Derivatives trading activities slightly lowered the earnings and value of bank holding companies (BHCs) actively trading derivatives during the last decade (2001–2011), except for those BHCs that are designated derivatives dealers (dealer banks).
A number of bank holding companies (BHCs) have increased derivatives trading activities over the past decade, but earnings from those activities have been very volatile, which has resulted in little incremental impact on valuation (as measured by Tobin’s q, a market-to-book value measure). In particular, during the 2007–09 financial crisis, most of the BHCs in the study experienced aggregate derivatives trading losses. Most of the trading has been concentrated in a small number of firms. Among those firms, dealer banks (i.e., designated derivatives dealers) tend to be larger banks, and their trading earnings volatility is significantly lower than for nondealer banks.
How Is This Research Useful to Practitioners?
The authors state that some believe derivatives trading has become a potential source of bank charter value. Their study provides some evidence to the contrary and supports the notion that derivatives trading activity by banks has been driven by profit rather than for hedging purposes.
The variable of interest is the impact of derivatives trading income on charter value (as proxied by Tobin’s q). Overall, the impact is slightly negative, but the findings are not statistically significant. Once a flag is included to identify designated derivatives dealers, two things change: The overall impact becomes statistically significant and the impact just for derivatives dealers becomes positive and statistically significant.
Stratifying the BHCs in the study into quartiles of Tobin’s q reveals some differences between the highest and lowest quartiles. The largest differences are in the amount of trading derivatives (the lowest quartile of Tobin’s q has the highest value of trading derivatives, indicating a negative relationship). Unfortunately, none of the quartile results are statistically significant.
The findings reverse in a robustness check that uses the ratio of core deposits to total deposits instead of Tobin’s q as the dependent variable. The authors believe that the reversal is because of the general downward trend in Tobin’s q for those banks compared with the sharp increase in core deposits since 2007.
How Did the Authors Conduct This Research?
The motivation for the study comes partly from the growth in derivatives trading by banks coupled with the significant losses experienced during the financial crisis. Attention from regulators, media, and investors has also drawn notice to derivatives trading.
The authors’ main questions revolve around bank charter value and the impact of derivatives trading income on it. The authors determine a scaled relationship between Tobin’s q and bank charter value, and then they measure Tobin’s q using stock market data for publicly traded BHCs.
The BHCs in the study are identified from a list of the top 50 BHCs reported by the Federal Financial Institutions Examination Council (FFIEC), which results in 18 publicly traded BHCs with large derivatives activity. An additional 9 are found by relaxing the “top 50” criterion, which creates a final sample of 27 BHCs.
Financial statements and details on derivatives trading are analyzed for the first quarter of 2001 through the third quarter of 2011. The authors believe this time period represents a full cycle from economic expansion (the housing bubble) to bust and financial crisis, all while the bank industry concentration in derivatives trading remained high.
Ultimately, the findings are not very strong. Derivatives trading does not appear to affect charter value much at all. Given that derivatives dealers would have significantly more volume in trading derivatives than individual banks engaging in trading, and that they would also commit more resources to managing the risks of such positions, it is not surprising that the dealer designation slightly improves charter value. The other banks that are speculating are essentially playing against the house (the dealer banks), and as the saying goes, in the long run, the house always wins.