Journal of Financial Services Research 10:131-141 (1996) © 1996 Kluwer Academic Publishers

Characteristics of Banks That Are More Active in the Swap Market

JULAPA JAGTIANI Baruch College, City University of New York

Abstract

The impact of swap-related risks on the safety and soundness of the banking system has been a topic of concern. This article provides evidence that some banks mayhave engaged in swaps as a means to generate incomewhen their loan activities were constrained by the fixed capital requirements. However, the results also suggest that creditworthiness plays an important role. All money center banks (too-big-to-fail) and those nonmoney center banks that are highly rated by S&P experience higher swap demand and achieve higher swap market shares. This implies some market discipline for nonmoney center banks, which may compensate for risk-measurement inadequacies in the current risk-based capital requirements. On the other hand, the results suggest that greater oversight may be required for money center banks.

I. Introduction

Banks have played an important role in the development of the interest rate swap market from its inception in 1981 to its explosive growth to $6.5 trillion in 1993.1 The notional amount of swaps now exceeds the equity capital of many banks. 2 Losses from swap activities could potentially wipe out banks' capital and threaten the safety and soundness of the banking system. Yet, until December 1990, when the risk-based capital require- ments were implemented, banks were able to take on swap risks, and at the same time enjoy deposit insurance, without any regulatory oversight.

Not only did the regulatory system lack oversight, Pyle (1985) and Pavel and Phillis (1987) suggest that the fixed capital requirements (binding leverage constraint) in con- junction with the fiat-rate deposit insurance premiums indeed encouraged banks to resort to off-balance-sheet (OBS) activities for revenue growth. A bank whose leverage con- straint was binding was more likely to move its income-producing activities off its balance sheet, thus avoiding the purview of regulatory authorities while maintaining the benefits of deposit insurance.

The author is grateful to Warren Bailey, Robert Eisenbeis, Tony Saunders, Greg Udell, and two anonymous referees for their extensive comments and suggestions. She also thanks participants at the European Finance and FMA Conferences, Richard Levich, Ingo Walter, Gordon Sick, Dan Thonton, and Richard Woodward. This article was adapted from the dissertation the author completed at the Stern School of Business, New York University. Part of the work was completed while the author was an assistant professor at the School of Management, Syracuse University.

132 JULAPA JAGTIANI

If market discipline exists in the swap market, then market control could compensate for the lack of regulatory control. Such a market would penalize risky banks by reducing demand for their swap services. This would moderate risky swap activities at less credit- worthy banks, and therefore supplement the risk-based capital requirements in main- taining the safety and soundness of the banking system and limiting potential liabilities of the Bank Insurance Fund.

2. Research objective and motivation

This article's objective is to answer two empirical questions. First, did the fixed capital requirements provide banks with the incentive to increase swap activities to avoid com- mitting capital when their loan activities were constrained? Second, did market discipline exist in the swap market?

Several researchers have studied the impact of fixed capital requirements on a bank's decision to engage in OBS activities. Koppenhaver (1989) and Benveniste and Berger (1987) suggest that leverage constraints did not significantly impact a bank's decision to issue loan guarantees. In contrast, Pavel and Phillis (1987) suggest that the constraints were significant for loan securitization. Although interest rate swaps have been the fastest growing OBS product, no research has examined the impact of a bank's capital deficiency on its decision to participate in the swap market--the focus of this article.

As to the second question, the existence of market discipline for OBS activities has not been fully explored in earlier research. 3 Previous studies on market discipline for on- balance-sheet uninsured liabilities have also provided mixed results. 4 The empirical evi- dence presented in this article suggests that bank creditworthiness plays an important role in determining swap demand. That is, risky banks do not have complete freedom to increase their swap risks and potential liabilities of the Bank Insurance Fund.

This article investigates banks in terms of their activity as dealers in the swap market. 5 Theoretically, like other corporations, banks may also use swaps for hedging. However, in practice, most banks entered swap contracts as floating-rate payers and fixed-rate receivers, which mirrors their business of financing long-term loans with short-term deposits. This suggests that banks have not been using swaps for hedging; rather, banks act as swap dealers (Montgomery, 1993). Indeed, swaps actually increase banks' exposure to interest rate volatility.

