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BANK LENDING AND INTEREST- RATE DERIVATIVES

Another notable increase occurred in the forward-rate agreement (FRA) usage. FRA is a contract that determines the rate of interest, or currency exchange rate, to be paid or received on an obligation beginning at some future date. At the end of 1996, 9.02 percent of the sample banks report using FRAs. By the end of 2004, the percentage using FRAs more than doubled. While the percentage of banks participating in the swaps and forwards increased over the sample period, the proportion of banks using interest-rate options fell. This decline is most notable between year-end 2000 and year-end 2004. With the. | BANK LENDING AND INTEREST- RATE DERIVATIVES Fang Zhao Assistant Professor of Finance Department of Finance Siena College Loudonville New York 12211 E-mail fzhao@Siena.edu Jim Moser Senior Financial Economist Office of the Chief Economist Commodity Futures Trading Commission Washington DC 20581 Email jmoser@cftc.gov BANK LENDING AND INTEREST- RATE DERIVATIVES Abstract Using recent data that cover a full business cycle this paper documents a direct relationship between interest-rate derivative usage by U.S. banks and growth in their commercial and industrial C I loan portfolios. This positive association holds for interestrate options contracts forward contracts and futures contracts. This result is consistent with the implication of Diamond s model 1984 that predicts that a bank s use of derivatives permits better management of systematic risk exposure thereby lowering the cost of delegated monitoring and generates net benefits of intermediation services. The paper s sample consists of all FDIC-insured commercial banks between 1996 and 2004 having total assets greater than 300 million and having a portfolio of C I loans. The main results remain after a robustness check. JEL Classification G21 G28 Key Words Banking Derivatives Intermediation Swaps Futures Option Forward 2 1. Introduction The relationship between the use of derivatives and lending activity has been studied in recent years. Brewer Minton and Moser 2000 evaluate an equation relating the determinants of Commercial and Industrial C I lending and the impact of derivatives on C I loan lending activity. They document a positive relationship between C I loan growth and the use of derivatives over a sample period from 1985 to 1992. They find that the derivative markets allow banks to increase lending activities at a greater rate than the banks would have otherwise. Brewer Jackson and Moser 2001 examine the major differences in the financial characteristics of banking organizations that use derivatives relative