Interest-Rate-Related Derivatives Growth at Credit Institutions in Ireland

Interest-Rate-Related Derivatives Growth at Credit Institutions in Ireland by David Doran1 ABSTRACT Credit institutions have expanded their off-balanc...
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Interest-Rate-Related Derivatives Growth at Credit Institutions in Ireland by David Doran1 ABSTRACT Credit institutions have expanded their off-balance sheet business, such as their use of interest-rate-related derivatives, in response to financial innovation, increased risk management and as a non-interest source of income. In light of these developments, this paper examines the growth in interest-rate-related derivatives across the three main categories of credit institutions in Ireland between 1999 and 2003. This coincides with a period of strong growth in lending by credit institutions in Ireland. The paper examines the relationship between lending growth and interest-rate-related derivatives growth to ascertain whether the categories of credit institution which expand their loans book the most also experience proportionately greater derivatives growth. Analysis shows that credit institutions’ usage of interest-rate-related derivatives has grown strongly, in particular interest rate swaps, which is symptomatic of euro area trends in response to the single currency and also in response to strong loan growth. It is also shown that the categories of credit institution with a domestic business focus, and largely dependant on traditional banking business such as loan issuance, have grown their interest-rate-related derivatives by similar proportions to their loans book, suggesting adequate hedging. The category of credit institution with a non-domestic business focus has expanded its derivatives usage at a far greater level than its lending growth. This is due to its non-traditional intermediation type business and as part of its overseas business focus. Analysis also shows that a significant amount of the counterparties to these derivatives contracts are resident outside of Ireland, with the result that few interdependencies between credit institutions in Ireland are generated as a result of derivatives contracts.

1. Introduction 2

The primary nature of the business of credit institutions consists of accepting deposits and issuing loans with different maturities and at different interest rates. This can lead them to become exposed to different types of risk, namely, (i) interest rate risk, which arises from a bank accepting deposits and issuing loans at different interest rates, (ii) default risk — the risk of borrowers defaulting on loan repayments, and (iii) liquidity risk — the risk that the bank will have insufficient funds to hand at a given time to deal with depositors’ cash demands and day-to-day cash and regulatory requirements. Their exposure to these risks has lead to their greater participation in the derivatives markets. Derivatives are off-balance sheet financial instruments with values derived from the price of an underlying asset or market. Broadly defined, they entail an agreement between two parties to exchange payments based on the value of a defined underlying asset at a certain date. These instruments are primarily of use to banks to hedge different types of risk by transferring some or all of the

risk held to other parties who take a converse position in the transactions. Derivatives can also be used to take speculative positions in various money, foreign exchange, bond and equity markets. Lending growth in Ireland over recent years has been well documented, with total loans at all credit institutions growing by roughly 71 per cent between 1999 and 2003. From a financial stability perspective, the strong growth in lending activity has raised concerns as to the risk levels being undertaken by banks and what they are doing to hedge the additional risk. The generation of interest rate risk arising from maturity mismatch between deposits and loans creates the possibility that volatile interest rate conditions will negatively affect banks’ financial condition and at worst give rise to insolvency. Therefore, suitable hedging of increased interest rate risk arising from strong loan growth is of crucial importance to financial stability. The use of derivatives in Ireland as a risk-hedging tool is high by international standards. The nominal value of both single-currency and cross-currency interest-rate-related derivative products at credit institutions in Ireland has more than tripled from yearend-1999 to year-end 2003. This has occurred at a time when global derivatives markets and usage has expanded in response to changing risk management and financial innovation. In the context of strong growth in

1

The author is an economist in the Monetary Policy and Financial Stability Department. The views expressed in this article are the personal responsibility of the author and are not necessarily those held by the CBFSAI or the ESCB. The author would like to thank Diarmuid Murphy for invaluable assistance in compiling the data and colleagues in MPFS for helpful comments. 2 The terms banks and credit institutions are used interchangeably throughout this paper. A credit institution is defined as an undertaking whose business is to receive deposits or other repayable funds from the public and to grant credits for its own account, or as an electronic money institution. Financial Stability Report 2004

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lending by credit institutions in Ireland, this paper examines the usage of interest-rate-related derivatives to hedge against the concomitant growth in interest rate risk, and examines the relationship between usage of interest-rate-related derivatives and lending activity within the main categories of credit institutions in Ireland. The most notable feature of the growth in off-balance sheet derivatives is that it has taken place at a time when traditional interest-income intermediation remains the most important item on their balance sheets (Doran and Fitzpatrick, 2003). Credit institutions reliant on traditional intermediation may become exposed to a high maturity mismatch and interest rate risk. To hedge against this type of exposure it would be expected that these credit institutions have a well-developed portfolio of interestrate-related derivatives and in particular a large holding of fixed/floating and floating/fixed rate swaps, which are perhaps the most effective method for hedging against interest rate and maturity mismatch exposure. This paper analyses the growth in interest-rate-related derivatives by product and institution category in order to illustrate where the growth lies and to establish whether credit institutions in Ireland observe the expected relationship between business type and derivatives use. An initial analysis of aggregate statistics for the banking sector suggests that the interest rate risk associated with strong loan growth is being adequately hedged by the banking sector. There is also evidence of some excess derivatives use by credit institutions. This could be acting as a substitute for further lending activity or perhaps as a noninterest source of income. Banks may be having increased recourse to this since the launch of the euro, which eliminated currency risks from euro area transactions thereby facilitating straightforward contracts with an increased range of counterparties. The relationship between derivatives usage and lending activity has been much commented on in related literature in recent years. The main questions that arise in the literature are: ‘does derivatives usage allow banks to increase their lending activity and/or does increased lending activity encourage more derivatives usage, and if not, is lending activity being substituted for derivatives?’ This paper, in attempting to answer this question, goes beyond the aggregate statistics for all credit institutions to compare derivatives usage and lending activity by category of institution in order to ascertain whether there is a relationship between the growth rate of interest-rate-related derivatives and lending activity within the different categories of credit institutions in Ireland. This will identify which category of institution has expanded its lending activity the most and will illustrate whether it is also the same category of 124

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institution that has significantly grown its interest-raterelated derivatives portfolio. The paper is structured as follows: Section 2 looks at the importance of interest-rate-related derivatives from a financial stability viewpoint and the rationale behind their growth through a literature review of the changes that have taken place at credit institutions and the subsequent role of interest-rate-related derivatives in credit institutions. Section 3 takes a descriptive look at the lending and derivatives statistics for the overall banking sector. Section 4 looks beyond the aggregate data at the growth areas of derivatives across categories of credit institutions in Ireland using data gathered by the Central Bank & Financial Services Authority of Ireland (CBFSAI). Section 5 looks at the relationship between derivatives use and lending activity and section 6 concludes.

2. The Importance of Interest Rate Risk Hedging to the Financial System 2.1 The Rationale behind the Recent Growth in Interest-Rate-Related Derivatives An operational definition of a bank is given as: ‘. . . an institution whose current operations consist in granting loans and receiving deposits from the public’ (Freixas and Rochet, 1997). Such traditional forms of intermediation are still the most important business types for credit institutions in Ireland (Doran and Fitzpatrick, 2003), and it is this traditional form of intermediation that leaves banks open to interest rate exposure and to duration or maturity mismatch exposure, which arises when banks borrow short and lend long. As a result, credit institutions have increasingly used derivatives products as part of their interest rate exposure risk management strategy (Brewer et al., 2001), as well as on a speculative basis in response to the increasing development of banks’ off-balance sheet business through financial innovation and also on behalf of nonbank customers. Banks making proprietary use of derivatives may be doing so on a speculative and arbitrage basis. For example, speculators take a position in a market for interest rates and bet whether rates will move in a particular direction. Speculation of this kind helps to add liquidity to derivatives markets (Sill, 1997). Arbitrageurs take positions in a number of markets simultaneously when it appears that a similar product has been mis-priced between markets. By doing so, arbitrageurs help to realign the price to its correct level while seeking to make a riskless profit from taking positions in a number of markets. In a fully efficient financial market economy, investors would be able to engage fully in cross-sectional risk