Further, the analysis in this article includes factors not considered in previous research, such as bank creditworthiness factors as measured by S&P rating, the "too-big-to-fail" effect, and a time variable to capture overall market changes in swap activities. In addition, this article examines the variation of market share of swaps across banks.

3. The data and empirical methodology

3.1. Data

Data from the Quarterly Reports of Condition and Income for Commercial Banks (Call Report) for the largest 99 banks are utilized. For the purpose of this article, smaller banks

CHARACTERISTICS OF BANKS THAT ARE MORE ACTIVE IN THE SWAP MARKET 133

which would not act as dealers in the swap market are not included in the sample. The analysis is performed on pooled time-series cross-section data from June 1985 (when banks were required to report their outstanding swaps for the first time) to September 1991, a total 26 quarters. On average, 85.5 percent of the sampled banks participated in the swap market.

3.2. Did banks engage in swap activities to avoid committing capital when loan activities were constrained under the fixed capital requirements ?

A logit analysis is performed to investigate the relationship between a bank's probability of engaging in swaps and its capital constraint variables. The general form of a logit model is written in (1), where Pi is the probability that bank i will engage in swaps.

Pi = (1 + e-Z/) -1 (1)

Swap propensity is characterized as a linear function of bank characteristics, as written in equation (2), where X/j is the ith bank's characteristics, 6j is the coefficient for the j th characteristic, and TIME is the time trend variable, indicating the number of quarters since the beginning of the sampling period. Bank i will engage in swaps if its swap propensity Zi exceeds some unobservable threshold specific to the bank, Zi*. 6 The observed probability is one for those banks that engage in swaps, and zero for those that do not. Given the binary choice and the characteristics of these banks, the maximum likelihood estimates of the parameters a and 13j are computed.

Zi = L n [ P i / ( 1 - P i ) ] = eL + ~, f3jXij + r TIME j=l

(2)

The characteristic variables (X/j) that may be important in determining whether the bank will engage in swaps include the following:

Capital Constraints Three measures of bindingness are used. KBINDING1 is equal to one for banks with ratios of primary capital to assets below 5.5 percent (the established minimum requirement for most of the sample period), and equal to zero otherwise. 7 KBINDING2 is equal to one if the capital ratios are between 5.5 and 7.0 percent (ap- proaching the binding level). KBIND, the difference between the capital ratios and the constraint 5.5 percent, is used as an alternative measure of degree of bindingness of the capital constraint.

Bank Size While swaps may be an attractive means for banks to generate revenue without tying up capital under the fixed-capital requirements, participation in the swap market may require that a bank be of a certain size in order to realize scale economies to justify the support of swap transactions, such as research, marketing, distribution net- works, contract settlement operations, etc. Thus, larger banks may be better able to participate in the swap market than smaller ones. BANKSIZE, log of total assets, is included as a control variable for "size constraint."

134 JULAPA JAGTIANI

3.3. Did market discipline exist in the swap market?

The OLS estimation is used to examine the factors that are important in determining variation in swap volume across participating banks. 8 An importance of creditworthiness factors will imply market discipline in the swap market. Two measures of swap volume are used: SWAPSHAREit (bank i's market share) is a percentage of the ith bank's notional amount of swaps to aggregate notional amount of swaps of all banks in the sample at time t; SWAPRATIOit is a percentage of the ith bank's notional amount of swaps to its assets at time t. The dependent variables are regressed on bank characteristics (Y/j) and a time trend factor (TIME). 9 The characteristic variables (Yt?) include the following:

CapitalRatio The effects of capital ratio on the demand for and supply of bank swaps are expected to be in opposite directions. On the demand side, capital is a measure of a bank's ability to absorb losses before it becomes insolvent. Swap demand is expected to be larger at a bank with a higher capital ratio, given the same asset/liability risk characteristics, since the market views these banks as being more creditworthy. This is supported by earlier studies, which demonstrate that a higher level of capital lowers a bank's probability of default and increases its creditworthiness (Merton, 1977; Sharpe, 1978). On the supply side, Furlong and Keeley (1987, 1989) suggest that a higher capital ratio reduces a bank's marginal gain from increasing the risk of its asset portfolio. Therefore, a bank with a higher capital ratio is expected to take on less swap risks and supply a smaller volume of swaps.

