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AFR
73,2 Derivatives as risk management
and performance of
agricultural banks
290
Xuan Shen and Valentina Hartarska
Department of Agricultural Economics and Rural Sociology,
Auburn University, Auburn, Alabama, USA

Abstract
Purpose The purpose of this paper is to estimate the impact of financial derivatives on profitability
in agricultural banks. Agricultural banks are new to the derivatives market and are unlikely to use
financial derivatives for risk speculation. Thus, the paper also provides evidence on the effectiveness
of financial derivatives as a risk management tool in small commercial banks.
Design/methodology/approach The authors use call report data from Federal Reserve Bank of
Chicago for 2006, 2008 and 2010 to estimate an endogenous switching model to evaluate how
profitability of derivatives user and non-user agricultural banks is affected by different risk factors.
This approach allows banks endogenous choices to use financial derivatives to be accounted for, and
to build a counterfactual analysis what user banks profitability would have been if they did not
participate in the derivatives activities.
Findings Results indicate that risk management through financial derivatives in agricultural
banks is effective and profitability of derivatives user agricultural banks is less affected by credit risk
and interest risk in the sample period. Derivatives activities have improved agricultural banks
profitability and these impacts were increasing over years. In particular, in 2010 without use of
derivatives, user banks would have had one-third lower profitability.
Originality/value This research is the first to study the role of derivatives in agricultural banks
and also provides empirical evidence on the effectiveness of risk management through financial
derivatives in agricultural banks.
Keywords Banks, Agricultural finance, Commercial banks, Risk management, Securities,
Agricultural banks, Financial derivatives, Profitability, Endogenous switching regression
Paper type Research paper

