Derivatives and Bank Performance

  • 14 Jul 2016
  • By James M. ONeill
  • Topics: Credit

Introduction

This is the second of a three-part series of papers aimed at examining patterns of use of rate-based derivatives at US banks, determining how the more active utilization of derivatives to manage risk has made an impact on bank performance, and finally the role that derivatives will play in the future as an instrument for risk management for US banks. 

Since the 2007 financial crisis, the financial benefit of scale has largely disappeared and financial performance of large and small banks have largely converged.This paper will review the use of rate-based derivatives by US banks and examine the correlation between the use of such derivatives and the overall financial performance of banks. All of the data presented in this paper is based on the statistics published by the Federal Deposit Insurance Corporation (FDIC) in its quarterly Statistics on Depository Institutions (SDI).

As was established in the first report, patterns in the use of derivatives (based on the notional value of the underlying instruments) can be found in reference to the asset tier of the bank as summarized in Table 1. 

Table 1: Classification of US Banks by Asset Size (YE 2015)

Tier Classification (# Banks)  Asset Size Total Derivatives
Tier 1 Global (4) $1 trillion and above $129.8 trillion
Tier 2 Superregional (22) $100 billion to $1 trillion $51.6 trillion
Tier 3 Large Regional (15) $50 to $100 billion $229.9 billion
Tier 4 Small Regional (35) $20 to $50 billion $166.3 billion
Tier 5 Large Community (32) $10 to $20 billion $80.2 billion

Source: FDIC SRI / Celent

The primary driver of use of derivatives by banks across all asset tiers is to manage interest rate-based risk, although for the global Tier 1 and superregional Tier 2 banks, managing foreign exchange rate is also an important use case for derivatives. 

Relationship with Financial Performance

In the wake of increased regulations and compliance obligations on the part of banks since the 2007 financial crisis, the financial benefit of scale has largely disappeared and financial performance of large and small banks have largely converged. Figure 1 depicts these factors at work and shows the resulting convergence of returns on equity for the shareholders of banks. 

The drivers of this convergence of banks large and small have been the lower yields on assets that have resulted from a continued low-rate environment for lending and the deleveraging of large banks that resulted from a post-crisis emphasis on financial stability. As a result, the return to shareholders across bank tiers has both declined considerably (from more than 25% in the mid-2000s to less than 10% today) and has converged within bank tiers. 

Figure 1: Convergence of Bank Financial Performance, 2006–2015

Source: Oliver Wyman

Table 2 focuses on the current dynamics of bank performance and makes it clearer how global Tier 1 and superregional Tier 2 banks generally reclaimed their edge in financial performance during 2015. The second column shows that the net lending spread on the lending portfolio of the Tier 1 and Tier 2 banks (measured by the Net Interest Margin divided by Total Loans and Leases) enjoys a clear advantage over that of Tier 3 and Tier 4 banks, with a lending spread advantage ranging from 20 to 40 basis points. 

Table 2: Key Indicators of Bank Performance by Bank Size (2015)

Tier NIM/ Loans & Leases Trading Profit/ Pre-Tax Income ROAA TL/SE ROE
Tier 1 (Global) 4.8% 16.7% 1.09% 8.5x 9.29%
Tier 2 (Superregional) 4.9% 1.8% 0.93% 8.6x 8.03%
Tier 3 (Large Regional) 4.4% 1.3% 0.96% 9.4x 9.44%
Tier 4 (Small Regional) 4.7% 0.0% 0.92% 8.0x 7.31%
Tier 5 (Large Community) 4.6% 0.0% 1.01% 8.1x 8.24%

Source: FDIC SRI / Celent

While unfortunately the FDIC data is not granular enough for direct observations to be made in regard to the composition of banks’ lending portfolios, it is apparent that based on their high usage of rate-based derivatives — more than $170 trillion for Tier 1 and Tier 2 banks versus less than $500 billion for Tier 3, Tier 4, and Tier 5 banks combined — has allowed the larger banks to provide a larger and more profitable suite of loan products than their smaller competitors.

The use of rate-based derivatives allows banks to convert their variable rate funding base of retail deposits into fixed rate funds of varying maturities; Tier 1 and Tier 2 banks have A Banker’s Guide to Derivatives 3 been able to offer their commercial clients both floating-rate and fixed-rate lending facilities of varying terms and maturities.

