The Role of Derivatives in Risk Management

Since the early 1980s, the number of banks operating in the US has declined by nearly two-thirds, from approximately 18,000 banks and thrifts at the beginning of 1984 to slightly more than 6,000 financial institutions at the end of 2015.

The driver of market consolidation during the 1980s and 1990s was the relaxation of longstanding prohibitions on interstate banking, and it was during this period that today’s global banks (those with assets of more than $1 trillion) grew rapidly through serial mergers and acquisitions. In 1999, the Gramm-Leach-Bliley Financial Modernization Act (Gramm-Leach-Bliley) repealed the provisions of the Glass-Steagall Act that separated the banking and securities industries, paving the way for many of the top-tier US banks to grow by extending their traditional banking business into the investment banking and securities businesses.

In the wake of the global financial crisis of 2007, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) in 2010 has had a sizable impact on the way banks manage financial risk and ensure continued regulatory compliance. Dodd-Frank introduced regulatory compliance requirements based on a bank’s asset size.

The net result of the past 30 years of bank merger and acquisition activity has been market share consolidation — today, the four largest US banks hold aggregate assets equal to the largest 100 banks in 1984. As impactful as bank consolidation has been to the largest banks, since the 2007 banking crisis there has been a heightened appreciation at all levels of the banking hierarchy of the importance of regulatory compliance and financial risk management.

For the purposes of studying the use of derivatives by US banks, we have divided the banks into five tiers based on their asset size at year-end 2015 (Table 1). As we will see later in this paper, these asset-based bank tiers are correlated with varying levels of use of derivatives.

Source: FDIC SRI, Celent

Tier 1 banks are the four US-based global banks with assets greater than $1 trillion at YE 2015:  JP Morgan Chase ($1.9 trillion), Bank of America and Wells Fargo (each with $1.6 trillion), and Citibank ($1.3 trillion). While these global banks each has a large retail banking franchise, they also maintain sizable investment banking and securities businesses that were built organically or via acquisition since the merger of Citibank with The Travelers Group and the subsequent introduction of Gramm-Leach-Bliley in the late 1990s. As we will see later in this paper, the use of derivatives among the global banks is extensive.

Tier 2 banks are the 22 superregional banks with assets of between $100 billion and $1 trillion as of YE 2015. The retail footprint of the superregional banks is much less extensive than that of the global banks, but like the global banks, capital markets and securities are important contributors to their long-term success.

Competing below the superregional banks are the 50 regional banks with assets between $20 billion and $100 billion. Due to significant variations in the patterns of use of derivatives between regional banks of various sizes, we sub-classified the regional banks into 15 Tier 3 large regional banks (assets between $50 and $100 billion) and 35 Tier 4 small regional banks (assets between $20 and $50 billion).

Tier 5 community banks have traditionally been the backbone of retail banking, taking retail deposits and converting them into residential mortgages and other retail-based lending products. Nearly 90% of community banks by number are those with assets of $1 billion and below; however, these smaller banks make virtually no use of derivatives and rather manage rate risk through careful asset/liability management practices. As a result, this analysis will focus only on the 32 Tier 5 large community banks with assets between $10 billion and $20 billion.

According to the FDIC-compiled statistics on the US banking industry, the notional value of derivatives reached $181.9 billion in 2015 and has averaged in excess of $218 trillion for the past five years. Included in these figures are derivatives swaps, futures, forwards, and options that are valued based on underlying changes in interest rates, foreign exchange rates, and commodity and equity prices. 

This is somewhat of a remarkable figure in that the aggregate assets of all 6,191 FDIC-insured banks in 2015 were $16.1 trillion, meaning that the notional value of derivatives in use within the banking industry was more than 10 times the direct assets deployed by the entire industry. While the notional value of a bank’s derivatives portfolio is not reflected directly on its balance sheet (only the fair value of the expected gains or losses of the portfolio is), notional value can be used to compare patterns between banks operating in different asset tiers and/or patterns between categories of derivatives.

