BHC Derivatives Usage, Cost of Debt and Lending Patterns

Consistent with Froot and Stein's (1998) model and Schrand and Unal (1998), we find evidence supporting the risk allocation hypothesis in bank holding companies (BHCs). Banks reduce their exposure to tradable risk (interest rate and foreign currency risks) via derivatives-hedging and simultaneously extend more loans and take greater credit risk in lending (their main area of expertise). This risk allocation strategy is associated with an increase in overall bank risk, measured by the cost of debt, before the 2007-2009 financial crisis but this relationship breaks down during the crisis. Moreover we find that hedging allows banks to extract greater rents from their bank-dependent borrowers, conditional on bank reputation and lending relationship.