sharing, whereby each individual could offset their position by another individual taking the converse position. However, the limitations of financial markets create a void that is filled by intermediaries. Depository intermediaries have in such circumstances an advantage in providing the risk sharing facility of intertemporal smoothing3, which in turn provides the main source of funding for their loans business. This acceptance of deposits and issuance of loans leads to the credit institution, in undertaking asset-transformation, becoming exposed through duration mismatch on its portfolio of fixed and floating interest rate assets and liabilities. As some of the collective investors’ risk has been passed onto the bank, it must hedge against this mismatch and this element of risk that remains and is on the books of credit institutions is increasingly hedged using derivative products. Where the existence of interest rate risk at credit institutions accounts for some of the growth in derivatives products, this can suggest that intertemporal risk smoothing illustrates the failure of markets at present to provide optimal risk sharing (Allen and Gale, 1995). Nevertheless, the growth in derivatives may conversely signify that markets are becoming more complete. This may, at best however, be partially true as credit institutions account for the vast bulk of the growth and find it easier than individual investors to hedge risk in this way. Banks are increasingly becoming enlarged facilitators of risk transfer, both in response to financial innovation and in an entrepreneurial context (see Allen and Santomero, 1998, and Scholtens and Van Wensveen, 2000). As a result of this changed activity, banks have experienced a substantial growth in off-balance sheet items through securitisation and growth in derivatives usage, both as part of a risk management strategy and to release additional capital from which to grant loans and carry out further business. For example, each loan that a bank issues contains a number of different risk components that the bank will unbundle and hedge against individually. In taking on higher risk, banks have increasingly offset the various risk components using credit, interest-rate-related and foreign exchange-related derivatives, which have become an important feature in the risk management portfolio. The response of banks and intermediaries to the growth in availability of derivatives products has seen further change in the composition of banks’ balance sheets. The nature and structure of derivatives markets makes them relatively inaccessible to the individual with the result that it is 3

much more efficient for intermediaries to act on their behalf, as they use derivatives to hedge against any remaining mismatch existing after the bank acts as intermediary for deposits and loans. It is apparent then that financial intermediaries are transacting heavily in derivatives as part of risk management. For example, Allen and Santomero (1998) show for the US that 82 per cent of the Over-theCounter (OTC) derivatives market was accounted for by financial institutions. While banks and intermediaries have always been engaged in risk management to some extent (Scholtens and van Wensveen, 2000), the style and volume of this has changed in line with the innovation that has been evident in the financial sector (Allen and Santomero, 2001). The growth in derivatives usage over recent years reflects this and is attributable to the expanding business practices of credit institutions and, more importantly, as a risk management tool. Interest-rate-related derivatives can be used to hedge closely the maturity mismatch of a bank, or depending on whether it has a strong belief in the future direction of interest rates can be speculatively used to realise a profit when interest rates rise or fall. An additional factor in the increase of interest-raterelated derivatives usage at credit institutions has been the increase in types of interest-rate-related derivative products and in the liquidity of the market for these products. Whereas interest rate futures were long the dominant choice for interest rate risk management, interest rate swaps have now become the most widely used instrument. It is likely that less volatile interest rates in world markets have contributed to this global trend. Interest rates were much more volatile in the years before the significant emergence of interest rate swaps and high volatility makes futures a more effective method of hedging given the uncertainty in the underlying product and the unwillingness of a counterparty to accept a converse position such as is required with swaps. In recent years as monetary authorities target low inflation, interest rates have become less volatile creating an atmosphere more conducive to swaps trading. Low inflation is a primary component in achieving price stability and wellcontrolled interest rates have been the main factor in achieving this. With authorities exercising tighter control of interest rates than ever before, their reduced volatility has eliminated some of the uncertainty regarding interest rate movements. With less volatile interest rates, banks

Credit institutions facilitate intertemporal risk sharing by accepting deposits and holding them over time, thereby smoothing out risk across expansions and contractions, and by issuing loans allowing the recipient to smooth out payments over time. Allen and Gale, 1995, offer two forms of intertemporal risk sharing. The first is intergenerational risk sharing, where risks can be smoothed over time by passing them from one generation to another. The second form of intertemporal risk smoothing is asset accumulation, i.e., by holding deposits at credit institutions. See Allen and Gale, 1995, for a more complete discussion of intertemporal risk smoothing. Financial Stability Report 2004

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are more accurately able to judge their interest rate exposure for a period of time in the future. This makes it easier for two counterparties to enact a swap agreement, as they are both more confident in their judgement of future interest rate movements and wild swings in interest rates are less likely. Brewer et al. (2000) state that, in the US, interest rate derivatives have given banks opportunities to manage their interest rate exposure and to generate revenue beyond that available from traditional bank operations and, as a result, banks have accumulated large positions in such derivatives. Non-interest income figures for Ireland, which encompasses derivatives, suggest that this may not be the case here, albeit these figures are on an aggregate basis and not on a bank-by-bank basis. Noninterest income accounts for about one third of Irish banks’ income and has remained close to this level for much of the late 1990s and early 2000s (Fitzpatrick and Doran, 2003). Interest-rate-related derivatives are particularly used for hedging duration mismatches between long and short term fixed and floating rates. An increase in loan issuance would tend to suggest that a credit institution would increase its hedged position in order to reduce exposure to interest rate fluctuations affecting its increase in assets. Results in Brewer et al. (2000) for the US confirm a positive association between growth in lending activity and use of derivatives over a sample period of 1985 to 1992. The use of derivatives has further implications for banks’ balance sheets where there is maturity mismatch to be hedged. In the absence of derivatives as an interest rate hedging tool, banks would be left solely with the option of buying long-term bonds if it wanted to lengthen the duration of its assets. This uses up funds that would otherwise be used for granting loans and in adjusting a bank’s balance sheet it would also increase the leverage ratio. The use of derivatives to hedge against duration mismatches is, on the other hand, an off-balance sheet item, which allows the bank to adjust its exposure and asset duration while not increasing the balance sheet or affecting prudential asset ratios, (Simons, 1995). However, by making more capital available for the granting of loans, banks may be prepared to take on too many loans and furthermore may begin to take on riskier loans than they normally would. Banks nonetheless still hold large amounts of bonds as part of their portfolio to manage liquidity risk. The growth of derivatives, however, has reduced the burden on this area and allows them to move some of this value off balance sheet.

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Furthermore, empirical evidence from the US suggests a number of relationships between derivatives usage and the type of credit institution. Brewer et al. (2001) suggest that banks using derivatives tend to grow their business loan portfolio faster than banks that do not use them. Their findings also suggest that banks using derivatives to manage interest rate risk have different risk profiles to non-users and that large banking organisations are more likely to use derivatives than small banks. 2.2 Implications for Financial Stability In effect, interest rate risk arises through the maturity mismatch between deposits received and loans issued by credit institutions. The greater the amount of such traditional intermediation type business carried out by credit institutions the greater the amount of interest rate risk they will incur and in turn create an increased risk to financial stability. Therefore, effective hedging of interest rate risk is highly important both to the bank and to the financial system as a whole as it will reduce the banks exposure to volatile interest rate movements. This will lessen the likelihood of extreme fluctuations in a bank’s financial condition and reduce the probability of a bank becoming insolvent (Brewer et al., 2001). This in turn reduces the amount of capital a bank must hold for regulatory requirements and thereby frees up extra capital for lending and other business. By hedging against interest rate risks, banks are insuring themselves against the possible losses arising from adverse or volatile market conditions. For example, the consequences of a bank allowing a large maturity mismatch on its books to go un-hedged could conceivably have adverse consequences. Suppose a sudden inflation scare caused a shock to the term structure of interest rates. This would likely draw a monetary policy tightening by the monetary authority and lead to a sharp inversion of the yield curve. The bank could, by virtue of a maturity mismatch, be committed to funding loans for a period of time into the future at the earlier lower interest rate from more expensive deposits, which it must accept at the new higher interest rate. This will have an adverse effect on the bank’s profits and capital ratio and increase the likelihood of insolvency. This creates the risk that the bank in question could find itself in a position of poor liquidity causing it to default on its payment obligations. Such a shock to an individual credit institution could propagate through the rest of the financial system through contagion, whereby other credit institutions suffer loss resulting from their claims on customers of the defaulting credit institution, or perhaps through interbank lending with that particular credit institution. This possible sequence of events would jeopardise the financial stability of the economy.