Agricultural Finance Review
Vol. 73 No. 2, 2013
pp. 290-309
q Emerald Group Publishing Limited
0002-1466
DOI 10.1108/AFR-07-2012-0036
Introduction
The financial crisis in 2008 brought financial derivatives to the forefront of academic
inquiry. Arguably misuse of derivatives instruments such as subprime lending
and structured notes (collateralized mortgage obligations (CMOs), mortgage backed
securities (MBS), and asset backed securities (ABS)), were at the core of the financial crisis
which wiped out all independent investment banks as well as several large commercial
banks in the USA. The effectiveness of derivatives in banking is brought into question
because of the perception that (large) banks use derivatives for speculative purpose
rather than for risk hedging. We evaluate how derivatives used as risk management tools
rather than speculation, affected the performance of agricultural commercial banks.
JEL classification G20, G21, G32
This paper was presented as a contributed paper at the 1st International Agricultural Risk
Finance and Insurance Conference held in Beijing PRC, June 20-21 2012. As such this paper has
not gone through the usual double blind review process.
 Use of derivatives by agricultural banks grew mostly in the past decade and by Derivatives
2012, 10 percent of the banks used such financial instruments. Unlike large banks as risk
which are the main players in the dealership derivatives market and highly likely to
trade derivatives for profits or speculation, agricultural lenders such as agricultural management
commercial banks and Farm Credit System (FCS) institutions, have limited funding
sources and use financial derivatives, such as forward, option and swap, mainly for
risk management rather than speculation[1]. Therefore, evaluating the impact of 291
derivatives on agricultural banks performance allows separating the effect
of derivatives used for risk management from that of for speculation. We estimate
the derivatives contribution to bank profitability by accounting for the fact that banks
may self-select into using or not using derivatives.
Uncertainty in banking has increased steadily since the 1980s due to deregulation,
increase in interest rate variability, and market structure changes. The main causes of
the banking crises in 1980s and 1990s were external shocks and sectoral recessions as
well as banks inability to properly manage the higher interest and credit risks. As a
result, risk management became the center of the developments in banking in the past
three decades. After the second oil shock in the 1980s, increased interest rate volatility
prompted commercial banks to manage interest rate risk through balancing fixed rate
assets, loans and securities, and liabilities to minimize the maturity gap and the duration
gap. The costs of on-balance-sheet risk management are high due to the potential
disruption to banks business strategy and are time-consuming because of the limited
flexibility to change the banks balance sheet structure (Hirtle, 1997; Brewer et al. 2001).
Advancements in financial theory and increased computerization led to financial
derivatives use as risk management instrument to isolate risk management from other
business objectives. Compared to traditional on-balance-sheet risk management, risk
management through financial derivatives, usually referred to as off-balance-sheet
activities, is less costly, could substitute for expensive capital, and gives banks the
flexibility to reach desired risk exposure. Hedging theory suggests that derivatives
activities could improve banks profitability and reduce risk. The risk is hedged
through derivatives when the gains from the derivatives offset or reduce the losses in
cash or spot market (Gorton and Rosen, 1995).
Large banks have been using derivatives for at least two decades long period but
changes in the banking regulations in the in 1990s, made it possible for small agricultural
banks to also hedge[2]. The Office of the Comptroller of the Currency (OCC) reports that
the value of commercial banks derivatives has reached $231 trillion in 2011 from only
$17 trillion in 1995. Over 93 percent of the derivatives activities are concentrated in the
top five large banks and over 90 percent of the derivatives activities are for trading
purposes (fee income) while the rest are for risk hedging. Agricultural banks mainly
participate in the non-trading (hedging) derivatives activities. Our data shows that few
agricultural banks (less than 10) participated in the derivatives markets before the
deregulation acts of 1999, while 10 percent or 241 agricultural banks did so in the 2010.
Agricultural banks use derivative contracts mostly to hedge against interest rate risk.
These data are not surprising because derivatives use requires extensive
investment in financial and human capital and high user compliance costs, which
create a natural barrier for small banks to enter the derivatives market. When small
banks such as an agricultural bank enter the market, it is more likely to use derivatives
for risk management than to trade derivatives and speculate. The decision to enter the
AFR market, furthermore, may be endogenous to overall bank profitability in that banks
73,2 with better management and human resources would use derivatives and because of
these skills, these banks would be the most profitable as well.
Simple means comparisons show that derivatives using agricultural banks are more
profitable than banks not using derivatives even during the recent financial crisis.
However, due to the heterogeneity of user and non-user agricultural banks and the
292 non-randomness of the banks choice to participate in the derivatives market, direct
comparison of the banks profitability between user and non-user agricultural banks
may be misleading. Thus, we allow for endogenous selection into user and non-user
and study the impact of derivatives use on agricultural banks profitability with an
endogenous switching model. This approach permits to build a counterfactual analysis
and evaluate user agricultural banks profitability if they did not participate in the
derivatives activities.
The next section describes derivatives use in (agricultural) banks. Third section
discusses the current literatures on derivatives contracts effects on performance.
Fourth section discusses empirical models and data; and fifth section will discuss
the empirical results. Finally, sixth section will summarize and conclude the paper.

