<i>CFA Institute Journal Review</i> summarizes "Risk Management in Financial Institutions," by Adriano A. Rampini, S. Viswanathan, and Guillaume Vuillemey, published in <i>The Journal of Finance</i>, April 2020.
The net worth of a financial institution significantly influences its ability to hedge interest and foreign exchange rate risk. Over time, US financial institutions with higher net worth hedge to a greater extent than those with lower net worth, and institutions with diminished net worth reduce hedging.
What Is the Investment Issue?
Hedging policies can mitigate downside risk and improve future financial performance, yet many financial institutions do not hedge. Previous studies demonstrate that institutions that hedge are larger, contrary to a 1993 study that suggests financially constrained institutions would want to hedge more. The authors in earlier studies explain that hedging requires collateral, and financially constrained institutions lack the resources to both lend and hedge the interest rate risks inherent in their loan portfolios and deposit bases. The authors note that the interest rate risk on deposits is low.
To illustrate this, the authors establish that the level of and change in net worth, rather than size, determine the extent to which financial institutions hedge interest and exchange rate risks. Across institutions, those institutions with higher net worth hedge both types of risks more often.
Within institutions, hedging is reduced when net worth declines. This observation is derived from studying the bursting of the housing bubble in 2009, when financial institutions experienced huge loan losses and many failed. The authors also show that institutions with higher levels of real estate exposure at that time reduced both types of hedging significantly more than those with less real estate exposure.
How Did the Authors Conduct This Research?
The authors study quarterly data on US bank holding companies for the period from 1995 to 2013, including approximately 22,723 observations, with balance sheet and derivative information from Call Reports, market data from CRSP, Standard & Poor’s credit ratings data from Capital IQ, and mortgage origination data from the Home Mortgage Disclosure Act. Data for the six main derivative dealers are excluded, but results are still robust when included.
Interest rate and foreign exchange derivatives represent almost all the derivatives used by the financial institutions studied (94% and 5%, respectively, of the notional value of all derivatives).
The authors use a difference-in-differences estimation to show that hedging activity dropped by approximately one-half for institutions most affected by the real estate crisis. The year 2009 is used as the “treatment” year, and treated institutions experienced below-median mortgage-weighted-average local housing price changes. A triple-differences specification controls for lending opportunity differences and compares the treatment effects across terciles of institutions based on their real estate exposure. Treated institutions with higher real estate exposure reduced both interest rate and foreign exchange rate hedging by approximately one-half. Although their net worth differentially decreased, their risk exposures do not show differential change.
Net worth includes access to unused credit lines and assets available as collateral for hedging. Size, market capitalization, net income, and dividends are positively correlated with net worth.
To account for size variation not connected to net worth, the authors scale relevant variables by total assets.
The change in the level of hedging cannot be explained by reduced lending, changes in the interest rate environment, sophistication level, the fixed costs of hedging, or risk shifting, because derivative trading is reduced at the same time.
What Are the Findings and Implications for Investors and Investment Professionals?
Regulatory capital for financial institutions is a major consideration for assessing risk absorption capacity. The authors conclude that regulatory capital does not drive hedging policy. An important implication for investors to consider, then, is how the risk absorption capacity of even highly capitalized institutions may change with potential fluctuations in net worth. A reduction in risk absorption capacity can have significant implications for profitability going forward, given exposed downward risk.
Financial institutions divide resources between lending operations and risk management. Therefore, the balance sheet size may be intact or growing, but because of reductions in hedging, risk could be increasing at the same time.
This quantitative study is useful to researchers, and policymakers may use it to better understand the interest and exchange rate hedging behavior of financial institutions.