The Risks of Off-Balance Sheet Derivatives in U.S. Commercial Banks

Abstract

This study employs both contingent and non-contingent claim models to test for the existence of market discipline hypothesis for derivative contracts in U.S. banking industry. In addition to the Capital Asset Pricing Model (CAPM) measure of systematic risk and standard deviation of a bank’s equity return, we apply Ronn-Verma option pricing model to assess whether market participants incorporate derivatives positions when they price banks’ market risk. The benefit of using the contingent claim model is that the traditional linear models seem to be inadequate in estimating the non-linear relation between derivatives and bank risks. In order to capture the differences in marginal propensity to risk (MPR) across banks, we divide our bank holding company (BHC) sample into three groups: big, medium, and small. The conclusions are as follows. First, among the derivatives contracts, swaps are the major contracts that are incorporated in market risk valuation. They are viewed as risk reducing tools according to the three risk measures (Beta, equity return risk, and implied asset volatilities) for both big and medium BHCs. Second, futures, forwards, and options do not seem to have a major effect in valuation of bank market risk for all the three BHCs groups. However, we find a significant positive relationship between these three types of derivatives and market systematic risk (Beta). Third, generally, market participants view swaps positions as more of potential risk diversification tools. Fourth, small BHCs have the highest MPR while big banks have the lowest MPR. Finally, more capital and regulations on bank derivatives activities are required to minimize the impact of derivatives on banks’ market risk.