S&PRating Swap demand is expected to be larger at a more creditworthy bank (with a better rating). The S&P rating (S&PRATE) is conve?ted into a cardinal number based on the conversion used by Ronn and Verma (1987); i.e., smaller numbers are associated with higher ratings.

Money Center Bank Money center banks have well-developed distribution networks with access to large and sophisticated clients who are likely to demand swaps. Therefore, money center banks' swap volume may be proportionately higher than that of nonmoney center banks. In addition, the market believes that regulatory agencies will not let a money center bank fail, because that might cause loss of public confidence in the banking system--the "too-big-to-fail" doctrine. In 1987, the "too-big-to-fail" policy was applied to the First Republic Bank of Texas (14th largest). This policy in effect extended FDIC protection beyond bank deposits to all obligations including OBS activities. This paper defines money center banks as the largest seventeen banks. 1°

Balance-Sheet Creditworthiness These factors included PROFIT: percentage of income before taxes and extraordinary items to assets; and NPLOAN: percentage of nonper- forming loans to assets. Higher profits are expected to enhance a bank's creditworthiness, since profits increase cash flows and can be retained to absorb future losses. 11 Similar creditworthiness measures are also used by Avery, Belton, and Goldberg (1988) to study market discipline.

CHARACTERISTICS OF BANKS THAT ARE MORE ACTIVE IN THE SWAP MARKET 135

Futures and Forward Contracts Smith, Smithson, and Wakeman (1988) and Arak, Es- trella, Goodman, and Silver (1988) suggest that swaps may be used to complete the futures and forward markets. The relationship between the volume of swaps outstanding and futures and forward contracts depends on whether the products are substitute (neg- ative) or complementary (positive).

4. Empirical results

4.1. Are banks with binding capital constraints more likeby to engage in swaps?

The analysis in this section focuses on the equilibrium relationship between a bank's capital constraint and whether or not it engages in swaps. A logistic analysis is employed, since many of the values of the dependent variable are zero. A time trend variable is included as a control factor for changes in the entire swap market over time. From table 1, column 2, the significant positive coefficient of KBINDING1 seems to suggest that banks that are facing a binding capital constraint are more likely to engage in swaps. However, KBINDING2 is not significant, which suggests that banks whose capital level approaches the binding level (but not yet binding) are not more likely to engage in swaps than banks whose capital level is much above the binding level. This result is consistent with the insignificance of KBIND, which is a measure of the gap between the bank's capital level and the binding constraint.

From table 1, column 3, when bank size is also included as a control factor, the coefficient of KBINDING1 remains positive and significant at the 5 percent level. The coefficients of BANKSIZE are significantly negative (unexpected), and the coefficient of KBINDING2 changes from insignificant to significantly negative (unexpected), sug- gesting multicollinearity between bank size and capital level. The coefficient of KBIND remains insignificant.

To summarize, the results suggest that a binding capital constraint may have induced some banks to engage in swaps as a means to generate fee income, since loan activities were constrained. However, a bank's decision to engage in swaps is not affected by the gap between its capital level and the binding level.

4.2. Does market discipline exist in the swap markets?

The results based on the ratio of swap volume (SWAPRATIO) and swap market shares (SWAPSHARE) are presented in table 2. Note that SWAPSHARE is likely to be a better measure than SWAPRATIO in examining a bank's ability to participate as a dealer in the swap market, since it takes into account a bank's swap activities relative to other banks.

From table 2, the coefficients of MCENTER are significantly positive regardless of whether swap activities are measured in terms of swap volume or swap market shares, implying that money center banks are more active in the swap market than nonmoney center banks. This is not surprising, because money center banks are advantaged in

136 JULAPA JAGTIANI

Table 1. Logistic analysis: to predict whether banks whose capital constraint is binding are more likely to engage in swaps.