It is also possible that if one credit institution were to suffer loss on account of bearing too large a maturity mismatch risk, other credit institutions would be equally exposed. In the case that un-hedged interest rate risk arising from maturity mismatch creates liquidity problems for a bank, such a situation would have arisen from the bank holding too risky a position for that particular maturity period. For a bank to be allowed to hold such a risky position, which could conceivably lead to financial instability, it may reflect a failure of regulatory supervision. Such sub-optimal supervision would increase the likelihood that other banks also exposed to too great a level of interest rate risk would also go undetected, thereby increasing the likelihood and speed of financial instability and contagion effects throughout the financial system. In an adequately regulated financial system, a credit institution holding a level of risk likely to pose a threat to financial stability should not go unnoticed for long and their hedging of this risk should therefore be reflected in their interest-rate-related derivatives positions held. Derivatives contracts allow risk to be spread between two risk adverse parties, for example, where one bank receives a fixed payment and pays out a floating rate whereas another has to pay out at a fixed rate and receive a floating rate. This leads both credit institutions to be exposed to fluctuations in interest rates. These two institutions can reduce this exposure by exchanging a fixed for a floating payment, for example, in a swap transaction. The first bank is at risk of a loss if the floating rate that it pays out rises above the fixed rate of income, so it wishes to swap the fixed rate of income for a floating rate. The second bank would suffer a loss if the floating rate it receives were to fall below the fixed rate it pays out. This bank, therefore, would prefer to swap its floating rate of income for a fixed rate, which would be more comparable to its fixed payout rate. In these circumstances, the first bank can pay a fixed rate to the second bank and receive a floating rate in return. While this is a simplified version, it illustrates how interest-raterelated derivatives can be of benefit in reducing the risk held by two risk averse credit institutions. A similar swap of fixed and floating payments could take place between a credit institution looking to hedge interest rate risk and another who wishes to take a larger position in a floating rate, perhaps in the belief that interest rates will rise. Interest-rate-related derivatives contracts thereby allow the transfer of risk from a risk averse party to a risk taker. The transfer of risk between two risk averse parties, such as in the first example, has the effect of significantly reducing the overall level of risk to both parties in the event of a shock, whereas the transfer of risk from a risk averse party to a risk taker such as in the second

example reduces the level of risk between the two parties, but transfers some of the risk from the risk averse to the risk taker. This illustrates that the use of interest-rate-related derivatives is key to credit institutions reducing their interest rate risk, in turn reducing the likelihood of insolvency and possible contagion. One partially offsetting effect, however, is the interlinkages that derivatives contracts create between credit institutions. Were a credit institution to suffer the effects of a shock and default on its payment obligations, the likelihood of this shock propagating through the system by contagion could be increased. The credit institution that has defaulted may in turn default on its payments under its derivatives contracts with other credit institutions. This would leave them exposed to high amounts of interest rate risk which they had hedged against originally, exacerbate the effects that the shock would have to the financial system and increase the speed of contagion across the system. However, derivatives are primarily used to hedge against risk so their effects in reducing the possibility of an adverse shock to the financial system and possible contagion in the first place are far greater than their potential role in exacerbating that contagion once it is underway. This risk associated with derivatives usage is just one such risk cited by critics of derivatives. It should be borne in mind, however, that it is not derivatives per se that are risky but the trading strategy used by credit institutions which creates or reduces the level of risk associated with derivatives. Among the risks inherent in derivatives usage are those associated with pricing models. According to Sill (1997), inaccuracies in complex derivatives pricing models may lead to their poor performance and the credit institution could become more exposed to risk than planned. There is also the risk of default, i.e., credit risk, attached to derivatives contracts. Default risk can arise if the counterparty to a bank’s contract defaults on payment, more likely on OTC traded contracts, and also in the instance where a bank offsets a swap contract between two companies. If neither firm defaults on its payments then the bank is hedged and suffers no loss. If, however, one firm defaults on its payment the bank must pay out to the other counterparty to the transaction and incur the losses associated with the default risk (Sill, 1997). Derivatives contracts are legal and therefore incur the associated legal risks. Also, OTC derivatives contracts tend to be less standardised than exchange traded contracts, which give rise to difficulties in trading the contracts, particularly in volatile conditions, creating a liquidity risk associated with derivatives. Financial Stability Report 2004

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The most worrying risk associated with derivatives contracts is, perhaps, from a regulatory and financial stability perspective. The difficulty from a regulatory point of view is to monitor adequately the exposures being built up by credit institutions in particular areas of the market. For example, what are the acceptable risk levels a bank could hold in the event of a sudden interest rate shock or in the event that a major dealer in the swaps market defaulted? Such risks are more prevalent at credit institutions that trade in derivatives as a line of business in itself, perhaps instead of traditional interestincome type business. Credit institutions may therefore engage in derivatives trading for speculative purposes, in effect betting a stake on their view of future interest rate movements. As with any betting strategy, there exists a possibility of losing the entire stake, a risk acceptable to individual gamblers but not to regulators of credit institutions when financial stability is at stake. Such a risk lies with the trading strategies of dealers within the credit institutions. While this could be the most hazardous form of risk in terms of potential financial instability given the scope for possible losses under a speculator’s derivatives trading strategy, it is a risk associated with human judgement and not derivatives contracts. Allowing that there are risks associated with any financial instrument, the role of derivatives is seen as important in reducing the level of interest rate risk held by credit institutions, which can only be of benefit to the long run financial stability of the financial system.

3. Descriptive Statistics of Loan and Derivatives Growth 3.1 Glossary of Instruments

Interest-Rate-Related

Derivatives

Derivatives instruments are traded over-the-counter (OTC) or on regulated exchanges. Instruments such as futures are primarily traded on regulated exchanges and are quite standardised in structure and type, whereas instruments such as swaps and forward rate agreements (FRAs) are more commonly traded over-the-counter. The OTC market is a more informal market mechanism of derivative trading and allows greater flexibility and custom tailoring of agreements between counterparties to suit their precise hedging needs. The following is a brief description of the predominant types of interestrate-related derivatives instruments that are currently used: (i) Interest rate swap An interest rate swap is an agreement between two parties to exchange or swap payments based on the value of a defined underlying asset over a fixed period. Streams of interest payments based on fixed and/or floating reference interest 128

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rates are exchanged, based on a notional principal amount that is not in itself exchanged. These payments can be based on a swap of a fixed and a floating rate or between two swap counterparties exchanging two different floating rates based on two separate market reference rates. This type of instrument is particularly useful to credit institutions that hold risk generated by a maturity mismatch between their deposit and loan books. Variations of the interest rate swap include cross currency swaps, which exchange a stream of floating payments in one currency for a set of fixed/floating payments in another currency. A constant maturity swap uses longer term maturities as the underlying asset for the floating rate reference, such as a 5-year rate, as opposed to the short term money market rates that are more commonly used. (ii) Forward rate agreements (FRAs) A FRA enables the transaction counterparties to fix in advance the receipts or payments of a future transaction. It is a contract for a set period, to begin at a specified time in the future, during which the interest rates to be paid and received on a notional principal amount are agreed upon at the time the counterparties commit to the transaction. Again, only interest rate flows are exchanged while the notional principal amount is not exchanged. This is beneficial to credit institutions in that it allows them to fix interest rate costs for a specified period in the future, reducing the interest rate risk associated with a maturity mismatch. (iii) Options The buyer of an option creates the right but not the obligation to buy a specified amount of an underlying asset at a specified price on or before a specified date in the future. The seller of an option has the obligation to exchange payment on the basis of a predefined reference interest rate on a notional amount if the other counterparty exercises the agreement. Options can be traded OTC and also on an exchange. They are of benefit to credit institutions who have a moderate exposure over a certain maturity or who have an interest rate exposure but have a strong belief that interest rate movements will be in its favour. They allow the holder to exercise the contract should the circumstances require and, if they choose not to, it is only the cost of the contract that is lost, which will probably be more than offset by the

gain from actual interest rate flows. They present an option to the buyer to minimise losses should a certain event or shock occur at a particular time, which reduces the level of downside risk being held. A variation of an option combined with a swap is a Swaption, which is effectively an option to enter into an interest rate swap arrangement giving the purchaser the right to pay fixed/receive floating under a payer swaption and the right to receive fixed/pay floating under a receiver swaption. Also, the purchaser of a FRAtion has the right but not the obligation to purchase a FRA at a predetermined strike price. (iv) Futures Futures contracts are exchange traded and consist of an agreement to purchase a specified quantity of a specified financial asset at a specified future date and at an agreed price. An interest rate future is therefore a futures contract with an interest rate bearing instrument as the underlying asset. Similar to FRAs, although not as tailor-made, they allow the counterparty to fix a future borrowing or lending rate for a specific period in the future, reducing the risk of interest payments being greater than interest receipts. Being exchange traded they are more standardised than OTC traded contracts but generally offer greater liquidity if the credit institution wishes to sell them before maturity. They are also less susceptible to credit default risk as they are usually marked to market on a daily basis and settled at the end of each day. (v) Other interest-rate-related instruments While the above four instruments are the predominant type of interest-rate-related derivatives used by credit institutions there are some other instruments which are generally more specific and tailor made to the exact hedging needs of the counterparties. These include interest rate caps, interest rate floors, interest rate collars, callable interest rate agreements and treasury locks. 3.2 Difficulties in Reporting Derivatives It should be noted at the outset that there are difficulties in the way in which derivatives contracts are reported statistically. This gives rise to distortions in that the amount that will actually change hands as a result of the 4 5