Financial derivatives use in banks

Banks use derivatives to reduce risk exposure and to improve profitability. Derivatives
are financial instruments whose value depends on the value something else S&P 500
equity index, three-month London Interbank Offered Rate (LIBOR), US/Euro exchange
rate, a group of loans, and default of corporate debt. The structure of derivatives
contracts separates risk factors from the underlying assets and allows investors to
benefit from the fluctuation of the underlying assets without investment in such assets,
As long as investors take positions in derivatives towards the opposite direction of
price fluctuation in underlying assets, uncertainty of future cash flow is removed
or hedged. For example, a bank has to pay interest to depositors on a principle of
$1 billion based on money market rate which is floating but the bank receives fixed
payments from loan investments. If the money market rate doubles, the interest
payment will also double. To hedge the risk, the bank could transform the money
market deposit accounts to time deposits but this may lead to fewer deposits. In
contrast, the bank could enter a swap and agree to pay fixed interest rate on $1 billion
to the counterparty and receive a payment based on the money market interest rate.
Then the bank could pay depositors with the floating rate payment received from swap
contract counterparty and the only payment the bank has to make is fixed interest
payment to the swap counterparty. Similarly, if banks receive payment dominated
in other currencies, they could enter a forward or future contract or a currency swap
when the payments is periodical to lock in the payment or they could take a position in
option to hedge against loss due to exchange rate fluctuations.
Financial derivatives, however, also expose banks to new risks. Entering a position
in derivatives contracts does not need much initial investment, but future cash flows
given fluctuation of the underlying assets could be huge. Secondly, it is relatively easy
to liquidate the exchange-traded derivatives with simple structure and standardized
contract. However, for some complex derivatives, such as over-the-counter derivatives,
only a small group of players are in the market. When wanting to hedge such exposed
derivatives positions, banks may find it difficult to find counterparty and have no
choice but to leave the risk exposure open. This is especially the case when unexpected Derivatives
events happen and banks have to liquidate the derivatives, it would be difficult to close
the position in the market without bearing a huge loss. Lastly, the structure of some
as risk
derivatives contracts, such as some collateralized debt obligations (CDOs), can be so management
complex that even some investors themselves do not understand what and how much
risk they are taking. This is an extremely dangerous situation when unfavorable
market conditions happen as in 2008. Thus, as stated by Stulz (2005), financial 293
derivatives allow investors to achieve payoffs that they could have never achieved
without derivatives, or could only achieve at greater cost but investors must
understand what are they getting and use them properly.
Agricultural lenders such as the FCS institutions are cautious with their investment
and neither originate subprime loans nor invest in lower rated MBS or ABS backed by
subprime loans within the system. They use derivatives, mainly interest rate swaps,
mostly to manage interest rate risk. Thus, they were less affected by the 2008 crisis.
However, Farmer Mac had to write off $54.5 million on debt securities issued by
Lehman Brothers (collateral debt obligations) in 2008. As most agricultural banks are
privately held and do not disclose detailed investment and risk management policies to
the public, there is little information on how agricultural banks participated in
derivatives market or how they were involved in corporate debt markets, especially
collateral debt obligations market. However, after the passage of Gramm-Leach-Bliley
Act of 1999, commercial banks are allowed to enter brokerage, insurance, and
investment banking business.
Our data shows that many agricultural banks such as Great Western Bank
(headquarter in South Dakota), Eastwood Bank (headquarter in Minnesota), Citizens
Business Bank (headquarter in California), etc. not only provide deposit and loans but
also asset management, insurance, and investment services. With more diversified
services and investment portfolio, compared to FCS institutions, agricultural banks are
more likely to make some risky investment such as subprime loans and lower-rated
non-agency MBS. Moreover, they could also manage risks using derivatives contracts
with underlying assets other than interest rate, such as equity, commodities, and foreign
exchange, and have the potential to apply much more complex risk management
strategies to better control risk exposures and mitigate variations in cash flow and
investment value. Robobank, the largest derivative user in our sample, stated in their
2010 report that they used derivative financial instruments as part of asset and liability
management to manage its interest rate risks, credit risks and foreign currency
risks. Their:
[. . .] derivative financial instruments generally comprise foreign exchange contracts,
currency and interest rate futures, forward rate agreements, currency and interest rate swaps,
and currency and interest rate options (written as well as acquired).
Overall, agricultural lenders, especially agricultural banks, have little exposures to credit
derivatives, such as credit options, credit default swaps and total return swaps, even
though securities especially credit default swaps, have been widely used in large banks
and other financial institutions to control credit risks. In 2010, only one agricultural
bank, State Bank Financial (headquarter in Wisconsin) in our sample used credit default
swaps.
According to our data, in 2010, derivatives user agricultural banks charged off
25 percent more loans but also had return on assets (ROA) 12 percent higher than that
AFR of non-user banks on average, which implies that the improved ROA for user banks
73,2 may come from the effective risk management through derivatives activities and they
have better controlled exposed risks.

