banks can benefit by using derivative contracts as hedges against rising interest rates.

According to a University of Michigan study of interest-rate risk management in the banking sector, derivatives allow banks to maintain smooth operating policies while avoiding unwanted costs, even in the face of external shocks.

The study reports derivative-user banks adjust their lending, borrowing and investing policies less than non-user banks and do not significantly cut their lending volumes when the Federal Reserve tightens the money supply. These findings have important implications for monetary policymakers, says the study's author, Amiyatosh Purnanandam, assistant professor of finance at the Ross School of Business.

"The fact that the lending volumes of derivative-user banks remain unaffected by changes in the Fed-funds rate suggests the presence of derivative contracts can alter the impact of monetary policies on aggregate lending volume in the economy," Purnanandam said. "Policy-makers need to consider the role of derivative instruments in setting monetary policies and evaluating their effects on the credit channels."

Purnanandam analyzed data from 8,000 commercial banks from 1997 to 2003 in order to determine how bank characteristics, macroeconomic shocks and managerial incentives influence bank decisions about managing interest-rate risks. To analyze the effect of Fed policies on the lending behavior of banks, he used a longer time series of data dating back to 1985.

Financial intermediation often exposes banks to interest-rate risks by creating mismatches in the maturity structure and re-pricing terms of their assets and liabilities. Under certain conditions, this mismatch can force banking firms to borrow money externally at great cost or to fail altogether and bear the brunt of bankruptcy. Therefore, banks find it optimal to hedge all interest-rate risks, either by using derivative transactions (off-balance-sheet method) or by matching the maturity of assets and liabilities (on-balance-sheet method). Hedging strategies also can reduce the variability of cash flows and remove inefficiencies, thereby increasing firm value.

The study finds that when banks face a greater likelihood of sustaining financial setbacks from interest-rate increases, they are more inclined to manage their interest-rate risks. Smaller banks achieve this mainly by adopting conservative maturity-gap policies while larger banks make use of derivative transactions as well. In addition to being larger in size, derivative-user banks tend to rely less heavily on deposit financing, keep relatively lower amounts of liquid assets, make more commercial and industrial loans and maintain higher maturity gaps than non-users.

While firm-level variables, such as financial-distress costs, growth and liquidity have a similar impact on the on-balance-sheet and off-balance-sheet methods of hedging, market-wide variables, such as Fed-funds rate hikes, have a differential impact on the two methods. Though maturity-gap management decisions are consistent with risk-management incentives, the effect of macroeconomic shocks on derivatives hedging suggests market-view-based strategies. The study finds derivative users are able to maintain their asset-liability mix in the event of macro-shocks, whereas non-users make significant adjustments.

"Non-user banks respond very aggressively to macroeconomic shocks, and when the Fed tightens the monetary supply, these firms significantly lower their maturity gaps and greatly reduce their lending volumes," Purnanandam said. His results show that a one percentage point increase in interest rates leads to a 0.38 percentage point decrease in a non-user bank's maturity gap. Non-user banks take similar measures to protect against risks when interest rates are volatile, credit quality is bad or term spreads widen.

However, banks that use derivatives are able to insulate their maturity-gap policies from external shocks and maintain their lending volumes at current levels. By protecting their core businesses amid changing macroeconomic conditions, these banks can stabilize their income streams, avoid costly operating-policy adjustments and add value for shareholders.

Written by Claudia Capos

For more information, contact:
Bernie DeGroat
Phone:(734) 936-1015 or 647-1847