contract is greatly exaggerated (Moessner, 2001). The notional value of a derivatives contract is the value of the notional principal amount on the contract underlying the derivative. This valuation method greatly exaggerates the total size of gross cash flows exchanged by counterparties under the contract as this notional principal amount is not actually exchanged but merely provides the benchmark from which interest payments are made. The following example illustrates the potential reporting variance from exchanged amounts. On a \2 billion swap of a fixed rate of 4 per cent for a floating rate at 3 month LIBOR plus 0.5 per cent, which works out, for example, at 2.5 per cent, the counterparty paying the fixed rate will not pay the \80 million to the other counterparty, who in turn does not pay the \50 million on the floating rate in return. The net payment of the interest rate times the notional amount, in this example \30 million, is exchanged and not the total notional value. The actual amount that changes hands between counterparties is therefore much less than the notional value that would be reported by each counterparty to the transaction, thereby greatly exaggerating the cash flows. To help account for these double counting distortions whereby two credit institutions holding different sides of a contract both report the contract value, and as such it is double counted for statistical purposes, the Bank of International Settlements (BIS) data uses a net-gross total figure to help account for this distortion.4 Derivatives contract values recorded by the Central Bank are the notional principal or ‘nominal value’ of the contract. For example, if a swap involves exchanging interest on a notional principal of \1 million equivalent, the swap is reported as having a nominal value of \1 million equivalent. This recording methodology also holds for the notional amounts of options contracts. Where futures contracts are concerned, the total nominal amount of all contracts sold is reported.5 This summary of some of the measurement difficulties when statistically reporting derivatives contracts illustrates how reported figures may not represent the values that actually change hands. In the following analysis of derivatives usage these distortions should always be borne in mind. The notional values, while overstating the actual amounts that will be transferred under the contracts, do nonetheless illustrate the growth trends in contract value. This total notional amount is important as it reflects the value of underlying assets that are being insured against. Nevertheless, this reporting

See Moessner (2001) and the BIS (2002) Triennial Central Bank Survey for a further discussion of BIS derivatives statistics and reporting methods. See the CBFSAI Quarterly Bulletin’s Explanatory Notes for more detailed reporting conventions and descriptions of individual derivatives products. Financial Stability Report 2004

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method should be particularly borne in mind when comparing derivative contract values with loan values, as the exaggeration of derivatives contract value means they will greatly exceed loan value in nominal terms. Accurate trends can be deduced nonetheless. 3.3 Loans and Derivatives Statistics Lending growth in Ireland over recent years has been

well documented, particularly private credit growth and mortgage growth figures. Table 1 shows the breakdown of total loans for 1999 to 2003 for all credit institutions in Ireland. The headline figure of total loans has grown from \229.5 billion to \392 billion, which represents a 71 per cent growth over the period. The notable increases are in residential mortgages and in term/revolving loans.

Table 1: Loan Growth at All Credit Institutions \ billion

1999

2000

2001

2002

2003

81.1 15.3 133.2 6.2 0.3 26.8 49.9 2.7 24.5 4.7

85.9 18.2 161.3 6.0 1.6 29.9 63.2 4.7 29.7 5.4

88.5 23.1 194.1 7.0 1.6 30.0 80.4 5.5 34.3 7.0

105.0 25.8 200.4 6.4 1.8 23.4 83.0 4.3 43.7 8.5

141.9 17.1 233.0 6.2 2.8 21.6 88.5 4.0 54.9 9.6

18.1

20.7

28.5

29.3

45.4

Total Loans

229.5

265.4

305.6

331.2

392.0

Total Assets

302.8

355.3

422.1

474.6

575.2

Loans Loans to credit institutions and other MFIsa Loans to general government Loans to other residents —Overdrafts —Repurchase agreements —Loans up to 1 year —Term/revolving loans —Instalment credit/hire-purchase/leases —Residential mortgages —Other mortgages —Other loans & securities issued to other residents

a

Monetary Financial Institutions (MFIs) comprise resident credit institutions as defined in EC Law and other resident financial institutions, the business of which is to receive deposits and/or close substitutes for deposits from entities other than MFIs and, for their own account, to grant credits and/or make investments in securities.

Source: CBFSAI

Over much of the past decade, low levels of interest rates, combined with strong economic growth raising disposable income, have fed much of the loan growth to the household sector. In view of the strong loan growth, the escalations in private sector credit growth have been identified as a significant cause for concern and warrant continued attention (Financial Stability Report, 2002). The concern attached to such strong lending growth relates to the risk levels associated with the lending activity, namely, the risk to credit institutions that loans will not be repaid and the risk to the economy and financial system of a bank failure stemming from the bank holding too many risky loans and/or suffering from over exposure and to adverse shocks such as sudden interest rate changes. In line with the strong credit growth and concern attached to lending procedures by credit institutions, a

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related concern of risk management is the level of derivative usage by credit institutions to hedge the increased risk attached to the additional lending growth. To ease the concerns of possible excess duration mismatch exposure and over exposure to interest rate fluctuations, one would expect a strong increase in derivatives usage by all credit institutions in line with the strong lending growth. Data from the BIS Triennial Central Bank Survey 2001 shows that Ireland, for a country of its size, has a high turnover of OTC single currency interest rate derivatives contracts, ranking fourteenth of forty eight reporting countries for Total Gross Turnover. Notably, turnover at credit institutions in Ireland is higher than in a number of other euro area countries. These high derivatives turnover figures for Ireland correspond with what would be expected following the strong lending growth experienced over recent years.

Table 2: OTC Single Currency Interest Rate Derivatives Turnover by Country and Counterparty in April 2001 $ million

Net Turnover

Daily averages Country

With reporting With reporting local dealers dealers abroad

With other financial institutions

With nonfinancial customers

Gross Turnover

Total

United Kingdom United States Germany France Netherlands Italy Spain Japan Belgium Australia Canada Switzerland Denmark Ireland Luxembourg Austria Singapore Norway Sweden Hong Kong SAR Other countries

296,430 146,485 107,156 77,834 29,478 24,886 21,282 18,351 14,521 13,799 11,970 9,939 6,787 6,121 4,477 4,393 3,491 3,396 3,276 3,074 4,384

237,762 115,668 94,030 65,096 24,212 23,698 20,464 15,761 14,093 9,811 9,916 9,615 5,787 5,815 4,455 4,238 3,193 2,907 3,224 2,641 3,719

58,668 30,817 13,126 12,738 5,265 1,187 818 2,584 427 3,988 2,054 324 1,000 306 22 155 298 489 52 433 660

133,810 56,259 55,107 37,904 11,238 13,129 9,733 10,189 7,369 3,907 5,900 4,522 3,688 4,865 3,869 3,690 2,419 1,406 1,223 1,887 2,137

39,488 21,644 22,382 12,454 7,516 9,131 9,759 2,023 5,973 753 1,117 4,709 859 583 433 368 411 856 561 216 601

5,796 6,947 3,415 2,000 192 248 154 934 324 1,164 846 60 240 52 131 24 62 156 1,389 106 290

Total

811,530

676,105

135,411

374,251

141,837

24,530

1999

2000

2001

2002

2003

1,097.3

1,494.9

2,407.4

2,714.5

3,496.0

51.6 47.6

39.8 27.8

21.0 13.7

28.5 20.5

63.9 56.7

333.4 330.6 26.3

456.1 468.5 49.1

814.9 860.4 76.8

1,066.7 1,072.9 63.4

1,370.7 1,353.4 68.0

82.3 117.4

105.8 123.3

169.9 218.0

139.8 203.5

174.3 281.0

37.6 48.9 21.4

54.5 54.5 115.6

59.8 36.1 136.8

58.6 47.5 13.2

41.5 66.4 20.2

Cross-Currency Interest-Rate-Relatedb

59.7

93.8

132.8

155.9

180.4

Swaps —Pay fixed/receive floating cross-currency swaps —Pay floating/receive fixed cross-currency swaps —Pay floating/receive floating cross-currency swaps Other cross-currency interest-rate related contracts

16.6 14.4 21.7 6.9

28.6 16.3 35.8 13.1

35.5 17.1 68.3 11.9

34.1 14.8 95.9 11.1

36.8 18.7 113.2 11.8

1,157.0

1,588.7

2,540.2

2,870.4

3,676.4

Source: BIS Triennial Central Bank Survey 2001.

