Banks and Derivatives

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Abstract
The relationship between risk and derivatives is especially important in banking since banks dominate most derivatives markets and, within banking, derivative holdings are concentrated at a few large banks. If large banks are using derivatives to increase risk, then recent losses on derivatives, such as those of Procter and Gamble and Orange County, may seem small in comparison to the losses by banks. If, in addition, the major banks are all taking similar gambles, then the banking system is vulnerable. This paper is the first to estimate the market value and interest rate sensitivity of bank derivative positions. The authors focus on interest rate swaps in the analysis, because interest rate risk is non-diversifiable and because banks naturally are repositories of interest rate risk. Difficulty in monitoring risk is especially important when the party entering into a derivative transaction is an agent managing money for outside principals. Since derivatives are opaque, a realized loss by one organization may be viewed as information about the portfolio positions of other organizations. The problems from derivative transactions thus come from information problems. This points out the need for changes in the accounting rules or investment regulations. When banks use derivatives, the problems are more severe. First, even knowing more about the derivatives position of a bank may not allow outside stakeholders to determine the overall riskiness of the bank. Banks invest in many non-derivative instruments that are illiquid and opaque. Thus, even if the value of their derivative positions were known, it would be hard to know how subject to interest rate and other risks the entire bank would be. This makes them different from most other organizations that invest in derivatives. Second, bank failures can have external effects. The failure of several large banks can lead to the breakdown of the payments system and the collapse of credit markets for firms. It is clear that if
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