Table 2 shows the pattern of use of derivatives by banks varies widely by bank tier, with Tier 1 global banks representing nearly three-quarters of derivatives use among US banks, Tier 2 banks representing more than one-quarter of derivatives use, and Tier-3, Tier 4, and Tier 5 banks showing negligible use of derivatives relative to their large competitors.

Source: FDIC Statistics on Depository Institutions / Celent

As Table 2 shows, the median value for derivatives use in relation to bank assets is 2,133.1%, meaning that the notional value of a Tier 1 bank’s derivatives portfolio is more than 21 times that of bank assets; this compares with an equivalent figure of 56.9% for Tier 2 superregional banks, which suggests that the use of derivatives by global banks is roughly 40 times that of the superregionals.

Viewing the average use of derivatives by banks within each tier (last column of Table 2) results in the conclusion that the use of derivatives between Tier 1 and Tier 2 banks is more comparable, with the average notional value of derivatives to bank assets by Tier 1 banks at 20.1X versus 12.8X for Tier 2 banks.  A significant drop off in the usage of derivatives comes at the Tier 3 large regional level, with an average value of 21.8% of assets, and this drop off extends into Tier 4 and Tier 5 banks (16.1% and 16.7% of average assets respectively).

The nature of these figures suggests that within bank tiers, the behavior of individual banks in relation to the use of derivatives can vary widely, and this is particularly the case with Tier 2 banks, where individual banks can vary widely in terms of geographic scope and business strategy. To illustrate, the median value for the ratio of the notional value of derivatives to total assets for Tier 2 banks is 56.9%, a figure that masks the outsized use of derivatives by Bank of New York Mellon (351.0%), HSBC Bank USA (2,297.6%), and Goldman Sachs Bank USA (30,475.7%).

While the global banks maintaining an outsized international capital markets business show some diversification in the use of derivatives, in Tier 2 through Tier 4, the most important use of derivatives at US banks is to manage interest rate risk (see Table 3).  At Tier 2 banks, rate-based derivatives represented a median value of 83.5% of the total derivatives portfolio, and the importance of rate-based derivatives jumps in Tiers 3 through 5, to a maximum level of 99.7% of total derivatives in Tier 5.

Source: FDIC SRI / Celent

As befitting their international footprint, the Tier 1 banks make significant use of foreign exchange rate-based derivatives, with 20% of the global bank’s derivatives portfolio derived from Forex-based contracts in 2015.  Not surprisingly, the importance of the Forex component of derivatives falls off sharply as we traverse the bank asset tiers, with Tier 2 banks showing a level of only 9.0% of Forex-based derivatives in their overall portfolio, and falling off sharply from there to Tier 3, Tier 4, and Tier 5 banks.

Bank consolidation has taken place in the US since the early 1980s, but in the past 10 years there has been a more sobering driver of bank mergers:  the increased cost and complexity of maintaining compliance with the bank regulations that have been introduced since 2010. As a result of the increasing cost of bank compliance, smaller community banks have been selling to larger and better capitalized mid-tier banks, and as a result the top 100 banks hold more than 80% of the banking industry’s assets. In fact, the four Tier 1 banks today hold aggregate assets equal to what the largest 100 banks held in 1984.

In this environment, managing financial risk is imperative to maintain the health and integrity of the industry, and for banks of any size the management of interest rate-based risk is an important component of overall risk management strategy. Despite this imperative, the use of derivatives in general and rate-based derivatives in particular varies greatly by bank asset tier. Specifically, there is a significant dropoff in the use of derivatives below the Tier 1 global and Tier 2 superregional banks: whereas superregional banks on average carry a derivatives portfolio (based on notional value) that is 12.8 times larger than their assets, Tier 3 large regional banks carry a portfolio equal to only 21.8% of average assets.

Part Two of this three-part series will examine the correlation between bank performance and the use of derivatives to manage financial risk and will take a closer look at the types of interest rate-based derivatives used by US banks. Part Three 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.

Celent, a division of Oliver Wyman, Inc.

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