The Use of Derivatives and Bank Risk Taking in China

Our paper examines the effect of derivatives activities on credit risk taking in Chinese banks theoretically and empirically. We develop a model of financial intermediation where bank can engage in costly monitoring to reduce the credit risk in its loan portfolios. Our model incorporates three key features: (1) has two stages including the hedging stage and the lending stage in turn; (2) captures the main characteristics of the banking sector in China such as ceiling on the deposit rate; and (3) treats the bank as one of a large number of monopolists in the local lending market. From the theoretical model, we derive that using the derivatives for hedging market risk (e.g., exchange rate and interest rate risk) makes bank expose to more credit risk. In the empirical section, we use a Two-stage Least Squares (TSLS) regression methodology with semi-annual data of China's listed banks from 2007 to 2013. We find that there is the positive effect on bank credit risk taking by not only the overall derivatives contract but also foreign exchange and interest rate derivatives. Furthermore, the results suggest that the positive effect of derivatives is statistically significant on the total credit risk, the mild and medium level of credit risk, but is weak on the severe level of credit risk. Our findings are also relevant for understanding the financial instability implications of derivatives activities in banking industry. In addition, Appendix of our paper provides a brief outline of the current Chinese banking sector