Table 3: All Credit Institutions: Derivatives Contracts \ billion Derivative Contracts Total Single-Currency Interest-Rate-Relateda Forward-rate agreements —Forward-rate agreements — deposit —Forward-rate agreements — loan Swaps —Pay fixed/receive floating interest-rate swaps —Pay floating/receive fixed interest-rate swaps —Pay floating/receive floating interest-rate swaps Options —Interest-rate option contracts purchased —Interest-rate option contracts written/sold Futures —Financial futures purchased —Financial futures sold Other single-currency interest-rate-related contracts

Total Interest-Rate-Related c

Other FX-Related Total contracts

153.7

179.3

207.5

203.4

231.9

1,310.7

1,768.0

2,747.7

3,073.8

3,908.3

a

Single currency interest-rate-related contracts are derivatives contracts agreed with a counterparty using one single currency within the contract. Cross currency interest-rate-related contracts are derivatives contracts agreed with a counterparty with an exposure to more than one currency within the contract. It may, for example, involve the swap of a fixed rate on an underlying amount denominated in euro for a floating rate on an underlying amount denominated in dollars. The amount that changes hands between counterparties will be based on the interest rate at the time of settlement and the exchange rate between the two currencies at that time. As it is an interest rate swap, albeit with a foreign exchange element, it is classified as a cross-currency interest rate swap. Note that currency swaps whereby fixed interest rate payments in one currency are exchanged for fixed interest rate payments in another currency are not recorded here. These are recorded under ‘Other FX-Related: currency swaps’. c Foreign exchange (FX) related-derivatives contracts are used to hedge against exposure to movements in exchange rates to which a bank can become exposed from its overseas business. As a category, they do not contain an interest rate element and are listed here purely for indicative purposes to illustrate their proportional usage in comparison to the discussed interest-rate-related derivatives. Source: CBFSAI. b

Financial Stability Report 2004

131

Net turnover figures reported, i.e., net of local interdealer double counting, show that credit institutions in Ireland contracted $4,865 million worth of derivatives products with reporting dealers outside of Ireland in April 2001, compared with $306 million reporting dealers in Ireland. Contracts with other financial institutions totalled $583 million, while turnover with non-financial customers totalled $52 million. This illustrates the volume of derivatives transactions taking place between credit institutions in Ireland and counterparties from other countries. This identifies that relatively few interdependencies are generated between credit institutions in Ireland as a result of derivatives contracts. This reduces the likelihood of a shock to a credit institution, arising from over exposure to interest rate derivatives or default of a counterparty, propagating through the Irish financial system through contagion.

Chart 1: All Credit Institutions: Interest-Rate-Related Derivatives and Loans as a % of Assets 700

% of total assets Total interest-rate-related derivatives Total loans

600

500

400

300

200

100

More detailed analysis of derivative usage by credit institutions in Ireland gives a clearer picture of the growth patterns observed and resultant interdependencies. Table 3 shows a breakdown of derivatives usage by type for all credit institutions for year-end 1999 to year-end 2003. Immediately apparent is that single-currency interest-rate-related contracts are the most important by type, accounting for 89 per cent of total derivatives value at year-end 2003, whereas cross-currency interest-rate-related and foreign exchange-related account for just below 5 per cent and nearly 6 per cent, respectively. Swaps are shown to be the most significant type of product used to hedge against interest rate exposure, with fixed/floating and floating/fixed rate swaps the most demanded, reflecting of the type of maturity exposure apparent at credit institutions heavily dependant on traditional intermediation type business. Analysis for all credit institutions shows the total value of derivatives contracts rising from \1,311 billion in 1999 to \3,908 billion in 2003. An increase in fixed/floating and floating/fixed rate swaps contracts with rest of the world residents has been the driver of this growth. Chart 1 (similar to Brewer et al., 2001) and Chart 2 illustrate the growth in interest-rate-related derivatives and loan value at all credit institutions over the period year-end-1999 to year-end 2003. Immediately apparent is the strikingly high percentage of derivatives, an offbalance sheet item, to total assets, an on-balance sheet item. While total loan value has risen from \229 billion to \392 billion over the period, loan value as a percentage of total balance sheet assets has fallen from 76 per cent to 68 per cent.

0 1999

2000

2001

2002

2003

In comparison, interest-rate-related derivatives growth has been very high, rising from roughly 380 per cent of total balance sheet assets in 1999 to nearly 640 per cent in 2003, as shown in Chart 1. However, as Chart 2 shows, the nominal value of interest-rate-related derivatives value grew by 218 per cent over the period compared with loan growth of about 71 per cent. In terms of growth in the nominal value of loans and interest-rate-related derivatives it appears that there is some positive relationship present.

Chart 2: All Credit Institutions: Interest-RateRelated Derivatives and Loan Value 4,000

€bn

800

€bn

3,500

700

3,000

600

2,500

500

2,000

400

1,500

300

1,000

200 Total interest-rate-related derivatives (LHS)

500

Total loans (RHS)

100

0

0 1999

132

Financial Stability Report 2004

2000

2001

2002

2003

Despite the negative relationship as a percentage of total assets, significant nominal value growth has been observed in both categories, which suggests that credit institutions have expanded their lending activity and grown their interest-rate-related derivatives accordingly. It would also appear that credit institutions, in addition, have grown their derivatives value even further than that required to hedge the increased lending activity, perhaps on a speculative basis and as a substitute for further loan growth. To analyse further the relationship between lending activity and the growth in interest-rate-related derivatives by credit institutions it is necessary to look beyond the aggregated statistics to determine whether derivatives growth corresponds with lending growth in different categories of credit institution. Depending on the category of institution, the presence or otherwise of this relationship has important consequences. Credit institutions in Ireland can be divided into three main categories, namely (i) clearing banks, (ii) non-clearing with business, and (iii) non-clearing business.

with

predominantly

predominantly

domestic

foreign

Clearing banks have a role in the settlement of non-cash retail payments such as cheques, etc., through accounts held at the Central Bank6, and are strong players in the deposits and loans markets in the country. Non-clearing banks with a domestic focus are institutions whose main business is conducted with domestic (Irish) residents and many of which grant significant volumes of mortgages and other types of loans and credit both to households and to business, while non-clearing banks with a foreign business focus are predominantly involved in nondomestic business conducted with other euro area countries and countries outside of the euro area and some of these institutions are affiliated to large overseas holding companies. First, the breakdown of derivatives usage across categories of credit institution illustrates where the growth lies, i.e., which category of institution is increasing its value of derivatives the most and what type of products are driving the growth. By looking at lending growth across these categories and comparing this with the interest-rate-related derivatives growth, it should give a picture of the interest rate risk hedging practices within 6

the different categories of credit institution. Conventional theory suggests that those institutions which have experienced the greatest amount of loan growth would also be responsible for a significant amount of derivatives growth. An alternative scenario would be that for some or all categories of credit institution, derivatives growth far exceed lending activity signifying that derivatives usage is perhaps substituting for lending activity. Such relationships also have important ramifications from a financial stability viewpoint across the different categories of institution. A clear positive relationship between loan growth and derivatives growth may be symptomatic of a sound hedging policy and would satisfy those concerned of the possible presence of excess risk at credit institutions following such strong lending growth such as has been observed in recent years. A situation where year-on-year percentage loan growth far exceeds year-on-year percentage derivatives growth may raise concerns that the additional risk associated with strong loan growth is not being adequately hedged, whereas a situation where derivatives growth is far in excess of loan growth suggests the possibility that derivatives usage is substituting for lending activity.

4. Recent Growth Areas in Derivatives Usage This section takes a look behind the typical aggregated view of derivative usage by credit institutions in Ireland that is normally portrayed, by analysing the individual categories of credit institution and sub-categories of interest-rate-related derivatives. Table 4 develops the breakdown of derivatives usage for clearing banks. As shown, single currency interest rate contracts account for nearly 76 per cent of total contracts at end-2003. Also notable is the relatively high weight of foreign exchange-related contracts, in part reflecting clearing banks’ exposure to movements in foreign currency via the currency exchange services that it offers the public. More significant, however, is that interest rate options are more important to clearing banks at end-1999 than swaps. Options were more beneficial to clearing banks before the introduction of the single euro area currency. Given the domestic nature of their traditional intermediation business, their requirements would have been for domestic currency interest rate hedging. However, with the majority of counterparties coming from overseas, options allowed banks to activate the contract if both interest rate and exchange rate movements were favourable.

