How do derivative securities affect bank risk and profitability?

Purpose - Using data on 5,491 commercial banks in the USA that were operational between 2001 second quarter and 2016 first quarter, the present study aims to examine the impact of derivative securities and its different constituent categories on bank-specific risks and profitability. Design/methodology/approach - The study uses panel data fixed effects model and Bayesian model averaging techniques. Findings - This study finds aggregate derivatives and both interest-rate and exchange-rate derivatives and their different constituent categories to reduce banks insolvency risks for the entire time period and the pre-crisis era. Moreover, aggregate derivatives increase banks’ risk-adjusted return on assets that are driven by exchange-rate derivatives. Such findings are robust to the size of banks, the degree of derivative use and extent of profitability. However, in the post-crisis period, derivatives reduce bank profits. Practical implications - While the results largely provide evidence of the beneficial effects of derivatives, the findings for the post-crisis period are rather concerning. It underscores a clear need to improve regulation and supervision across different categories of derivatives to ensure the benefits exceed their costs for banks. Originality/value - Disaggregate analysis of derivatives can not only unmask important differences in how they affect banks risks, profits, etc. but also help banks mitigate risks arising from specific types of derivative securities banks hold. Furthermore, discerning the impact of derivatives on banks risks and profits in the post-crisis eravis-à-visthe pre-crisis one is extremely important to restore a sounder banking system and foster overall financial stability.