Derivatives as risk management and performance of agricultural banks

Introduction

The financial crisis in 2008 brought financial derivatives to the front of academic review.
Possibly misuse of derivatives tools such as subprime lending and asset backed securities
(ABS), were at the essential of the financial crisis which wiped out all independent
investment banks as well as numerous large commercial banks in the USA.

The efficiency of derivatives in banking is taken into question because of the perception
that (large) banks practice derivatives for speculative purpose rather than for risk hedging.

The purpose of this paper is to estimate the influence of financial derivatives on

profitability in agricultural banks. Agricultural banks are new to the derivatives market and
are unlikely to use financial derivatives for risk speculation.

Literature review

Relative to previous financial crises impacts, the 2008 financial crisis had less of an impact
on agricultural banks, because they were in a better position to manage risks and because
agriculture as sector was doing better than the rest of the economy (Briggemanet al., 2009;
Ellinger, 2009; Hartarska and Nadolnyak, 2012).

Design/methodology/approach

The authors use call report data from Federal Reserve Bank of Chicago for 2006, 2008 and
2010 to estimate an endogenous switching model to estimate how effectiveness of
derivatives user and non-user agricultural banks is affected by diverse risk factors.
The number of derivative using agricultural banks has increased in time from 154
derivatives users in 2006 to 241 by 2010, which signifies around 10 percent of agricultural
banks.
Derivatives user banks are approximately four times as big as those not using derivatives.
Before the end of the economic crisis profitability of user and non-user agricultural banks
was similar though slightly higher for user-banks.
 However, the difference was increasing over time, and the difference 0.12 percent in 2010
was statistically substantial.
Throughout the 2006-2010 period, derivatives user agricultural banks assigned more assets
to investments and loans, which make higher interest than money market accounts,
marketable securities and treasury bills, than non-user banks especially during and after the
financial turmoil (2009and 2010) with around 91 percent of total assets as earning assets
for user banks but only89 percent for the non-user banks in 2010.
Linked to non-user banks, derivative user agricultural banks had more expanded loan
portfolio with around 30 percent of their total loans classified as agricultural while non-
user agricultural banks had 39 percent agricultural loans.
In general, associated to non-user banks, derivatives users are greater, more gainful, have
more diversified loan portfolio and efficient internal management, and have lower interest
risks but higher liquidity risks.
Even with higher loan charge-offs after the financial crisis, derivatives user banks still
Outclassed non-user banks.

Findings

Results show that risk management through financial derivatives in agricultural Banks is
effective and profitability of derivatives user agricultural banks is less affected by credit
risk and interest risk in the sample period.
Derivatives activities have improved agricultural banks profitability and these impacts
were increasing over years. In particular, in 2010 without use of derivatives, user banks
would have had one-third lower profitability.
We find that derivatives activities help mitigating the negative effects of credit risks and
interest risks before, during and after the 2008 financial crisis
Moreover, the difference in profitability for the derivatives user banks was increasing over
time.
We conclude that agricultural banks have master the skill of risk management with
derivatives and use it properly. Risk management with derivatives at agricultural banks is
effective.