On the Determinants of Interest Rate Swap Usage by Indian Banks

Abstract

Banks have twin objectives of maximizing profitability and at the same time trying to ensure sufficient liquidity. To achieve these objectives, it is essential that banks have to monitor, maintain and manage their assets and liabilities portfolios in a systematic manner taking into account the various risks involved in these areas. Balance sheet risk can be categorized into two major types of significant risks, which are liquidity risk and interest rate risk (IRR). Interest rate risk is the risk to earnings or capital arising from movement of interest rates. For measuring interest rate risk, banks use a variety of method such as gap analysis, the duration gap method, the basis point value (BPV) method, and simulation methods. The need to manage IRR arises as its management is critical to the overall profitability of banks and they have started using derivative instruments such as interest rate swap, interest rate futures, and forward rate agreements. Hence, the present study entitled “On the Determinants of Interest Rate Swap (IRS) Usage by Indian Banks” has been taken up to model the factors which determine the use of interest rate swap to manage IRR. The sample for this study includes 24 Indian Commercial Banks and it used annual data for the financial year 2007-08. For this purpose, the bank specific characteristics such as size, asset quality, capitalization, profitability, interest rate risk profile are regressed against the notional amount of the interest rate swap reported for hedging activities. It is found that the larger banks (as explained by the total assets) and profitable banks (as explained by the profit before tax to total asset ratio) do not seem to have any comparative advantage to use interest rate swaps for hedging purpose more intensively than smaller banks. Further, it is found that the banks with more exposure to interest rate risk, high net worth, and higher loans to asset ratio tend to be larger users of interest rate swaps.

Keywords: Interest Rate Risk, Interest Rate Swap, Hedging, Indian Banks

JEL Classification: E43, D81, G21