Academic journal article Academy of Banking Studies Journal

Derivative Use by Banks in India

Academic journal article Academy of Banking Studies Journal

Derivative Use by Banks in India

Article excerpt

ABSTRACT

Derivative use by banks operating in India is hypothesized to improve their intermediary function. The research outcome identifies the influence of derivative use on the growth of advances by banks. Bank participation in advances increases with increase in hedging activities through futures. It has also been found that the Indian private sector banks have a high exposure of risk and have externalized their risk management process. Foreign banks operating in India have a low risk exposure level, but still they have moderately externalized their risk management practices. Indian public sector banks have a large deposit bas and high risk exposure but are still internalizing their risk management through ALM. The policy implication of the study is that derivative usage by banks is likely to increase the intermediary role of banks, i.e., the increase in advances growth rate rather than investment portfolio growth rate. Banks with large deposit base could gain relatively by externalizing their risk management practices since the study reveals that interest rate risk exposure of derivative users is statistically lesser than non-users / partial users.

INTRODUCTION

Banking sector faces numerous risks and the transit towards risk management practices has become imperative in the present scenario. Present day measured risk could be a potential loss to the bank. Risk measurement of revenue and cost potential of a bank is comparatively apparent while the interest rate risk is not as visible as these tangible revenues and costs. Modeling the interest rate risk management practices for banks has potential incentives to the sector as a whole in the form of improved profits, capital and integration with economic expectations.

Indian Banks have long used risk management activities such as duration and gap analysis. Risk management through derivative securities has been another avenue for banks to refine risk management practices. Similar to other international markets, price and interest rate volatility in Indian financial markets is high; hence the implications of not hedging the bank portfolio may prove to be disastrous.

Derivatives give banks an opportunity to manage their risk exposure and to generate revenue beyond that available from traditional bank operations. The research objectives framed to reiterate the importance of risk management practices through derivatives are to examine the derivative exposures in banks and to determine the influence of derivative exposure on bank's intermediation role.

LITERATURE REVIEW

Interest rate volatility and the globalization of capital markets have induced the usage of derivative futures by banks. The competitiveness in the market and the need to identify risk and hedge accordingly requires more coordination in the management of assets and liabilities of these banks. Research on introduction of derivatives, especially financial futures, into the balance sheet of banks and as an off-balance sheet hedging tool can be discussed through the works of Ederington (1979), Franckle (1980), Schweser, Cole & D'Antonio (1980), Arak & McCurdy (1980) and Morgan & Smith (1986). They have addressed the use of financial futures and have suggested hedging through interest rate derivatives as an ideal risk management solution. However, focus is more on hedging a cash position in a treasury bill or to hedge an anticipated issue of a Certificates of Deposit (CD). Further studies added multidimensional aspects to financial intermediary's hedging practices under conditions of uncertainty. Morgan, Shome & Smith (1988) considered uncertainties around deposit supply and loan demand as well as random rates of return on loans and CD's. They had also concentrated on the effect of deregulation on interest rate risk borne by financial institutions.

Risk management decisions of banks have been analyzed in detail and specifically with respect to hedging of bank risks. …

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