In the case of the Tier 1 banks, the additional profit contribution coming from trading activities (including trading in the types of derivatives that is the subject of this paper) have served to augment its advantage in return on assets over their smaller rivals, with trading activities contributing nearly 20% of their pre-tax operating income in 2015. While Tier 3 banks demonstrated an advantage in return on shareholder equity during 2015 over all other bank tiers, Table 3 demonstrates that this advantage was built on higher leverage (total liabilities to shareholders equity of 9.4X for Tier 3 banks versus 8.5X for Tier 1 banks).

Use of Rate-Based Derivatives by Banks

At year-end 2015, rate-based derivatives (RBD) represented a median value of 72.3% of the total derivatives portfolio of Tier 1 banks, with foreign exchange rate derivatives also an important part of the Tier 1 bank derivatives strategy at a median 20.0% of their total derivatives portfolio. Traversing down the bank asset tiers, RBDs become increasingly dominant in the bank’s overall derivatives portfolio, beginning at a median value of 83.5% for Tier 2 superregional banks and peaking at a median value of 99.7% for Tier 5 large community banks.

Within the RBD portfolio of US banks, another line of separation is visible between Tier 1 and Tier 2 banks and the rest of the industry (Table 3). Interest rate swaps have traditionally been the workhorse of financial risk management by US banks and are still the primary vehicle used to manage rate risk at banks of all sizes. Among Tier 1 banks, swaps represent about two-thirds of their RBD portfolio, and this share continues to grow as the asset tiers are traversed, reaching 90.8% share for Tier 3 banks before settling down to 87.0% share for Tier 5 banks.

Table 3: Composition of Rate-Based Derivatives by Type of Instrument (2015)

  Composition of RBD Portfolio
Tier Total RBD % Total RBD Swaps Futures/ Forwards Options
Tier 1 (Global) $938.5 billion 72.3% 67.9% 14.1% 14.0%
Tier 2 (Superregional) $43.1 billion 83.5% 72.1% 8.7% 6.8%
Tier 3 (Large Regional) $203.7 billion 88.6% 90.8% 2.0% 4.4%
Tier 4 (Small Regional) $160.0 billion 96.2% 87.4% 1.4% 5.3%
Tier 5 (Large Community) $80.0 billion 99.7% 87.0% 2.0% 1.4%

Source: FDIC SRI / Celent

Conversely, the use of alternative instruments including interest rate futures, forwards, and options is found more at the Tier 1 bank level and drops off as the smaller asset tiers are traversed. Whereas 28.1% of the derivatives portfolio of Tier 1 banks is composed of futures, forwards, and options (divided equally between futures/forwards and options), this falls off to only 15.5% for Tier 2 superregional banks, 6.4% for Tier 3 large regional banks, and a negligible 3.4% for Tier 5 large community banks.

Reliance on Swaps

The falloff in use of alternative instruments to manage interest rate-based risk is most pronounced in the area of futures and forwards; for example, while the composition of interest rate-based options in the Tier 4 small community banks’ overall RBD portfolio is 5.3%, comparable with the 6.8% that exists in the Tier 2 superregional banks’ RBD portfolio, the use of futures and forwards at Tier 4 banks is only 1.4% of RBD compared with the 14.1% seen at Tier 1 banks and the 8.7% seen at Tier 2 banks.

Given the apparent advantages on utilizing interest rate futures as a component of a bank’s interest rate management strategy, why have smaller banks in Tier 3 through Tier 5 traditionally relied so heavily on a traditional swap-based approach to managing interest rate risk? It is very likely that the lack of in-house skills and training in the use of advanced derivatives like interest rate futures within smaller banks has resulted in the reluctance of these banks to use these instruments as part of their rate-risk management strategy. 

Unlike traditional over-the-counter swaps that can be tailored to the specific instrument for which a hedge is being constructed, exchange-traded futures are based on a set of standardized product parameters that include the rate basis, the tenor, and the settlement period(s) of the specific product (Figure 2). Additional complications arise when the underlying instrument for which the hedge is being constructed — for example a fixed-rate corporate loan — is subject to early repayment by the bank’s client, resulting in the need for the bank to close out the futures contract(s) that were used to construct the rate hedge.