Literature review
When it comes to the evaluating banks performance, profitability and risk are usually
294 discussed together. Much of the literature on banks performance focuses on testing
whether derivatives use reduces risk exposure. Popular performance measures, such as
standard deviation of historical stock prices and implied volatilities, are derived from
the historical price of public traded stocks for sample banks (Hassan and Khasawneh,
2009a, b; Zhao and Moser, 2009a, b; Choi and Elyasiani, 1997; Brewer et al., 1996). The
majority of agricultural banks in the sample are privately held and do not have
publicly traded stocks. This work is based on the alternative dealership models
developed by Ho and Saunders (1981), Allen (1988) and Angbazo (1997) which link
bank profitability to various risk exposure factors.
Since derivatives use by agricultural banks grew mostly in the past decade, the link
between derivatives use and profitability has not been studied. The predominant
agricultural banking literature is focused on, or motivated by, the 1980s farm credit
crisis, when increased competition from S&Ls, interest rate volatility, and farm real
estate bubble lead to the failure of 1,617 commercial banks during 1980s and early
1990s, of which 78 percent were agricultural banks (FDIC, 1997). Belongia and Gilbert
(1990) identify the lack of diversification into assets other than loans and the high
proportion of agricultural loans as primary causes for the farm credit crisis, while
affiliation with large bank holding companies (BHCs) was associated with lower
probability of failure of agricultural banks. Since consolidation of agricultural bank
followed the crisis, consequent studies explored performance in terms of efficiencies
and economies of scale and scope. Studies have also evaluated banks response to
regulation changes which removed restrictions on intrastate, interstate, and
international banking (Belongia and Gilbert, 1990; Gilbert, 1991; Ahrendsen et al.,
1995; Featherstone and Moss, 1994; Neff et al., 1994; Dias and Helmers, 2001; Choi and
Stefanou, 2006; Choi et al., 2007; Settlage et al., 2009).
Relative to previous financial crises impacts, the 2008 financial crisis had less of an
impact on agricultural banks, because they were in a better position to manage risks and
because agriculture as sector was doing better than the rest of the economy (Briggeman et al.,
2009; Ellinger, 2009; Hartarska and Nadolnyak, 2012). While delinquencies have been
increasing, the share of problem loans of agricultural lenders remains less than 50 percent
of that of non-agricultural banks (Briggeman, 2011; Ellinger, 2011). Recent work on
derivatives use by agricultural banks suggest that hedging to reduce risk benefited
agricultural banks while in non-agricultural banks (likely speculative) derivatives
operations reduced profitability and increased risk level (Shen and Hartarska, 2012).
Most agricultural banks that entered derivatives market after the regulation
changes in 1999 continue to use derivatives to hedge risk, but remain relatively small
and are thus vulnerable to inappropriate hedging suggesting likely positive overall
impact on performance. In the post crisis environment, the huge losses of financial
institutions due to derivatives trading have reinvigorated a debate on the purpose of
derivatives speculation or risk hedging. The academic literature on the effects of
derivatives on banks performance has identified both positive and negative impacts
and provided ambiguous empirical evidence likely due to the fact that speculation and Derivatives
hedging remain difficult to distinguish empirically. We believe that since agricultural as risk
banks are small and likely using derivatives only for risk management, by analyzing
derivatives activities of agricultural banks we provide evidence on the risk reducing management
impact of derivatives in banks.
The mainstream capital structure irrelevance theory developed by Modigliani and
Miller (1958) argues that in a perfect world, the equity value of a commercial bank is 295
not affected by its hedging activities. However, market imperfections, such as existence
of tax, contracting cost, and information asymmetries, create incentives for firms to
hedge due to the potential benefits from increased equity value and reduced cash flow
variations, from reduced tax liability, bankruptcy cost and managerial risk a version
(Smith and Stulz, 1985).
The financial intermediary theory developed by Diamond (1984) and Froot and
Stein (1998) implies that hedging observable or tradable risks and non-tradable risks,
allows commercial banks to obtain optimal benefits from portfolio diversification and
intermediation services, to enjoy lower monitoring costs, and to reduce use of costly
external financing. Thus, risk hedging derivatives activities serve as complements to
the banks lending activities and improve performance.
Some of the empirical literature supports the financial intermediary theory by
Diamond (1984). For example, Gorton and Rosen (1995) study commercial banks during
1985-1993 and find that the change in banks net income due to the change in interest rate
is partially offset by the opposite change in net income from the interest rate hedges, and
thus interest rate swaps have helped commercial banks hedged most of the systematic
risks. Zhao and Moser (2009a, b) find that with both on- and off-balance sheet (OBS) risk
management methods, maturity gap matching and interest rate derivatives, BHCs
effectively reduced their interest rate sensitivity of equity value during 1998-2003.
Brewer et al. (1996) find that interest rate risk was lower for derivatives user S&Ls
during 1985-1989. Studying the effects of macroeconomic shocks on interest rate risk
management of commercial banks, Purnanandam (2007) finds that derivatives using
banks make less or no adjustment to the on-balance sheet maturity gaps and do not cut
lending when Feds tighten monetary supply, which indicates that derivatives activities
could help smoothing to the commercial banks cash flows.
Other work, however, finds that derivatives increase commercial banks risk-taking.
By extending the two-factor market model developed by Flannery and James (1984)
and Hirtle (1997) examines the relationship between derivatives activities and BHCs
interest rate sensitivities of stock return between 1986 and 1994. He finds that the
interest rate derivatives increased BHCs interest rate exposure and this effect varied
for BHCs of different size with stronger effects for large dealer BHCs. Based on the
dealer model developed by Ho and Saunders (1981), Allen (1988) and Angbazo (1997)
analyzes the effects of OBS activities on banks profitability during 1989-1993. He finds
that while OBS activities improved banks profitability by allowing participation in
activities otherwise restricted with debt or equity financing, OBS activities increased
banks exposure to liquidity and interest rate risk.
Recently, Hassan and Khasawneh (2009a) compare the risk effects of different
derivatives contracts based on three main risks measures: systematic risk (b), standard
deviation of the stock returns, and implied volatility. They find that while interest rate
swap contracts are risk reducing products across all three risks measures, other
AFR derivatives contracts (option, future and forward) are positively correlated to systematic
73,2 market risk (b). A study by Instefjord (2005) suggests that credit derivatives securities
increase bank risks and credit derivatives trading could hurt bank stability.

