Interest-Rate Derivatives and Bank Lending in China

Abstract

With interest rate liberalization, China’s commercial banks expose to more interest rate risks and use interest-rate derivatives to manage these risks. This paper develops a theoretical model, capturing the main characteristics of the banking sector in China, to analyze the effect of interest-rate derivatives on bank lending. In our model, banks choose lending activity in a way analogous to Cournot competition commonly described in industrial organization. We find the positive effect of interest-rate derivatives position on the total loan volumes in the credit market under the condition that the von Neumann-Morgenstern utility function of bank using derivatives displays either constant or decreasing absolute risk aversion and the derivatives market is unbiased. In the empirical section, we use Vector Autoregression (VAR) model with China’s monthly data over the period from Jan 2007 to Jun 2014. Based on techniques commonly used in the VAR literature, the main results suggest that the interest-rate derivatives market transaction has bi-directional Granger causality with bank loan growth, and derivatives transaction has a significantly and persistently positive effect on loan growth. Moreover, we find that derivatives transaction accounts for 20 percent of variations in bank loan growth in the long run.