Working Paper 96-3
by Joe Peek and Eric S. Rosengren

Revised article published in the Journal of Financial Services Research 12, no. 2/3 (October/December 1997): 287-302.

We find that a relatively large number of banks active in the derivatives market have low capital ratios and are considered institutions with a significant risk of failure by bank supervisors. However, we also find no evidence that the volume of derivatives activity at troubled banks affects the probability of formal regulatory intervention or even a downgrade in supervisory rating. While derivatives have become an essential instrument for hedging risks, moral hazard can lead to their misuse by problem banks. Given that the absence of comprehensive data on bank derivatives activities presents an accurate assessment of bank risk-taking, banks have an opportunity to take unmonitored second bets. Troubled banks have the motive to increase risk, and derivatives provide the means to do so. The role of bank supervisors should be to limit the opportunity through more comprehensive data reporting requirements and closer supervisory scrutiny of derivatives activity at problem banks.