Alligators in the Swamp: The Impact of Derivatives on the Financial Performance of Depository Institutions

Abstract

It has been argued that underpriced federal deposit insurance provides incentives for insured institutions to increase the value of shareholder equity by expanding into activities that shift risk onto the deposit insurer. Derivative instruments have been used by firms to change their risk exposure. Permitting firms with substantial moral hazard incentives to utilize interest-rate derivative instruments could lead to higher rather than lower exposure to risk. This article, using a sample of savings and loan associations (S&Ls), examines the proposition that involvement with interest-rate derivative instruments increases depository institutions' risk. We find that there is a negative correlation between risk and derivatives usage. In addition, S&Ls that used derivatives experienced relatively greater growth in their fixed-rate mortgage portfolios.

JEL Classification: G21, G28, G11