July 1995
Federal Reserve Bank of Dallas

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Who's Capitalizing on Derivatives?
Jeffery W. Gunther and Thomas F. Siems

Are banks using derivatives to hedge financial risks or to make speculative gambles? While data are not available to answer this question fully and directly, the relationship between bank capital and derivatives activities may provide an important clue. This study provides evidence that those banks with the highest capital cushion with which to absorb losses and potentially the lowest risk-taking incentives are the ones with the highest derivatives participation. This finding is consistent with the view that either financially strong institutions are using derivatives to hedge, or regulatory and market discipline have made higher capital levels a prerequisite for derivatives activities. Either way, a positive relationship between derivatives activities and capitalization should help ease concerns regarding bank derivatives activities.

Interesting Times for Banks Since Basle
Kenneth J. Robinson

Unanticipated increases in interest rates are often viewed as harmful to banks. This assumption arises partly from the fact that banks are frequently viewed as institutions that borrow short and lend long. Because the implementation of the Basle risk-based capital standards did not include a capital charge for interest-rate risk, banks may have been encouraged to substitute interest-rate risk for credit risk in their portfolios. Here, two approaches are used to estimate whether interest-rate risk at banks has increased significantly since the implementation of risk-based capital standards. One method relies on bank stock price data to judge the effects of interest-rate increases on banks' market value, while the other approach uses bank accounting data to infer long-run effects of interest-rate movements on bank profitability. Overall, the results provide some evidence that interest-rate risk is higher after the Basle capital standards took effect.