Characteristics of Interest Rate Swap End-User Commercial Banks: Evidence from Pakistan

Abstract

The research empirically investigates the characteristics of interest rate swap end-user commercial banks in Pakistan. Since 2003, financially engineered products are actively been pursued by the banks as a risk management and mitigating tool. There are prior studies on the determinants of the usage, the extent of usage of the interest rate and foreign exchange derivaties, but all have focused on the non financial and listed companies in Pakistan. This study fills the gap and extends the prior research to the unstudied banking sector, by exploring four end-user commercial banks to determine the characteristics of the banks using interest rate swaps for hedging risk - based on the notional value of interest rate swaps using cross sectional pooled data for nine years (2005 — 2013). The study has adapted the empirical model used by (Carter & Sinkey Jr., 1998). It involves the application of OLS regression technique to examine the relationship between the independent variables (size, capital adequacy, liquidity, dividends, intermediation profitability, joint risk management & exposure to interest rate risk and the dependent variable (interest rate swap usage). The findings indicate that interest rate swap usage is statistically significant for size, liquidity and coordinated risk management. The size variable is negatively related which implies that the usage of swap derivatives by end-us-ers banks in Pakistan is primarily a niche rather than a main line activity. For liquidity and joint risk management, the coefficients of interest rate swap usage are significant and positive relationship implying liquid banks make extensive usage of swaps to diversify risk exposure and these end-user banks in Pakistan practiced coordinated risk management because banks having more credit risks used more interest rate swaps.Keywords: Authorized Derivative Dealers; Interest Rate Swaps; End-User Banks; Hedging; Interest Rate Risks.