These are AIB, Bank of Ireland, Ulster Bank, National Irish Bank. Irish Life and Permanent is also a clearing bank but is classified as non-clearing for statistical reporting due to confidentiality reasons. Financial Stability Report 2004

133

Table 4: Clearing Banks: Derivatives Contracts \ billion

1999

2000

2001

2002

2003

Derivative Contracts Single-Currency Interest-Rate-Related

139.4

87.9

132.1

153.3

203.9

10.3 10.0

4.6 4.5

5.8 4.6

3.7 3.5

7.6 11.4

24.9 24.8 0.1

27.3 38.0 1.0

45.7 60.2 1.0

56.0 75.2 1.4

71.9 94.4 1.1

34.6 33.1

3.5 3.0

3.6 3.7

2.0 3.8

6.0 5.4

0.6 0.9 0.0

1.8 4.2 0.0

2.9 4.5 0.0

3.0 4.8 0.0

2.1 4.0 0.0

Cross-Currency Interest-Rate-Related

4.2

3.5

4.2

3.6

5.3

Swaps —Pay fixed/receive floating cross-currency swaps —Pay floating/receive fixed cross-currency swaps —Pay floating/receive floating cross-currency swaps Other cross-currency interest-rate related contracts

1.5 2.1 0.7 0.0

1.0 1.1 1.5 0.0

1.1 0.9 2.3 0.0

1.0 0.8 1.8 0.0

1.6 0.9 2.8 0.0

143.6

91.4

136.3

156.9

209.2

Forward-rate agreements —Forward-rate agreements — deposit —Forward-rate agreements — loan Swaps —Pay fixed/receive floating interest-rate swaps —Pay floating/receive fixed interest-rate swaps —Pay floating/receive floating interest-rate swaps Options —Interest-rate option contracts purchased —Interest-rate option contracts written/sold Futures —Financial futures purchased —Financial futures sold Other single-currency interest-rate-related contracts

Total Interest-Rate-Related Other FX-Related Total Contracts

54.7

47.4

61.4

54.5

61.0

198.3

138.8

197.7

211.4

270.2

Source: CBFSAI

Chart 3: Clearing Banks: Interest-Rate-Related Derivatives by Counterparty €bn ROW Residents

Irish Residents

160

140

Other MUMs 120

100

80

60

40

20

0 1999

2000

2001

2002

2003

The change to interest rate swaps immediately preceding and after the launch of the euro currency has been significant. As recently as 1995, interest rate swaps 7

accounted for only 12.1 per cent of total ‘net-gross’ turnover of OTC derivatives in Ireland (Nugent, 1999). This trend has been observed across swap markets in several of the euro legacy currencies (Remolona and Wooldridge, 2003). The authors report that the euro swap market has nearly doubled in size since the launch of the single euro area currency. Also, in the US, total swaps grew from $22.3 trillion in 1997 to $46 trillion at end-1999, compared with US government debt outstanding of $5.7 trillion in 2001 (Haubrich, 2001), while Remolona and Wooldridge (2003) report that while the US swap market was significantly smaller in value to the euro swap market immediately prior to the launch of the single currency, it reached approximately the same notional value size by end-June 2002. Interestingly, as Chart 3 illustrates, clearing banks contract the vast majority of their interest-rate-related derivatives with counterparties from the rest of the world7. This suggests that the remainder of the derivatives market in Ireland is not large enough to satisfy the contract requirements of clearing banks. Contracts carried out with Irish residents have increased, however, to equal those carried out with other euro area

Residence of counterparties is defined within three categories, Irish Residents, Other Monetary Union members (MUM’s) and Rest of the world (ROW) residents. Transactions contracted with Irish counterparties are defined within Irish residents. Transactions contracted with counterparties from other countries within the single currency euro area are contained within the Other MUM’s category, whilst remaining contracts with counterparties from other countries are contained within ROW residents.

134

Financial Stability Report 2004

members. Notably, cross-currency derivatives are only partly responsible for this distribution of counterparties as they account for a small fraction of the total value.

Chart 4: Non-clearing Institutions (with Predominantly Domestic Business): Interest-RateRelated Derivatives by Counterparty €bn

140

ROW Residents

Irish Residents

120

Other MUMs

100

80

Interest-rate-related contracts contribute roughly 82 per cent of total derivatives value for non-clearing domestic institutions at end-2003, with foreign exchange-related contracts accounting for the remaining 18 per cent. Interestingly, interest rate futures are most significant for this type of credit institution at end-1999. The nature of futures contracts and the importance of these to nonclearing domestic institutions suggest that they have less maturity or duration mismatch exposure than other categories of banks and perhaps a greater interest rate spread exposure.

60

40

20

0 1999

2000

2001

2002

A different trend entirely is observed over the period at non-clearing domestic business credit institutions. In contrast with the other categories of credit institution, contracts carried out with Irish resident counterparties are the most significant over the course of the period. However, contracts with rest of the world residents, while starting off at a small amount, are almost as significant at end-2003. This is largely attributable to the transfer of virtually all futures contracts from Irish counterparties in 1999 to rest of the world resident counterparties by 2003. Again, notably, cross-currency interest rate contracts account for only a small amount of these contracts.

2003

Table 5: Non-Clearing Institutions (with Predominantly Domestic Business): Derivatives Contracts \ billion

1999

2000

2001

2002

2003

131.7

147.2

114.8

147.0

230.3

8.3 7.6

8.7 8.1

3.9 3.0

0.6 0.8

1.3 1.2

28.2 16.0 9.0

29.6 25.2 12.1

33.8 32.5 2.1

66.6 47.6 6.0

94.0 82.0 5.3

0.3 0.3

0.3 0.3

0.1 0.6

0.0 1.5

7.0 8.0

30.2 31.6 0.1

31.6 31.2 0.1

18.3 19.2 1.3

11.5 10.3 2.2

12.4 14.7 4.4

Cross-Currency Interest-Rate-Related

3.9

5.1

5.2

9.1

11.7

Swaps —Pay fixed/receive floating cross-currency swaps —Pay floating/receive fixed cross-currency swaps —Pay floating/receive floating cross-currency swaps Other cross-currency interest-rate related contracts

1.7 0.2 1.6 0.4

3.6 0.1 1.0 0.3

4.5 0.1 0.4 0.2

7.0 0.4 1.6 0.0

4.2 1.7 5.8 0.0

135.6

152.2

120.0

156.1

242.0

65.5

74.5

58.5

61.1

52.9

201.1

226.7

178.5

217.2

294.9

Derivative Contracts Total (\ billions) Single-Currency Interest-Rate-Related Forward-rate agreements —Forward-rate agreements — deposit —Forward-rate agreements — loan Swaps —Pay fixed/receive floating interest-rate swaps —Pay floating/receive fixed interest-rate swaps —Pay floating/receive floating interest-rate swaps Options —Interest-rate option contracts purchased —Interest-rate option contracts written/sold Futures —Financial futures purchased —Financial futures sold Other single-currency interest-rate-related contracts

Total Interest-Rate-Related Other FX-Related Total Contracts Source: CBFSAI.

Table 6 shows the value of derivatives products at nonclearing foreign business institutions is far in excess of the other institution categories at end-1999, totalling some \911.3 billion and rising to \3,343 billion by end2003. Of this, single currency interest rate contracts

account for nearly 92 per cent, with cross-currency interest-rate-related accounting for nearly 5 per cent and foreign exchange-related the remainder. While this type of credit institution apportions a significant amount among all the different product types, single currency Financial Stability Report 2004

135

interest rate swaps are by far the most important, with over \280 billion apportioned to both fixed/floating and floating/fixed rate swaps at end-1999, rising to roughly \1,200 billion at end-2003. The growth in interest-rate-related contract value at nonclearing foreign business institutions, as shown in Chart 5, has occurred relatively evenly by residence of

counterparty, with value by Irish residents, other Monetary Union members and rest of the world residents all rising by roughly threefold. Many of these credit institutions are affiliated to large overseas parent companies and this strong capital base and business relationship with parent companies is the backdrop to much of this strong growth in derivatives contract value in recent years.

Table 6: Non-Clearing Institutions (with Predominantly Foreign Business): Derivatives Contracts \ billion

1999

2000

2001

2002

2003

826.2

1,259.8

2,160.5

2,414.1

3,061.8

33.0 30.0

26.4 15.2

11.2 6.1

24.1 16.3

54.9 44.1

280.3 289.7 17.2

399.2 405.3 36.0

735.4 767.6 73.8

944.1 950.1 56.0

1,204.8 1,177.0 61.5

47.5 84.0

102.1 119.9

166.2 213.7

137.8 198.2

161.3 267.7

6.8 16.5 21.3

21.1 19.2 115.5

38.6 12.4 135.5

44.1 32.5 11.0

26.9 47.7 15.8

Cross-Currency Interest-Rate-Related

51.5

85.3

123.3

143.3

163.4

Swaps —Pay fixed/receive floating cross-currency swaps —Pay floating/receive fixed cross-currency swaps —Pay floating/receive floating cross-currency swaps Other cross-currency interest-rate related contracts

13.5 12.1 19.4 6.5

24.0 15.1 33.3 12.8

29.9 16.1 65.6 11.9

26.0 13.6 92.5 11.1

31.0 16.1 104.6 11.8

877.8

1,345.1

2,283.8

2,557.4

3,225.2

33.5

57.4

87.6

87.8

118.0

911.3

1,402.5

2,371.5

2,645.1

3,343.2

Derivative Contracts Total Single-Currency Interest-Rate-Related Forward-rate agreements —Forward-rate agreements — deposit —Forward-rate agreements — loan Swaps —Pay fixed/receive floating interest-rate swaps —Pay floating/receive fixed interest-rate swaps —Pay floating/receive floating interest-rate swaps Options —Interest-rate option contracts purchased —Interest-rate option contracts written/sold Futures —Financial futures purchased —Financial futures sold Other single-currency interest-rate-related contracts

Total Interest-Rate-Related Other FX-Related Total Contracts Source: CBFSAI.

