Derivative use and its impact on Systematic Risk of Indian Banks: Evidence using Tobit model

The use of derivatives by Indian banks has increased in the recent past. Derivatives are complicated assets, and many characteristics of these relatively new assets have been evolving day by day. The fast growth of bank involvement in derivative markets has raised concerns about the potential hazards of this activity. On the flipside, certain characteristics of derivatives make them highly useful in hedging risks. It is a well-known fact that derivative activity is concentrated among relatively larger banks. However, very little is known about other factors that govern the decisions regarding derivative usage by banks. In theory, an exposure of bank to interest rate risk should impact the derivative transaction volume. Furthermore, the use of derivative will vary according to bank capital, bank size and its use of alternatives to hedge. The paper uses the financial characteristics of banks those trade in derivatives and banks those do not trade in derivatives , by using bank level data for 46 Indian Scheduled Commercial banks for the year 2013. A Tobit Model is used to analyse censored data on notional amount of derivative use and its relationship with various financial characteristics of banks. These financial characteristics include bank size, capital adequacy, exposure to credit and interest rate risk, profitability and liquidity. We find that derivative user banks have higher liquidity, lower interest margins, are larger. Additionally, there is evidence in support of the “assurance” capital hypothesis highlighting the use of derivatives by large well capitalised banks. The larger banks exposed with lower interest margins and higher capital ratios are more likely to use derivatives to hedge their interest rate risk. Using an augmented market model, we further calculate systematic risk exposure of banks for the year 2013 and test whether usage of derivatives and interest rate derivatives contribute towards an aggravation in the systematic risk exposure of banks. The results point towards a significant decrease in exchange rate riskiness using derivatives as well as a significant decline in the long term interest risk as well. It implies and motivates banks to indulge in derivative trading, as the systemic risk do not seem to be potentially aggravated by using them. Nevertheless, derivative activity is concentrated among well capitalised banks which can safely manage risks.