Financial Derivatives and Bank Performance

Abstract

Recent financial regulation changes have brought many challenges to community banks. In particular, the Volcker Rule, section 619 of the Dodd-Frank Financial Reform Act of 2010, prohibits banks from engaging in proprietary trading in derivatives. Banning proprietary trading has the potential to deter smaller banks, especially community banks, from using permissible risk management derivatives. This dissertation provides empirical evidence on how profitability and riskiness at banks would be affected when derivative activities are restricted under the requirement of the Volcker Rule. The focus is on community banks, and specifically agricultural banks, which are small, relatively new to the derivatives market, and thus more vulnerable to inappropriate derivative activities. Chapter 2 explores how profitability and its variability in agricultural banks are affected by the volume of derivative activities by product – swap, option and future. The effects of derivatives on agricultural banks are also compared to those on non-agricultural banks. Chapter 3 analyzes the effects of derivatives on profitability of agricultural banks before, during and after the 2008 financial crisis by constructing a counterfactual analysis through the endogenous switching model. Chapter 4 extends the analysis to community banks by the lending specialty, and the endogenous switching model is modified to use panel data. All the three chapters find evidence contrary to the ideas in the Volker Rule– community banks benefit from, rather than are hurt by, derivative activities in terms of improvement in profitability and reduction in profitability variability.