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Derivatives activity at troubled banks

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Author Info

  • Joe Peek
  • Eric S. Rosengren

Abstract

We find that a relatively large number of banks active in the derivatives market have low capital ratios and are considered institutions with a significant risk of failure by bank supervisors. However, we also find no evidence that the volume of derivatives activity at troubled banks affects the probability of formal regulatory intervention or even a downgrade in supervisory rating. While derivatives have become an essential instrument for hedging risks, moral hazard can lead to their misuse by problem banks. Given that the absence of comprehensive data on bank derivatives activities presents an accurate assessment of bank risk-taking, banks have an opportunity to take unmonitored second bets. Troubled banks have the motive to increase risk, and derivatives provide the means to do so. The role of bank supervisors should be to limit the opportunity through more comprehensive data reporting requirements and closer supervisory scrutiny of derivatives activity at problem banks.

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Bibliographic Info

Paper provided by Federal Reserve Bank of Boston in its series Working Papers with number 96-3.

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Date of creation: 1996
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Publication status: Published in Journal of Financial Services Research 12, no. 2/3 (October/December 1997): 287-302.
Handle: RePEc:fip:fedbwp:96-3

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Keywords: Bank capital ; Derivative securities;

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References

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  1. Koppenhaver, G. D. & Stover, Roger D., 1991. "Standby letters of credit and large bank capital: An empirical analysis," Journal of Banking & Finance, Elsevier, vol. 15(2), pages 315-327, April.
  2. Avery, Robert B. & Berger, Allen N., 1991. "Loan commitments and bank risk exposure," Journal of Banking & Finance, Elsevier, vol. 15(1), pages 173-192, February.
  3. Gary Gorton & Richard Rosen, 1995. "Banks and Derivatives," NBER Chapters, in: NBER Macroeconomics Annual 1995, Volume 10, pages 299-349 National Bureau of Economic Research, Inc.
  4. Katerina Simons, 1995. "Interest rate derivatives and asset-liability management by commercial banks," New England Economic Review, Federal Reserve Bank of Boston, issue Jan, pages 17-28.
  5. Sinkey, Joseph F, Jr, 1978. "Identifying "Problem" Banks: How Do the Banking Authorities Measure a Bank's Risk Exposure?," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 10(2), pages 184-93, May.
  6. John H. Boyd & Mark Gertler, 1993. "U.S. Commercial Banking: Trends, Cycles, and Policy," NBER Chapters, in: NBER Macroeconomics Annual 1993, Volume 8, pages 319-377 National Bureau of Economic Research, Inc.
  7. Gary Whalen & James B. Thomson, 1988. "Using financial data to identify changes in bank condition," Economic Review, Federal Reserve Bank of Cleveland, issue Q II, pages 17-26.
  8. Joe Peek & Eric S. Rosengren, 1996. "Will legislated early intervention prevent the next banking crisis?," Working Papers 96-5, Federal Reserve Bank of Boston.
  9. Peek, Joe & Rosengren, Eric, 1995. "Bank regulation and the credit crunch," Journal of Banking & Finance, Elsevier, vol. 19(3-4), pages 679-692, June.
  10. Sinkey, Joseph F, Jr, 1975. "A Multivariate Statistical Analysis of the Characteristics of Problem Banks," Journal of Finance, American Finance Association, vol. 30(1), pages 21-36, March.
  11. Jagtiani, Julapa & Saunders, Anthony & Udell, Gregory, 1995. "The effect of bank capital requirements on bank off-balance sheet financial innovations," Journal of Banking & Finance, Elsevier, vol. 19(3-4), pages 647-658, June.
  12. Joe Peek & Eric S. Rosengren, 1995. "Banks and the availability of small business loans," Working Papers 95-1, Federal Reserve Bank of Boston.
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Cited by:
  1. R. Vander Vennet & O. De Jonghe & L. Baele, 2004. "Bank risks and the business cycle," Working Papers of Faculty of Economics and Business Administration, Ghent University, Belgium 04/264, Ghent University, Faculty of Economics and Business Administration.
  2. Brock, W.A. & Hommes, C.H. & Wagener, F.O.O., 2009. "More hedging instruments may destabilize markets," Journal of Economic Dynamics and Control, Elsevier, vol. 33(11), pages 1912-1928, November.
  3. L. Baele & R. Vander Vennet & A. Van Landschoot, 2004. "Bank Risk Strategies and Cyclical Variation in Bank Stock Returns," Working Papers of Faculty of Economics and Business Administration, Ghent University, Belgium 04/217, Ghent University, Faculty of Economics and Business Administration.
  4. Chiara Oldani, 2005. "An Overview of the Literature about Derivatives," Macroeconomics 0504004, EconWPA.
  5. Helwege, Jean, 2010. "Financial firm bankruptcy and systemic risk," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 20(1), pages 1-12, February.
  6. Joshua Charap & Jelena Pavlovic, 2009. "Development of the Commercial Banking System in Afghanistan," IMF Working Papers 09/150, International Monetary Fund.

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