The impact of hedging and trading derivatives on value, performance and risk of European banks

The objective of this paper is to examine the relationship between bank characteristics, in particular value, performance and volatility of bank stock returns, and its exposure to financial derivative contracts. The study is based on 109 publicly traded European banks over the period from 2005 to 2010. The database contains both accounting data from Bankscope and manually collected information from the notes to financial statements. After controlling for bank-specific characteristics, time effects and cross-country differences, we find that banks efficiently using hedging derivatives have a lower risk and a higher value. However, this relationship becomes less pronounced or is inversed in the post-crisis period and concerns both trading and hedging derivatives. For systemically important banks heavily involved in derivatives, market volatility of stock returns is higher and valuations are lower. We notice, however, that derivatives play second fiddle to bank risk and performance. Our findings corroborate the importance of distinction of derivatives by the purpose of use, which becomes less obvious for investors in the post-crisis period. Our results have important policy implications, especially in the light of the recent debate over the necessity of separation of risky banking activities from commercial bank branches (for instance, as proposed in Liikanen report) in an attempt to reduce systemic risk. We emphasise the need for a higher transparency of disclosures regarding hedge accounting and harmonisation of reporting formats across EU.