(1) Time trend (2) (3)

Variables effect Capital constraint effect Full model

Intercept

TIME: number of quarters since the beginning of sam- piing period KBINDINGI: equals 1 if capital ratio is below 5.5%, and 0 otherwise KBINDING2: equals i if capital ratio is between 5.5% and 7%, and 0 otherwise KBIND: equals the capital ratio minus 5.5% capital constraint BANKSIZE: log of total assets Model's C

1.2921"* 1.5859"* 0.9534** 15.5666"* 16.4426"* (.0001) (.0001) (.0001) (.0001) (.0001)

-0.1361"* -0.2106'* -0.1413"* -0.2028** -0.2019"* (.0001) (.0001) (.0001) (.0001) (.0001)

2.1699"* 0.3902* (.0001) (.0315)

-0.1643 -0.2959* (.1383) (.0222)

0.0647 -0.0475 (.1647) (.3312)

.788 .866 .860

-0.8834** -0.9358** (.0001) (.0001) .883 0.885

Dependent variable is l n (P i /1 - P/), where P i is the probability that banki will engage in swaps. The sample is from June 1985 to September 1991 (26 quarters) for 99 banks. P-values are reported in parentheses: ** and * indicate significance at the 1 and 5 percent level, respectively.

issuing swaps because of their global presence and access to sophisticated customers who are more likely to demand swaps. In addition, swap customers may prefer to deal with money center banks, because they are perceived to be more creditworthy due to the "too-big-to-fail" doctrine.

The coefficients of the S&P rating are significantly negative, as expected, when swap activities arc measured in terms of either swap volume or swap market share, implying that highly rated banks are more successful in obtaining larger volumes and market shares in the swap market.

The coefficients of PROFIT change from significantly positive to insignificant when FWD is included. The coefficients of FWD are significantly positive, indicating that banks are more active in the futures and forward market are also more active in swaps. This is consistent with the argument that there may be cost complementarity between these two OBS products. 12

The coefficients of NPLOAN are significantly positive. This indicates that banks with higher nonperforming loans are more active in swaps. From a supply perspective, banks that are more willing to make risky loans may also attitudinally be willing to take more swap risks. From a demand perspective, the market, when considering entering a contract with a bank, does not seem to take into account its level of nonperforming loans. The most important creditworthiness factors in the market's view seem to be the "too-big-to-fail" and S&P rating.

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138 JULAPA JAGTIANI

Unlike other creditworthiness variables, the coefficients of CAPITAL vary, depending on whether swap activities are measured in terms of SWAPRATIO or SWAPSHARE. The coefficients of CAPITAL are significantly positive in determining swap volume (SWAPRATIO), suggesting that a bank whose capital ratio is small is associated with a smaller volume of swaps as a proportion of its assets. The market seems to prefer to deal with more creditworthy banks (with higher capital to cushion losses). The positive coef- ficient of capital ratio is consistent with the prediction by Koehn and Santomero (1980) that the incentive for a bank to increase asset risk rises as its capital ratio increases. The coefficients of CAPITAL, however, are insignificant in determining the variation of market shares (SWAPSHARE) across banks in the swap market.

To summarize, the results in this section suggest that banks that are more creditworthy can attract more swap businesses and achieve higher swap market shares, suggesting that market discipline does exist in the swap market. It is noteworthy that the market seems to rely on only a few factors (S&PRATE and MCENTER) in determining a bank's credit- worthiness, and seems to ignore some other factors such as the level of nonperform- ing loans.

The above analysis is also performed on a sample of only money center banks, in order to examine the importance of creditworthiness factors among them. Over the period of study, several money center banks were downgraded by S&P----examples include Bankers Trust, Bank of New York, Chase Manhattan Bank, Bank of New England, Citibank, and Manufacturers Hanover. Ratings for others, such as Mellon Bank and Continental Illi- nois, fluctuated up and down during the sampling period. Morgan Guaranty is the only one that was rated AAA throughout the period of study. From table 3, the coefficients of BANKSIZE, CAPITAL, and S&PRATE are significant in explaining the variation in SWAPRATIO across money center banks. In the analysis of SWAPSHARE, bank size remains highly significant, S&P rating is weakly significant, while capital ratio and non- performing loans become insignificant. These results suggest that asset size and S&P rating play an important role in explaining swap activity variation across money center banks.

5. Concluding remarks

The results suggest that binding capital constraints under the fixed capital requirement may have induced some banks to engage in swaps as a means to increase fee income and risk when loan activities reached the limit. However, due to the existence of market discipline in the swap market, the level of swap activities that banks can engage in is also determined by their creditworthiness.

The market uses S&P ratings as a highly visible sign of creditworthiness. Specifically, banks with higher S&P ratings are viewed as more creditworthy, and experience higher swap market shares. Conversely, banks with lower S&P ratings do not have complete freedom to increase swap risks. Money center banks seem to be an exception and are probably not limited by their S&P rating due to the market's belief that regulators will bail out money center banks' creditors.

