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Derivatives activity at troubled banks

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  • 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.

Suggested Citation

  • Joe Peek & Eric S. Rosengren, 1996. "Derivatives activity at troubled banks," Working Papers 96-3, Federal Reserve Bank of Boston.
  • Handle: RePEc:fip:fedbwp:96-3
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    References listed on IDEAS

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    1. Peek, Joe & Rosengren, Eric, 1995. "Bank regulation and the credit crunch," Journal of Banking & Finance, Elsevier, vol. 19(3-4), pages 679-692, June.
    2. 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.
    3. 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.
    4. 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.
    5. 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.
    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. 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.
    8. Joe Peek & Eric S. Rosengren, 1995. "Banks and the availability of small business loans," Working Papers 95-1, Federal Reserve Bank of Boston.
    9. 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.
    10. 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.
    11. Joe Peek & Eric S. Rosengren, 1996. "Will legislated early intervention prevent the next banking crisis?," Working Papers 96-5, Federal Reserve Bank of Boston.
    12. 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 184-193, May.
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    Citations

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    Cited by:

    1. Ioannidou, Vasso P., 2005. "Does monetary policy affect the central bank's role in bank supervision?," Journal of Financial Intermediation, Elsevier, vol. 14(1), pages 58-85, January.
    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. Joshua Charap & Jelena Pavlovic, 2009. "Development of the Commercial Banking System in Afghanistan; Risks and Rewards," IMF Working Papers 09/150, International Monetary Fund.
    4. 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.
    5. 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.
    6. 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.
    7. Chiara Oldani, 2005. "An Overview of the Literature about Derivatives," Macroeconomics 0504004, EconWPA.

    More about this item

    Keywords

    Bank capital ; Derivative securities;

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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