Derivatives Activity at Troubled Banks

Because of moral hazard associated with deposit insurance, troubled banks that have a relatively thin capital cushion to absorb losses have an incentive to take speculative positions. Thus, the prevalence of problem banks among those actively engaged in derivatives markets should be of concern to bank supervisors. However, we find no evidence that bank supervisors take into account, either favorably or unfavorably, the derivatives activities of troubled banks in their decisions to downgrade bank ratings or impose regulatory actions. The derivatives activity of troubled banks should raise the same concerns expressed about banks' on–balance-sheet positions, namely, that they may not be fully exploiting hedging opportunities or may be placing their remaining capital at risk, intentionally or unintentionally.