Diversifying away risks through derivatives: an analysis of the Italian banking system

Abstract

The derivatives market has experienced quick growth internationally in the last two decades. Banks decide to participate in the derivatives market either to hedge against unexpected movements in economic variables or for trading and broker–dealer activities. This paper analyses the determinants of Italian banks’ use of derivatives over a long time horizon (2003–2017) by using quarterly Bank of Italy supervisory data. We find that size and being part of a banking group positively affect the banks’ use of derivatives. Moreover, these banks mainly employ derivatives for hedging purposes, especially to hedge against interest rate and credit risks. Finally, derivatives represent a hedging alternative to capital and liquidity, while dealers behave differently when involved in the trading activity. We also take some characteristics that delineate the bank’s business model into account. For example, lower dependence on retail deposits or higher exposure to interbank funding are positively associated with the use of derivatives. Finally, we assess the sensitivity of the main determinants of derivatives across different types of crises and normal times. Our results are robust to different specifications that take into account the classification of derivatives by purpose (hedging versus trading).