Do Derivatives Moderate Default Probability of Commercial Banks?

Banks’ role as financial intermediaries necessitates the use of financial derivatives for trading and hedging, and exposes banks to the probability of default. This unattended default probability, along with the external risk exposure of banks, translates into contagious risk. This three-dimensional effect between derivative usage, external risk and default probability leads to economic failure. Studies rarely address the fact that derivatives are an intermediary (moderator), used to either transfer or diversify the risk absorbed through financial intermediation. This article aims to identify the moderating impact of derivatives on the relationship between banks’ probability of default and banks’ risk exposures. The study involves data from 110 commercial banks between 2005 and 2019 to perform a moderation effect on pooled panel data. Results show that the hedged derivatives, along with the market risk factor and the exchange rate risk factor, have a significant moderating effect on the default probability of banks. It is further identified that the default probability of a systemically important bank is linked to the default of its financial system of home or parent country (D-SIB) rather than global economic system.

JEL Codes: G21, G32, G23, O50