This paper tries to grasp banks' motivation for entering derivative markets. The motivation question is interesting for the following reason: if banks' main motivation for using derivatives is speculation, derivatives are likely to increase the risk to banks' capital and thus increase the cost of deposit insurance. ; The first major finding of the paper is that currently available data are not informative of banks' usage of derivatives. We find no evidence that derivatives are mainly used for speculation purposes. There is some indication that users of derivatives are interested in expanding into non-traditional banking activities for the purpose of revenue enhancement. On the other hand, the data also indicate that these users tend to be more avid commercial lenders. A possible explanation for these relationships is that banks are using derivatives as hedging instruments. We search for evidence of such hedging activity as well as for measures of derivative users' risk attitude. Based on our assumptions, the results of this paper give little support to this hedging hypothesis. Furthermore, derivative users tend to be less risk averse than nonusers judging from the credit risk that they undertake. We note that banks which are newcomers to the derivative industry tend to be more growth oriented than banks that have a longer history of derivative use. They also seem to be less interested in their traditional business. These newcomer banks bear watching. ; To summarize, the current Call Reports provide little information on how and why derivatives are being used in the banking industry. We see no obvious warning signs in the data, but we also find little supporting evidence from the data that derivatives have contributed to the safety and soundness of the banking industry. We conclude that better data are needed in this area.
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Paper provided by Federal Reserve Bank of Kansas City in its series Research Working Paper with number
95-12.