Chart 5: Non-clearing Institutions (with Predominantly Foreign Business): Interest-RateRelated Derivatives by Counterparty €bn

2,500

ROW Residents

Irish Residents Other MUMs

2,000

1,500

1,000

500

0 1999

136

2000

2001

2002

Financial Stability Report 2004

2003

As expected with this type of institution, contract value with rest of the world counterparties accounts for much of the total contract value, with Irish resident counterparties accounting for a minimal amount in comparison. Further analysis of the above breakdown of contracts across categories of credit institution up to year-end 2003 identifies the growth areas in derivatives usage. There was relatively little growth in derivatives usage at clearing institutions over the duration shown, with moderate increase in contract value with Irish residents and in swap contracts. Similarly for nonclearing domestic institutions, there has been only a moderate growth in derivatives contract value. While cross-currency interest rate contracts increased by three times its 1999 amount, the most significant increase in absolute terms was an increase of nearly \100 billion to end-2003 in single currency interest rate contracts. This was driven by a large growth in swaps contract value and a fall off in futures contract value. The most remarkable and significant aspect of the growth trends in the value of derivatives by credit

institutions in Ireland is found at non-clearing foreign business institutions. Over the period 1999 to 2003 the value of single currency interest rate, cross-currency interest rate and total derivatives contracts has more than tripled. As with the other categories of institution, it is an increase in swaps contracts which has driven the overall growth. This large growth in interest rate swaps is a noticeable trend across Europe over these years, as they became benchmarks for European fixed income markets (BIS, 2002).

Chart 6: Clearing Banks: Interest-Rate-Related Derivatives and Loans as % of Assets 200

% of total assets

180 160 140 120 100

5. Impact of Derivatives Usage on Lending Activity As stated earlier, traditional intermediation type business, involving a heavy reliance on deposits and loans, is still the most important balance sheet item for credit institutions in Ireland. In conjunction with this it would be expected that such credit institutions would hold a significant amount of interest-rate-related derivatives contracts, in particular fixed/floating and floating/fixed rate swaps contracts to hedge against maturity mismatch exposure. The analysis of the previous section suggests this as being the case on an aggregate level. Two important questions that arise in the literature are ‘do banks increase their derivatives usage in response to loan growth, which requires additional hedging, or does derivatives growth facilitate loan growth whereby reducing exposure to volatilities allows banks to expand their loan portfolios?’ Another question that arises is ‘do banks increase their derivatives usage as an investment strategy aside from a risk management strategy?’. Diamond (1984) identifies a positive relationship between loan growth and derivatives usage. Brewer et al. (2000) also find that banks using interest rate derivatives experience greater growth in their commercial and industrial loans than banks which do not use interest rate derivatives. They state that the relationship between derivatives usage and loan growth is consistent with the notion that derivatives markets allow banks to increase lending activities at a greater rate than they would have otherwise. Indeed, Brewer et al. (2001) find that banks which use derivatives also grow their business loan portfolio faster than banks which do not use them. They also suggest, however, two instances which would give rise to a negative relationship between derivatives usage and lending. The first arises where banks use derivatives for speculative purposes, in order to generate returns by taking a position on predicted interest rate movements. The second arises where banks act as OTC dealers and charge a fee for placing derivative positions.

80 60 40

Total interest-rate-related derivatives Total loans

20 0

1999

2000

2001

2002

2003

A detailed look within the categories of credit institution reveals some interesting trends. Chart 6 shows total interest-rate-related derivatives and total loans at clearing banks as a percentage of clearing banks’ total assets, while Chart 7 shows the absolute value of interest-raterelated derivatives and loans at clearing banks. Chart 6 shows that interest-rate-related derivatives have fallen as a percentage of total assets from 183 per cent to 137 per cent while loans have only fallen very slightly as a percentage of assets, from 81 per cent to 79 per cent.

Chart 7: Clearing Banks: Interest-Rate-Related Derivatives and Loan Value 220

€bn

200 180 160 140 120 100 80 60 Total interest-rate-related derivatives

40

Total loans 20 0 1999

2000

2001

2002

Financial Stability Report 2004

2003

137

At the same time however, as Chart 7 illustrates, interestrate-related derivatives have grown slightly in absolute terms, by a little under 46 per cent, while total loans have increased by roughly 90 per cent from \63 billion to \120 billion. This confirms that derivatives usage is not substituting for lending activity at clearing banks over the period and in fact complements the growth in lending activity at clearing banks, hedging the increased interest rate risk. A similar positive relationship is observed however between interest-rate-related derivatives usage and loan value at non-clearing domestic business institutions, as shown in Charts 8 and 9.

additional loan business over the period, albeit that derivatives value was far greater to begin with so it is unlikely that there is an overall hedging shortfall. This again suggests that this category of credit institution is using interest rate derivatives to suitably hedge against the increased interest rate risk arising from strong loan growth.

Chart 9: Non-clearing Institutions (with Predominantly Domestic Business): InterestRate-Related Derivatives and Loan Value 260

€bn

240

Chart 8: Non-clearing Institutions (with Predominantly Domestic Business): InterestRate-Related Derivatives and Loans as % of Assets

220 200 180

200

% of total assets

160

180 140

160

120 100

140

80

120

60

100

Total interest-rate-related derivatives

40

Total loans

80

20 0

60 1999

Total loans 20 0 1999

2000

2001

2002

2000

2001

2002

2003

40

Total interest-rate-related derivatives

Chart 10: Non-clearing Institutions (with Predominantly Foreign Business): InterestRate-Related Derivatives and Loans as % of Assets

2003

% of total assets

While there has been an increase in absolute value of both interest-rate-related derivatives and loans, the proportionate increase in loans has been much greater than for derivatives. Chart 8 shows derivatives value have fallen as a percentage of total assets from 150 per cent to 121 per cent, while loans have fallen from 85 per cent of total assets to 74 per cent.

1,600

1,400

1,200

1,000

800

Chart 9 however shows there is a positive relationship between derivatives usage and loan value as both have increased in nominal value over the period, with loan growth standing at 91 per cent and interest-rate-related derivatives growing by 78 per cent. While the absolute value of both has increased over the period shown, loan growth was in excess of the growth in interest-raterelated derivatives, suggesting that they are not a substitute for lending activity at non-clearing domestic business credit institutions. The excess in loan growth above derivatives growth however suggests the possibility that there is a shortfall in fully hedging the 138

Financial Stability Report 2004

600 Total interest-rate-related derivatives 400 Total loans 200

0 1999

2000

2001

2002

2003

Charts 10 and 11, however, illustrate a remarkably different trend for non-clearing foreign business credit

institutions. As Chart 10 illustrates, interest-rate-related derivatives have grown as a percentage of total assets from 650 per cent to approximately 1,440 per cent, while loans have fallen as a percentage of total assets from 67 per cent to 56 per cent.