Empirical approach
Banks earn profits from accepting and managing risks. Commercial banks are viewed as
296 intermediaries between depositors and borrowers, profiting from the difference of the
interest they charge for loans and the interest they paid to the depositors. Ho and Saunders
(1981), Allen (1988) and Angbazo (1997) develop a dealership framework to study banks
performance, which is modeled as determined by several risk factors, including credit risk
or default risk, liquidity risk, interest risk, concentration risk and operating risk. In
particular, in this literature banks profitability in the earlier studies measured by net
interest margin (NIM) is modeled as a function of series of bank risk factors:

NIM FDefault risk; Interest risk; Liquidity risk; Capital adequacy;

1
Management; Diversification risk

Since 1980, however, commercial banks have been relying increasingly on services that
earn non-interest-rate (sensitive) incomes and their share in banks operating revenue has
been steadily increasing in the past few decades. For example, in 2010 around 31 percent of
the operating revenue of the agricultural banks in our data comes from noninterest income.
We use the ROA to measure bank profitability because it measures efficiency of a bank
use of every dollar of its assets and take into account financial leverage and associated
risks (Dietrich and Wanzenried, 2011; Flamini et al., 2009).
To estimate the effect of derivatives on profits, the general form is to include a
dummy variable which identify the banks which participated in the derivatives market
in the above equation:
ROA X b I z 1 2
where ROA is the measure for profitability of the agricultural bank, X is a vector of
endogenous variables suggested by the dealership framework are described below and
spelled out in equation (1), and Iis the dummy variable which identifies derivatives user
agricultural banks. This model assumes that the banks decision to use derivatives is
exogenous to profitability in that banks derivatives use activities only affect the average
profitability (intercept effect) rather than the sensitivities of profitability (b) to various
risk factors. However, such assumption is too strong and unrealistic and can be tested
empirically. First, the decision to use or not to use derivatives is affected by unobserved
characteristics such as managers knowledge of derivatives, banks risk management
policy, and managers risk preference. Such unobserved factors likely also affect
profitability. Derivatives users are likely systematically different from non-users and
have self-select themselves to use derivatives. Thus, banks decision to use derivatives
and profitability are not independent and profitability for derivatives users and
non-users should be estimated separately. OLS regression with a simple dummy variable
on pooled data will lead to biased results.
We apply instead the endogenous switching model, developed by Maddala and
Nelson (1975) and Maddala (1986), to control for the endogenous selection problem
by allowing the correlation between the decision to use derivatives and profitability.
This framework permits user and non-user banks profitability to react differently to Derivatives
risk factors. In this model, the profitability functions on derivatives user and non-user
banks are estimated simultaneously with the decision function:
as risk
management
Y 1i X 1i b1 11i if I i 1 3
Y 2i X 2i b2 12i if I i 0 4
297
Y *3i Z i g ni 5

