Hedging, usually done through the use of derivative securities, is an important way for banks to manage risk in their investments. If, say, interest rates were to rise and the value of mortgage securities fell, it would have a serious impact on the bottom lines of lenders or those who hold mortgage securities, making interest rate derivatives an attractive mechanism for hedging.
While capital buffers are important for financial stability, it is an open question whether or not a better (worse) capitalized bank will choose to increase (decrease) hedging or use their extra capital to make loans. A new NBER paper finds that better-capitalized banks hedge more than their less-capitalized peers:
We study risk management in financial institutions using data on hedging of interest rate and foreign exchange risk. We find strong evidence that better capitalized institutions hedge more, controlling for risk exposures, both across institutions and within institutions over time. For identification, we exploit net worth shocks resulting from loan losses due to drops in house prices. Institutions that sustain such shocks reduce hedging significantly relative to otherwise similar institutions. The reduction in hedging is differentially larger among institutions with high real estate exposure. The evidence is consistent with the theory that financial constraints impede both financing and hedging.
The theoretical question of whether better- or worse-capitalized banks would hedge more is an open one. On the one hand, a bank with more capital would have “skin in the game,” and thus would want to guard against future risk. On the other hand, since it has a better loss-absorbing cushion, it may choose to lend, which is more profitable.
The empirical findings of the paper point to the former case as being true.
One interesting finding of the paper: regulatory capital does not have an effect on these findings.
Given these findings, one way to encourage hedging by financial institutions would be to make the cost of capital cheaper relative to that of debt. The most efficient way to do so would be to eliminate the preferential tax treatment of debt through the deductibility of interest payments.