Figure 2: Overview of CBOT Treasury Futures Contracts

TIER 2-YR Note Futures 5-YR Note Futures 10-YR Note Futures T-Bond Futures Ultra T-Bond Futures
Face Amount $200,000 $100,000 $100,000 $100,000 $100,000
Maturities 1 ¾ to 2 yrs. 4 1/6 to 5 ¼ yrs. 6 ½ to 10 yrs. 15 to 25 yrs. 25 to 30 yrs.
Contract Months Quarterly cycle in March, June, September, and December

Source: CBOT

In many cases, a bank can hedge a single fixed-rate corporate loan with a single rate swap, and in fact the availability of fixed-rate loans has traditionally been linked to the existence of companion OTC swaps in the market. In contrast, the use of futures can require the bank’s treasury staff to model the expected cash flows arising from the corporate loan and align these cash flows with a series of futures contracts that can serve to hedge the underlying risk of the loan.

Many smaller banks lack the expertise needed to properly construct futures-based hedges that are effective in protecting the bank from the financial risk of their fixed-rate loan portfolio to changes in short-term interest rates, and as a result they default to using OTC swaps as their primary (and in some cases exclusive) vehicle for management rate risk.

The apparent overreliance by Tier 3, Tier 4, and Tier 5 banks on swaps as the primary instrument to manage interest rate risk is interesting in that futures and options are exchange-traded instruments, with the exchange effectively guaranteeing settlement of the contract by maintaining daily accounting of the transaction and in appropriate circumstances requiring additional capital to be added to a party’s margin account.

In contrast, interest rate swaps are not exchange-traded but rather are over-the-counter agreements between individual companies, dealers, or service providers. While the counterparties to OTC swaps are generally signatories to a master swaps contract that conforms with International Swaps and Derivatives Association (ISDA) standards, the use of OTC swaps by Tier 3 and smaller banks subjects them to increased regulatory compliance (including Dodd-Frank) and the possibility of counterparty risk.

As a result of this dynamic, the heavy reliance of Tier 3, Tier 4, and Tier 5 banks to OTC swaps as their primary tool of managing interest rate risk may have unintended consequences in that counterparty risk for some banks may have increased even as direct interest rate risk has declined. As the financial crisis of 2007 clearly demonstrated, counterparty risk (in this case, the risk of a party defaulting on a hedging transaction) is an issue that all banks and corporates must actively measure and manage in order to ensure that the hedging transactions put in place to protect the bank from IRR are honored by the counterparties to these transaction.

By shifting some of the responsibility for hedging from traditional swaps to exchangetraded products including futures and options, banks can additionally benefit from the enhanced liquidity and financial transparency that these instruments offer the bank throughout the life of the hedging transaction.

The effective management of compliance and counterparty risk forms part of the treasurer’s overall risk management strategy and is discussed in Part 3 of this series.

Summary

As the data presented in this report suggests, the Tier 1 and Tier 2 banks that make active use of financial derivatives benefit in two different ways: first, these banks benefit from a measurable 20 to 40 basis point advantage in their lending spread (as measured by the net interest margin earned from their total lending portfolio); and second, derivatives trading plays a significant role in generating pretax income, especially at Tier 1 banks. The advantages enjoyed by the larger banks are derived in part from the use of a wide range of derivatives, including swaps, forwards, futures, and options.

Below the level of the global and superregional banks, the smaller banks make much less use of derivatives, and those that do are focused almost exclusively on rate-based derivatives, primarily through the use of traditional OTC interest rate swaps. It is likely that the low usage of exchange-traded interest rate-based futures and options by the Tier 3 and Tier 4 regional banks is based on a lack of in-house expertise and training on the part of these banks. 

This lack of expertise coupled with the familiarity of the OTC swaps market has resulted in an overrepresentation of traditional swaps in the regional banks’ derivatives portfolio, and raises the question of whether counterparty risk could be more actively managed by increased diversification by the regional banks into other exchange-traded instruments for managing rate risk.

The final installment of this three-part series on the use of derivatives by banks will illustrate through a use case how interest rate futures can be used to manage interest rate risk, and will go on to assess the role that derivatives will play in the future as an instrument for effective risk management by US banks.

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About the Author

James M. O’Neill is a senior analysis on the Celent banking team. He specializes in retail banking: core banking systems, corporate banking: treasury management systems, and cloud services: horizontal coverage across banking applications.

Prior to joining Celent, James spent five years at North Goodwin Advisors LLC. in IT advisory services, 10 years at FIS/Metavante Corporation in Fintech outsourcing services, and five years at DBG Development Capital LTD. in private equity.

James received his professional master’s degree at the University of Illinois at Urbana-Champaign, and earned his MBA at Harvard Business School.

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