Ii 1 iff Y *3i $ 0 6

Ii 0 iff Y *3i , 0 7
where X1 and X2 are vectors of variables which affect profitability; and Z is a vector of
variables which affect the derivatives use decisions. The error terms 11, 12 and n are
assumed to be trivariate normally distributed with mean 0 and covariance matrix as
follows:
2 2 3
sn : :
6 7
V6 s s12 : 7 8
4 21 5
2
s31 : s2

where s 21 , s 22 and s 2v are the variance for 11,12 and n in the above equations, s21 is the
covariance for 11 and n, s31 is the covariance for 12 and n. Covariance for 11 and 12 is
not defined because y1 and y2 are never observed simultaneously. The model is
estimated with full information maximum likelihood method and the log likelihood
function for the above equations is as follows:
X
ln L {I i lnFh1i ln f 11i =s1 =s1
1 2 I i ln1 2 Fh2i
i1

9
ln f 12i =s2 =s2
}
where F is a cumulative normal distribution functions, f is a normal density function,
and:
Z i g rj 1ji =sj
hji q j 1; 2 10
1 2 r2j

where rj is the correlation coefficient between n and 1i. After estimating the model, a
term similar to inversed Mills ratio used in Heckmans selection model is added to the
profit function to control for the correlation between banks profitability and decision
of derivatives activities when calculating the expected profitability conditional on
derivatives activities. Conditional expectation could be calculated as follows[3]:
EY 1i jI i 1; x1i x1i b1 s1 r1 f Z i g=FZ i g 11
EY 1i jI i 0; x1i x1i b1 2 s1 r1 f Z i g=1 2 FZ i g 12
AFR EY 2i jI i 1; x2i x2i b2 s2 r2 f Z i g=FZ i g 13
73,2 EY 2i jI i 0; x2i x2i b2 2 s2 r2 f Z i g=1 2 FZ i g 14

The counterfactual effects or the effects of derivatives activities in this case, which is
represented by the difference in the outcomes if the individual is in the other group, are
298 estimated after estimating the conditional expectations:

