The value of using interest rate derivatives to manage risk at US banking organizations Elijah Brewer III, William E Jackson III, and James T Moser Introduction and summary payments (say, fixed rate) for another set of interest Commercial banks help their customers manage the payments owned by another party (say, floating rate) financial risks they face Of the risks that banks help This article examines the major differences in the to manage, one of the most important is interest rate financial characteristics of banking organizations that risk For example, suppose that we obtain a fixed rate use derivatives relative to those that do not Specifi- 1 mortgage from our bank From our perspective, we cally, we address six research questions First, do banks have eliminated most of the interest rate risk associated that use derivatives also grow their business loan port- with this mortgage In reality the risk is shifted from folio faster than banks that do not use derivatives? us to the bank Now, the bank that approved our fixed Our results suggest that they do So, derivative usage rate mortgage loan is subject to losses from changes appears to foster greater business lending, or finan- in interest rates These changes affect the costs to the cial intermediation bank of providing the mortgage For example, if mar- Second, do banks that use derivatives to manage ket interest rates rise, our mortgage payment to the interest rate risk also have different risk profiles than bank is not affected because we have a fixed rate nonusers? Our results suggest that they do They tend mortgage However, the cost to the lending bank does to hold lower levels of (expensive) capital This implies increase unless it actively manages its cost This rise that derivative usage (and interest rate risk management in market interest rates increases the banks funding in general) allows banks to substitute (inexpensive) costs, that is, the interest rate the bank pays on the risk management for (expensive) capital Derivative money it uses to fund our mortgage loan users have higher balance-sheet exposure to interest rate Changes in funding costs are considered part of risk This is reasonable because interest rate derivatives the interest rate risk associated with a fixed rate mort- provide them with an opportunity to hedge this balance- gage loan Managing this interest rate risk is very sheet exposure Users tend to have lower insolvency important to the bank as it lessens the likelihood of risk, suggesting that derivative activity allows banking extreme fluctuations in the banks financial condition organizations to lower their risk or that low risk bank- and thus decreases the probability of the bank becoming ing organizations are more likely to use derivatives insolvent Lessening the likelihood of insolvency Third, are large banks more likely to use deriva- allows the bank to hold less capital, as capital is the tives? Our results strongly suggest that large banking banks first line of defense against insolvency How- organizations are much more likely than small banking ever, capital is expensive Thus, interest rate risk man- organizations to use derivatives This is in agreement agement is valuable because it lessens the amount of with the idea that there is a fixed cost associated with expensive capital that a bank must hold initially learning how to use derivatives Large banks A typical bank has several methods available to manage interest rate risk For the purposes of this arti- Elijah Brewer III is an economic adviser and assistant cle, we focus on the use of certain interest rate deriva- vice president at the Federal Reserve Bank of Chicago tive instruments (for example, interest rate swaps) to William E Jackson III is an associate professor of finance and economics at the Kenan-Flagler School of Business of offset the inherent interest rate risk in fixed rate lend- the University of North Carolina at Chapel Hill James T ing An interest rate swap is a financial contract that Moser is a senior economist and research officer at the allows one party to exchange (swap) a set of interest Federal Reserve Bank of Chicago Federal Reserve Bank of Chicago 49 are more willing to incur this fixed cost because they economic characteristics of a banks inflows from as- will more likely use a larger amount of derivatives sets with its outflows from liabilities Early on, a bank Thus, this fixed cost can be spread across more oppor- matched the maturities of its assets and liabilities More tunities to actually use derivatives and thereby lower precise matching came later as banks began to look at the average usage cost the duration of assets and liabilities (we will discuss Fourth, does derivative usage negatively affect duration later in this section) US commercial banks banking organizations performance? Our results sug- need to match assets to liabilities arose from their stra- gest that the performance of users is not better or worse tegic decisions regarding interest rate exposure If the than that of nonusers Accounting-based measures of going forward changes in revenue from assets perfect- performance suggest that returns on assets and book ly match the changes in expense from liabilities, then equity are roughly the same for derivative users and a rise or fall in interest rates will have an equal and off- nonusers However, net interest margins are higher for setting effect on both sides of the balance sheet In nonusers than for users A part of this margin could principle, perfect matching leaves a banks earnings be nonusers compensation for bearing interest rate or market value unaffected by changes in interest rates risk Banks charge their loan and deposit customers Alternatively, a bank can adjust its portfolio of assets for providing interest rate intermediation services and liabilities to make a profit when rates rise, but take and assuming the associated interest rate risk This a loss when rates fall It could also position itself for fee is included in the difference between the loan the opposite Realizing profits from changes in interest rate charged and the deposit rate paid rates does represent a speculation and is risky, perhaps Fifth, are derivative users more efficient than non- more risky than other profit opportunities users? The results here are mixed In the two smallest In the past, banks typically had relatively fewer groups, users are less efficient than nonusers, while in long-term fixed rate liabilities (such as CDs) than they the large banking organization category, users are not had long-term fixed rate assets (such as loans) To make more efficient than nonusers up for this shortfall, banks that wished to match assets Lastly, and perhaps most importantly, we ask and liabilities complemented their loan portfolios with whether derivative usage by commercial banks is fixed rate investments commonly called balancing associated with different sensitivities to stock market assets, such as Treasury securities By adjusting the and interest rate fluctuations? Interestingly, our results characteristics of these balancing assets, a bank could imply that it is better match the revenue inflows from its assets to the In the next section of this article we present some expense outflows from its liabilities background on derivative usage and interest rate risk Prior to the 1980s, most banks did not precisely management by US banking organizations Next, we measure their exposure to changes in interest rates present an explanation of how the use of interest rate Instead, they generally avoided investing in longer derivative instruments by banking organizations can maturity securities, feeling that these investments added complement lending strategies We summarize some undue risk to the liquidity of their investment portfolio recent research on the relationship between lending By the early 1980s, it had become clear to most bank and derivative usage of commercial banks Then, we management teams that measuring interest rate risk report some new results on the relationship between more precisely was a critical task The second oil shock lending and derivative usage using a sample of bank of the 1970s had increased the level and volatility of holding companies that have both commercial bank- interest rates For example, the prime rate soared to ing and nonbanking subsidiaries Finally, we exam- more than 20 percent in early 1980, twice the average ine the risk sensitivity of banking organizations for the 1970s and four times as large as the average stock returns in the 1960s In 1980 alone, the prime rate rose to 198 percent in April, fell to 111 percent in August and Measuring and managing interest rate risk rebounded to more than 20 percent in December To A typical US bank has some floating rate liabil- determine their exposure to interest rate movements ities (such as federal funds borrowings) and some in this new, more volatile environment, many banks fixed rate liabilities (such as certificates of deposit, began measuring their maturity gaps soon after 1980 or CDs) It will also have some floating rate assets Maturity gap analysis compared the difference in (such as variable rate mortgages and loans and float- maturity between assets and liabilities, adjusted for their ing rate securities) and some long-term fixed rate repricing interval The repricing interval was the amount assets (such as fixed rate mortgages and securities) of time over which the interest rate on an individual Techniques for managing interest rate risk match the contract remained fixed For example,