The Evolution of Derivative Use by Community Banks from 1995-2003

By Robicheaux, Sara H. | Academy of Banking Studies Journal, January-July 2005 | Go to article overview

The Evolution of Derivative Use by Community Banks from 1995-2003


Robicheaux, Sara H., Academy of Banking Studies Journal


INTRODUCTION

It goes without saying that the banking industry has changed over the last decade. There have been several seminal events to cause the changes, notably the easing of Depression era regulations and as a result the ever-increasing penetration of the large "mega-banks" into smaller and smaller markets. Additionally, and likely a result of the increased competition caused by the aforementioned events, banks have been forced to dramatically increase their product offerings. It is now common for the smallest of banks to offer such products as home equity lines of credit, certificates of deposit with the interest rate tied to the performance of an equity index, and even interest-only home mortgages.

The increased competition from the mega-banks has also forced the small bank to manage itself in ways that they did not need to in the past. For example, it is not uncommon to see smaller banks using more sophisticated derivative securities as a vital tool in Asset/Liability management. Clearly, the use of these complex financial tools introduces additional accounting and regulatory risks to the small bank. It is our goal in this paper to determine how this subset of banks has evolved since 1995 in their use of derivative securities. A second question that we will attempt to answer is whether or not derivative use affects the performance of the banks in our sample, and whether the results are driven by the largest banks.

The firms we examine are U.S. commercial banks with total assets between $100 million and $1 billion, which we will refer to as community banks. We choose these firms because they are small enough so that derivatives should be a relatively new tool for them as compared to the larger national banks. Yet, they are large enough that they should have enough interest rate risk on their balance sheet to warrant hedging with derivatives. Also, as pointed out by Carter and Sinkey (1998) this subset of banks should be using derivatives for hedging purposes rather than for dealer activity.

The paper proceeds as follows. Section 2 reviews the existing literature. Section 3 describes the data used in our study and our methodology. Section 4 presents the results and Section 5 concludes.

RELATED LITERATURE

There are several studies that have examined the effect of derivative use on the firm. Smith and Stulz (1985) were the first to discuss how hedging with derivatives can be used to offset interest-rate risk and decrease the probability of insolvency. Carter and Sinkey (2000) use year-end data from 1996 and find approximately 5% of community banks use derivatives. They examine the user versus nonuser banks and find usage related to riskier capital structure, larger maturity mismatches between assets and liabilities, greater net-loan charge offs, and lower net interest margins. An additional set of researchers are studying swap positions of U.S. commercial banks. Gorton and Rosen (1995) find that interest rate risk from swap positions has had very little effect on the systematic risk of the banking industry as a whole. Boukrami (2003) finds larger banks with better asset quality and higher capitalization use swaps more intensely.

One study which focuses exclusively on community banks is Deyoung, Hunter, and Udell's (2004) examinion of the past, present, and future of community banks. They show that although regulatory and technological changes have created increased competition for community banks, it has also left well-managed community banks with a potential exploitable strategic position in the industry. Carter and Sinkey's (1998) evaluation of derivative use by community banks from 1990-1993 shows that cost-related incentives motivate interest-rate derivative use. Specifically, they show that community banks use derivatives to control interest-rate risk, with swaps being used in conjunction with credit-risk minimization mechanisms. We will build on the existing literature in two ways. …

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