What Motivates Banks to use Derivatives: Evidence from Taiwan

Abstract

Banks are active users of derivatives. Using banks listed on the Taiwan Stock Exchange for which there is detailed derivatives information for the period 1998 to 2005, we examine the determinants of derivatives usage and its impact on bank risk. Using specific bank characteristic variables that proxy for the motivations and effects of banks participating in the derivatives market and end-quarter transaction volumes, we investigate the rationale for derivatives usage that are discussed in the literature. Using Probit and panel data methods and testing for endogeneity, we investigate whether risk management, informational and economies of scale arguments as well as agency and managerial explanations are good predictors of observed activity. Our results support the evidence of prior studies that risk management, and informational and scale factors explain the use of derivatives. On the other hand, our findings do not show that the use of derivatives affects observable risks. We also observe a substitution effectwhich suggests a rational approach to the participation decision. However, we find no support for agency and managerial motives, which we partly attribute to the specific regulatory, legal, and cultural environment that exists in Taiwan.