Abstract
In a sample of 335 commercial banks, we do not detect a systematic effect on bank values from derivatives use in either the high growth period of 2003–2005 or the low growth period of 2007–2009. These findings apply to all types of derivatives including credit default swaps. Our results suggest that banks take a more balanced approach and restrict their derivative activities to providing derivative services for customers and risk management. We also find that the market disciplined banks significantly for taking TARP funds, indicating that receiving TARP funds was a signal that the banks were financially distressed. Lastly, we cannot discern valuation effects resulting from derivatives use even in large and poorly capitalized banks that are more likely to take risk-shifting opportunities. Collectively, we find no compelling evidence supporting the widespread allegation that derivatives use increased banks’ speculating behaviors and significantly contributed to the loss of value during the subprime mortgage crisis.
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Notes
This view implicitly assumes that either default risk remains constant, or that stockholders believe the market will respond favorably to the higher risk. The latter seems implausible in competitive markets.
See Strunk and Case (1988) for a long list of factors that also contributed to the thrift failures. Key issues were the legal limits on interest paid on deposits by Savings and Loans and their undiversified portfolios of long term mortgages which had been mandated by law, in conjunction with rapidly rising interest rates caused by inflation.
Smith and Stulz (1985) argue that hedging reduces the probability of incurring bankruptcy costs and therefore benefits shareholders. The transaction costs of financial distress can stem from direct bankruptcy costs such as legal fees and accounting expenses in the bankruptcy or indirect bankruptcy costs like business disruption and loss of reputation. To the extent that corporate risk management reduces the likelihood of financial distress, it can add value. Froot, Scharfstein, and Stein (1993) also propose that costly access to external financing makes corporate hedging a value-enhancing strategy. When external financing is sufficiently expensive and internally generated cash flows are not sufficient to fund growth opportunities, the underinvestment problem arises. Moreover, Leland (1998) and Graham and Rogers (2002) show that firms’ use of derivatives can increase debt capacity and interest deductions by lowering the volatility of earnings.
Stated differently, do banks have different production activities and thus use derivatives, or is the use of derivatives the only difference between the banks?
Another specification is to include interaction terms of the hedging dummy variable with other cross sectional variables. When we attempted the interactions, there was severe multicollinearity and these variables had to be dropped from the regressions.
Note that riskier banks as indicated by receiving TARP funds would have future cash-flows discounted at a higher rate, and therefore their prices would fall, creating negative returns.
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Cyree, K.B., Huang, P. & Lindley, J.T. The Economic Consequences of Banks’ Derivatives Use in Good Times and Bad Times. J Financ Serv Res 41, 121–144 (2012). https://doi.org/10.1007/s10693-011-0106-y
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DOI: https://doi.org/10.1007/s10693-011-0106-y