International evidence for the substitution effect of FX derivatives usage on bank capital buffer

Abstract

Banks are the most important users in the foreign exchange (FX) derivatives market, while the effect of FX derivatives usage on bank capital buffer is hitherto underexplored. We construct an international sample consisting of non-US banks from 59 economies, and examine the relationship between them. We find that banks with more FX derivatives have lower capital buffers, suggesting that FX derivatives usage is a substitute for capital buffer, and banks use FX derivatives largely for risk management purpose. The substitution effect is more significant for non-dealer banks, banks with high capital buffers, and banks in economies with floating currency system. It is also more significant when the FX rate and stock market are volatile. Our findings support policymakers, especially in developing economies, in promoting the development of FX derivatives market to facilitate the risk management of banks.