This website uses cookies.

By clicking the "Accept" button or continuing to browse our site, you agree to first-party and session-only cookies being stored on your device to enhance site navigation and analyze site performance and traffic. For more information on our use of cookies, please see our Privacy Policy.

  1. Home
  2. ASSA Annual Meeting
  3. 2024
  4. Program
  5. Risk Management
« Back to Results

Risk Management

Paper Session

Friday, Jan. 5, 2024 10:15 AM - 12:15 PM (CST)

Marriott Rivercenter, Grand Ballroom Salon K, & L
Hosted By: American Finance Association
  • Chair: Kairong Xiao, Columbia University

Limited Hedging, HTM Accounting, and Gambling for Resurrection during the 2022 Monetary Tightening

Erica Xuewei Jiang
,
University of Southern California
Gregor Matvos
,
Northwestern University
Tomasz Piskorski
,
Columbia University
Amit Seru
,
Stanford University
Joao Granja
,
University of Chicago

Abstract

We analyze the strategies employed by banks to manage interest rate risk amid a period of escalating interest rates. We focus on the 2022 monetary tightening during which interest rates substantially increased exposing banks to $2 trillion decline in the value of their long-duration assets. Using data from call reports and SEC filings, we find that banks reported no material use of interest rate swaps to hedge this large risk exposure as only 6% of aggregate assets in the U.S. banking system were hedged by interest rate swaps. Notably, the most vulnerable banks further reduced their already limited hedges during 2022, allowing them to record accounting profits but exposing their assets to additional rate increases. Furthermore, banks collectively reclassified approximately $1 trillion of their securities as held-to-maturity (HTM), enabling them to shield their balance sheets and income statements from acknowledging asset losses that might otherwise draw scrutiny. Banks with lower capital ratios, higher share of run-prone uninsured depositors, and a larger proportion of assets exposed to interest rate risks were more likely to reclassify securities to HTM. These actions are reminiscent of a classic gambling for resurrection: if interest rates had decreased, equity would have reaped the profits, but if rates increased, then debtors and the FDIC would absorb the losses. There is some evidence that different regulators enforce HTM accounting rules differentially. Our findings carry important implications for the bank regulatory framework and its enforcement, suggesting the need for a reevaluation of risk management practices within the banking sector.

Banking on Uninsured Deposits

Itamar Drechsler
,
University of Pennsylvania
Alexi Savov
,
New York University
Philipp Schnabl
,
New York University
Olivier Wang
,
New York University

Abstract

We model the impact of interest rates on the liquidity risk of banks. Banks hedge the interest rate risk of their assets with their deposit franchise: when rates rise the value of their assets falls, but the value of their deposit franchise rises. Yet the deposit franchise is only valuable if deposits remain in the bank. This makes the deposit franchise runnable if deposits are uninsured. We show there is no run equilibrium at low interest rates, but a run equilibrium emerges as rates rise. This is because the value of the deposit franchise rises with rates, making a run more destructive, and hence more likely. To prevent a run, the bank needs to keep the value of its uninsured deposit franchise from exceeding its equity. It can do so by shortening the duration of its assets, so that their value falls less if rates rise. However, this undoes the bank’s interest rate hedge, which can make it insolvent if rates fall. The uninsured deposit franchise therefore poses a risk management dilemma: the bank cannot simultaneously hedge its interest rate and liquidity risk exposures. We show banks can address the dilemma by buying claims with option-like payoffs to interest rates, or by raising additional capital as interest rates rise. These strategies minimize the additional capital needed to prevent a run if rates rise and avoid insolvency if rates fall.

Hedging, Contract Enforceability and Competition

Erasmo Giambona
,
Syracuse University
Anil Kumar
,
Aarhus University
Gordon Phillips
,
Dartmouth College

Abstract

We study how risk management through hedging impacts firms and competition among firms in the life insurance industry - an industry with over 7 Trillion in assets and over 1,000 private and public firms. We examine firms after a staggered state-level reform that reduces the costs of hedging by granting derivatives superpriority in case of insolvency. We show that firms that are likely to face costly external finance increase hedging and reduce risk and the probability of receivership. Firms that are likely to face costly external finance, also lower prices, increase policy sales and increase their market share post reform.

What's Wrong with Annuity Markets?

Stephane Verani
,
Federal Reserve Board
Pei-Cheng Yu
,
University of New South Wales

Abstract

We show that the supply of U.S. life annuities is constrained by interest rate risk. We identify this effect using annuity prices offered by life insurers from 1989 to 2019 and exogenous variations in contract-level regulatory capital requirements. The cost of interest rate risk management---conditional on the effect of adverse selection---accounts for about half of annuity markups or eight percentage points. The contribution of interest rate risk to annuity markups sharply increased after the Great Financial Crisis, suggesting new retirees' opportunities to transfer their longevity risk are unlikely to improve in a persistently low interest rate environment.

Discussant(s)
Andres Sarto
,
New York University
Yufeng Wu
,
University of Illinois
Chotibhak Jotikasthira
,
Southern Methodist University
Ishita Sen
,
Harvard University
JEL Classifications
  • G3 - Corporate Finance and Governance