CHARACFERISTICS OF BANKS THAT ARE M O R E ACTIVE IN THE SWAP M A R K E T 139

Table 3. Reduced form analysis for money center banks

Dependent variable is SWAPRATIO Dependent variable is SWAPSHARE

(1) (2) (3) (4) (1) (2) (3) (4)

Intercept

TIME

BANK- SIZE CAPITAL

NPLOAN

PROFIT

S&PRATE

FWD

Adjusted R-square

-6.3007** -6.7775** -0 .0398 (.0002) (.0001) (.9883) 0.0907** 0.0802** 0.0798** (.0001) (.0001) (.0001) 0.3225** 0.2961"* -0 .0916 (.0008) (.0020) (.5543)

0.1680" 0.2154"* (.0174) (.0038)

0.1964"* (.0140) 0.0394

(0.6374)

.395 .408

- 1.3236"* - 1.3135"* - 1.1581"* - 1.0711"* 2.5219 (.3978) (.0001) (.0001) (.0001) (.0001) 0.0664"* - 0.0001 0.0001 0.0001 - 0.0003 (.0001) (.7049) (.7964) (.7215) (.5101)

-0 .2346 0.0793** 0.0799** 0.0709** 0.0660** (.1669) (.0001) (.0001) (.0001) (.0001) 0.2404"* - 0.0036 - 0.0019 - 0.0010 (.0014) (.2276) (.5483) (.7439) 0.1566t 0.0037 0.0023 (.0550) (.2812) (.5080) 0.0099 0.0011 0.0001 (.9061) (.7556) (.9754)

- 0.1046"* - 0.1007"* - 0.0027t - 0.0026t (.0018) (.0025) (.0562) (.0689)

0.0001" 0.0001 (.0446) (.1111)

.427 .435 .642 ,642 .644 .646

Dependent variables are notional principal amount of swaps as a percentage of total assets (SWAPRATIO) and market share in the swap market (SWAPSHARE). Sample is from June 1985 to September 1991 (26 quarters) for 15 money center banks. P-values are reported in parentheses. **, *, and t indicate significance at the 1, 5, and 10 percent level, respectively.

Therefore, market discipline is at work in the swap market among nonmoney center banks, and could supplement the regulatory control in limiting potential FDIC liabilities. This market discipline may help compensate for reporting/risk-measurement inadequa- cies in the current risk-based capital requirements. On the other hand, greater regulatory oversight of money center banks is warranted due to the market's belief that they are "too-big-to-fail."

Notes

1. Literature also suggests that bank intermediation has contributed tremendously to the swaps market growth (Campbell and Kracaw, 1991). For more on swap risks, see Brown and Smith (1993), Cooper and Mello (1991), Hull (1989), Litzenberger (1992), and Rendleman (1993).

2. For example, the notional amount of swaps were 55 and 45 times total equity for Bankers Trust and Morgan Guaranty, respectively, in September 1991.

3. Koppenhaver and Stover (1991) look at standby letters of credit, and Unal and Kane (1987) discuss the market 's assessment of OBS activities in general.

4. Hannan and Hanweck (1988) find some evidence of market discipline, while Avery, Belton, and Goldberg (1988) and Gorton and Santomero (1990) do not.

5. Kim and Koppenhaver (1993) study swaps as part of a hedging program. 6. See Amemiya (1973, 1981) for more details on a logit model.

140 JULAPA JAGTIANI

7. As of September 1990, the ratio of primary capital to assets of the sampled banks ranged from 5.1 to 9.5 percent, with an average of 6.7 percent.

8. The estimation may result in biased coefficients since our sample banks may not represent the entire population (see Cole and Eisenbeis, 1994).

9. The coefficients estimated, based on a reduced-form regression, suggest the equilibrium relationship be- tween swap volume and bank characteristics, when the demand for bank swaps is equal to the swap supply.

10. Unlike nonmoney center banks, the largest 17 banks (the multinationals) were not subject to the general capital adequacy standards until June 1983.

11. On the other hand, higher profits may also reflect premiums to banks for more risky activities. 12. For further research on scope economies among different on- and off-balance-sheet activities, see Jagtiani,

Nathan, and Sick (1995).

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