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
123
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
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Financial Stability Report 2004
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
125
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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Financial Stability Report 2004
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
127
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
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Financial Stability Report 2004
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
129
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
130
Financial Stability Report 2004
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
139
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
Financial Stability Report 2004
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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