Winners and losers from financial derivatives use: evidence from community banks

ABSTRACT

This article provides empirical evidence on how profitability of small community banks was affected by derivatives use before and after the 2008 crisis. We use an endogenous switching regressions model to estimate the sensitivity of bank profitability to risks and control for the endogenous choice to use or not to use derivatives. We then compute counterfactual effects and show how profitability would have looked without derivatives use for banks that used derivatives and how it would have looked with derivatives for banks that did not use derivatives. The results show that derivatives helped reduce the sensitivity of profitability to credit risks and improved profitability for most specialists. However, for the largest number of banks which are non-user non-specialists, devivates use would have resulted in lower return on assets had they used derivatives post 2008. Therefore, our evidence suggests that implementation of the Volcker Rule, imposing high compliance costs on community banks and, thus, discouraging hedging, may have a negative impact on profits of specialists banks but, overall, a neutral effect on profits in the community banks industry as a whole.

KEYWORDS:

• Community banks
• financial derivatives
• financial crisis

JEL CLASSIFICATION:

• G21
• G01
• G28

Disclosure statement

No potential conflict of interest was reported by the authors.This article was supported in part by the Alabama Agricultural Experiment Station and the Hatch program of the National Institute of Food and Agriculture, U.S. Department of Agriculture

Notes

¹ The SD of banks’ profitability is another possible measure especially because derivatives are designed to balance future cash flow and thus reduce the variation in profitability. Reliable SD calculation requires a relative large sample or longer period and the data points available for the post-crisis period to calculate SD are limited in size. Most importantly, in such setting, dynamic changes in banks’ business strategy, management, capital structure, among others, cannot be appropriately controlled for. Therefore, we use ROA to measure the actual profitability, rather than its variation.

² Appendix includes detailed classification criteria of lending specialty groups used in this research. The performance of C&I specialists and consumer specialists is not analysed because the first-step probit regressions did not converge for these two groups and prevent us from correcting sample selections.