Chart 11: Non-clearing Institutions (with Predominantly Foreign Business): InterestRate-Related Derivatives and Loan Value 3,500

€bn

350

€bn

3,000

300

2,500

250

2,000

200

1,500

150

1,000

100 Total interest-rate-related derivatives (LHS) Total loans (RHS)

500

50

0

0 1999

2000

2001

2002

2003

Chart 11 further highlights the exceptional growth of interest-rate-related derivatives at non-clearing foreign banks. While loan value increased slightly from \89.5 billion to \125 billion, an increase of only 39 per cent, interest-rate-related derivatives grew by 267 per cent to \3,225 billion at year-end 2003. This shows that while usage of interest-rate-related derivatives rose over the period as did loan value, the growth in derivatives is disproportionate to loans, suggesting that the increase in interest-rate-related derivatives is at best only part attributable to the increase in loan value. The strong divergence between the growth rates suggests that non-clearing foreign business banks are substituting interest-rate-related derivatives for lending activity. This may be on a speculative basis and/or on a treasury basis, acting on behalf of overseas holding companies in a risk management capacity. It is clear that the trend of derivatives usage growth at non-clearing foreign business banks is driving the growth trend shown for all credit institutions. Interest-rate-related derivatives value has grown on a smaller proportion to loans for clearing and non-clearing domestic business banks and it appears that these institutions are not substituting interest-rate-related derivatives for lending activity or engaging in excess purchasing of derivatives

for speculative reasons. The proportion of interest-raterelated derivatives held at these two types of credit institution, particularly in comparison with their proportion of lending activity, suggests that only a calculated portion of the interest rate risk associated with the strong loans growth witnessed in recent years was hedged using interest-rate-related derivatives. However, these institutions hold a greater amount of derivatives than loans so it is unlikely that the additional lending is not hedged. This trend is in stark contrast to that observed at nonclearing foreign business banks, where the proportion of derivatives to loans as a percentage of total assets is significantly greater. This picture is largely expected given the nature of business carried out at these credit institutions: they are not heavily reliant on traditional intermediation type business, of receiving deposits and granting loans, and they carry out the majority of their business with residents from the rest of the world. In that respect, the use of derivatives by these banks will have relatively little implication for the financial health of the system as they have little interdependence with the domestic market. The high derivatives usage suggests that this category of credit institution is more exposed to interest rate changes via derivatives products, albeit, more so through the proportion of derivatives held for speculative purposes. However, large amounts of derivatives themselves are not inherently risky; it is the strategy and management of a derivatives portfolio that can generate risk. Nevertheless, the analysis of loan and derivatives growth relationship across the categories of credit institutions identifies a mismatch between the categories of credit institution which have significantly increased their lending activity and interest-rate-related derivatives usage. The growth in interest-rate-related derivative usage by credit institutions in Ireland has the added effect of reducing their sensitivity to interest rate changes. In the context of the monetary policy transmission mechanism, derivatives might increase the speed and extent with which short-term interest rate variations are transmitted along the maturity spectrum as they allow expectations to be expressed more vigorously by banks in their market activity (BIS, 1994). If banks are suitably hedged against interest rate changes, when the authority changes the main interest rate banks should be in a position to adjust their deposit and lending rates quickly as their potential losses would be hedged and therefore should be able to react quickly to a rate change. Also, if banks expect rates to change at a certain time they may adjust their longer term rates to reflect this before the actual change takes place, using derivatives contracts to Financial Stability Report 2004

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hedge against the lesser possibility of the rate not changing. This in effect passes on expected interest rate changes to depositors and/or borrowers before policy interest rates are actually adjusted. However, in reducing banks’ sensitivity to interest rate changes, the presence of interest-rate-related derivatives can also allow credit institutions to respond with a lag to policy actions by monetary authorities if they so desire. This hedging of interest rates to policy rate changes can contribute to credit institutions’ delay in the pass-through of policy rates to borrowers and depositors.

6. Conclusions Interest-rate-related derivatives usage by credit institutions has witnessed a global growth trend in response to increased risk management techniques and also on a speculative and arbitrage basis as banks increase their non-interest income type business. The use of interest-rate-related derivatives by credit institutions to hedge against maturity mismatch risk also has strong implications from a financial stability viewpoint. Interest rate risk arises from the mismatch at maturity between deposit and loan interest rates on banks’ books. A strong growth in lending activity results in a proportionate rise in potential mismatch risk exposure. Adequate hedging of interest rate risk by credit institutions allows banks to insure themselves against the possible losses arising from adverse or volatile market conditions. This helps reduce the volatility of a bank’s financial condition and by virtue of reducing the effects of a shock to interest rates on bank cash flow, it reduces the likelihood of the bank becoming insolvent. This not only improves the stability of the bank but also contributes to the financial stability of the whole system, as a shock to one bank could otherwise spread through contagion. The question was raised as to whether the interlinkages between banks brought about by derivatives contracts would increase the speed and magnitude of contagion through the system were a shock to occur to a credit institution. While derivatives are more likely to reduce the effects of a shock to a bank in the first place, were a shock to have an adverse effect on a bank it is unlikely that interlinkages between credit institutions arising from derivatives contracts would have much effect on the propagation of that shock through the system through contagion. It has been identified that most of the derivatives contracts at credit institutions in Ireland are agreed with counterparties from other MUMs and rest of the world residents. The proportion of contracts agreed with Irish resident counterparties is far smaller than agreed with counterparties from other countries, with the result that the interlinkages between domestic credit institutions arising from derivatives contracts are 140

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not of a magnitude which would amplify the effects of contagion were a shock to occur. Having identified the importance of traditional intermediation business to credit institutions in Ireland, this paper sought to identify the areas of growth in lending activity and interest-rate-related derivative usage by credit institutions in Ireland. Lending growth at all credit institutions is shown as 71 per cent over the period and such growth raises concerns as to the risk level attached and the resultant hedging levels. Derivatives usage in Ireland is shown to be high by international standards and interest-rate-related derivatives usage has grown by 218 per cent over the period for all credit institutions. As expected of credit institutions with a heavy reliance on traditional intermediation, interest-rate-related derivatives are shown to be the most significant type of derivative product and have experienced large growth rates over the period year-end 1999 to year-end 2003. The largest area of growth by derivative product is fixed/floating and floating/fixed rate swaps, indicative of the need for banks to hedge the maturity mismatch exposure significant of deposit and loan reliant institutions. Growth by category of credit institution is shown to be most significant for non-clearing foreign business institutions, where interestrate-related derivatives grew nearly fourfold between end-1999 and end-2003, figures that clearly drive the growth rate for the sector as a whole. By comparing data for interest-rate-related derivatives usage and lending activity, it was sought to identify a relationship between these two activities purely on a sub-category aggregate level. With significant growth in lending activity and derivatives usage at all credit institutions, it appeared that a positive relationship existed and that lending growth was being fully hedged and additional derivatives usage was effectively excess insurance or for speculative or arbitrage purposes. However, it is unlikely that banks will fully hedge against all possible interest rate risks, as this is sub-optimal. Fully hedging risks will leave the bank holding the lowest risk possible while it will also put an upper-bound limit on its return by capping the benefit it may achieve from interest rate changes and it will also incur the costs of hedging transactions. Not hedging against risk will leave the bank holding the highest risk possible and also puts no upper bound on possible returns arising from interest rate changes. The bank will find a point within this range that is optimal in terms of the risk reduction and profit generating trade-off. While there was significant growth in absolute value of interest-rate-related derivatives at clearing banks, about

46 per cent, and at non-clearing domestic business institutions, about 78 per cent, this was not as disproportionate to loan growth as at non-clearing foreign business institutions. In non-clearing foreign business institutions, interest-rate-related derivatives grew nearly fourfold, showing a nominal value increase of 267 per cent and grew as a percentage of total assets to approximately 1,440 per cent while loans fell from 67 per cent to 56 per cent of total assets over the period. The greater proportional increases in lending compared with derivatives usage by clearing banks and nonclearing domestic business institutions suggests that the strong lending growth of recent years may not have been fully hedged. However, these two categories of credit institution began with a derivatives portfolio of much greater value than their loans portfolio, possibly incorporating some excess insurance while interest rates were at a higher level and open to wider volatility in both directions than they are currently. This in turn suggests that there is still likely to be adequate hedging in place and that this large derivatives portfolio has allowed banks to increase their lending activity at such a strong rate. This relationship indicates that clearing banks and non-clearing domestic business banks are not substituting derivatives activity for lending activity and that traditional intermediation business is complemented by the derivatives usage. The trend growth relationship between lending and derivatives activity suggests that sufficient hedging is in place in these two categories of credit institution, alleviating concerns of possible shocks to the financial system resulting from losses arising from the increased interest rate risk brought about by strong loan growth. An overall mismatch is identified within the banking sector between the category of institutions that have significantly grown their lending activity and those that have significantly grown their derivatives usage. This suggests that derivatives growth is not substituting for lending activity at clearing and non-clearing domestic business institutions, but that it may be at non-clearing foreign business institutions. This is to be expected somewhat, as this category of institution has a different product type portfolio and is not as reliant on traditional intermediation type business. However, the majority of the domestic market is not exposed to this type of financial institution, so their derivatives growth should not affect the domestic lending market. As a result, there is scope for this category of credit institution to engage in speculative and arbitrage derivatives trading in place of traditional intermediation type business without raising concerns as to financial stability. The fact that the domestic market has relatively little exposure to nonclearing foreign business banks by the nature of their

business means that were any of these to suffer a loss arising from derivatives trading, it would be unlikely to cause a shock to the system such as might arise following a shock to one of the clearing banks.

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