Do financial derivatives make banks sounder? – Evidence from eleven developed markets

This paper seeks to answer the question concerning to what extent the use of financial derivatives makes banks sounder. We carry out this investigation by examining the relationship between equity risk and the use of financial derivatives using a sample of 613 banks from eleven developed markets from 2005 to 2014. The main result of the analysis suggests that banks’ overall equity risk increases when they use derivatives. A fixed effects model that this relationship is nonlinear in nature, as we find that 184 banks reduce risk and 245 banks assume additional risk by using derivatives. A comparison between the highest realized risk-reducing portfolio and the highest realized risk-increasing portfolio suggests that the banks featured in our study achieved better results in reducing risk than they did in increasing risk by using derivatives. A key implication of our findings is that the ability of capital adequacy to discipline bank behavior is limited, as banks can use financial reporting discretion to circumvent capital adequacy requirements and assume additional risk. We call for new rules on derivatives and the reconciliation between accounting and prudential regulation, as the widely applied capital adequacy regulation appears to be insufficient in addressing the issue of risk.