Diff 1i EY 1i jI i 1; x1i 2 EY 1i jI i 0; x1i for I i 1 15

Diff 2i EY 2i jI i 1; x2i 2 EY 2i jI i 0; x2i for I i 0 16

Previous research shows that participation in derivatives market has high fixed cost,
associated with implementing efficient hedging strategy and these costs are a barrier
for small banks ability to hedge (Brewer et al., 1996, 2000, 2001; Carter and Sinkey,
1998; Sinkey and Carter, 2000; Koppenhaver, 1990; Kim and Koppenhaver, 1993).
Therefore, large agricultural banks or small agricultural banks which are part of the
BHCs may get access to the sophisticated hedging techniques. That is why apart from
the risk factors in the profitability model, a dummy variable which identifies the bank
that is affiliated to a BHC, and the size of the bank are also added in the decision model
to improve identification.
Risk factors entering the empirical models are consistent with the criteria used by
FDIC to evaluate the commercial banks, namely the CAMELS rating which captures
banks capital adequacy, asset quality, management quality, earnings, liquidity and
sensitivity to market risk[4]. Detailed variables construction and expected signs are
presented in the Appendix. Default risk (or credit risk) is measured by loan charge offs
(CHARGEOFF) which is scaled by total loan portfolio and its increase is expected to be
associated with lower profitability. Interest risk is measured by the short term maturity
gap (GAP), constructed with the method similar to that by Flannery and James (1984),
with the absolute difference of the banks short-term asset and liability scaled by earning
asset. Increase in the gap is expected to decrease profitability in unfavorable market
conditions and to increase profitability in favorable market conditions.
Liquidity risk is measured by the proportion of the banks liquid assets scaled by
total assets (LIQUID). Because liquid assets usually have lower return, increase in
liquidity asset or decrease in liquidity risk will result in lower operating revenue and
thus lower ROA, but the probability of financial distress is lowered as well. Capital
adequacy is measured by the asset-to-equity ratio (LEVERAGE). Increase in leverage
signals more borrowed money or liability and increased interest expense which signals
increased insolvency risks, thus is associated with lower ROA. In addition, agricultural
loan (AGLN), scaled by total loan portfolio, is also included in the model to measure
diversification.
Following the method used by Angbazo (1997), management quality (MANAGE) is
measured by the banks earning assets scaled by total assets. Because management
affects the allocation of assets which earn high interests (or liabilities which in turn pay
low interests), it is expected to be positively correlated to profitability. Logarithm of
bank total asset (ASSET) and a dummy variable for BHC, which identifies the banks
which are affiliated to BHCs, are included in the selection model to improve
identification.
 Since the financial crisis of 2008 was followed by substantial changes in banking Derivatives
regulation and market structure, affecting derivatives activities of agricultural banks, as risk
derivatives impact on bank performance was likely different before, during and after
the crisis. To capture such differential effects, cross-sectional regressions are estimated management
separately for the period before, during, and after the recent financial crisis or for the
years 2006, 2009, and 2010[5].
299
Data
Bank data used in the estimation comes from the Reports of Condition and Income (call
reports) from Federal Reserve Bank of Chicago. Following the definition of agricultural
banks by Federal Reserve, commercial banks with agricultural loan ratio larger than
the mean for the banking industry are classified as agricultural banks[6]. For each year
of the analysis there are over 2,000 observations, with 2,447 in 2006; 2,337 in 2009; and
2,267 in 2010.

Characteristics of derivatives user and non-user banks

Table I presents summary statistics of key variables for the sample. The number of
derivative using agricultural banks has increased in time from 154 derivatives users in
2006 to 241 by 2010, which represents around 10 percent of agricultural banks. Derivatives
user banks are about four times as big as those not using derivatives. Before the end of the
financial crisis profitability of user and non-user agricultural banks was similar though
slightly higher for user-banks. However, the difference was increasing over time, and the
difference 0.12 percent in 2010 was statistically significant. Throughout the 2006-2010
period, derivatives user agricultural banks allocated more assets to investments and loans,
which earn higher interest than money market accounts, marketable securities and
treasury bills, than non-user banks especially during and after the financial turmoil (2009
and 2010) with around 91 percent of total assets as earning assets for user banks but only
89 percent for the non-user banks in 2010. Compared to non-user banks, derivative user
agricultural banks had more diversified loan portfolio with around 30 percent of their total
loans classified as agricultural while non-user agricultural banks had 39 percent
agricultural loans. These improvement in management quality likely come from the
reduced delegation costs from risk management activities consistent with what Diamond
(1984) suggests.
Derivative user banks were more leveraged and as indicated by the higher assets to
debt ratio. There was, however, a trend of deleveraging over time, i.e. restructuring
balance sheet through lending cut-off and asset sale, with the value of LEVERAGE
reduced from 11 in 2006 to 10.3 in 2010. On the other hand, non-user agricultural
banks, increased their leverage over time with from 9.7 in 2006 and to 10 in 2010,
Thus, by the end of 2010, both groups had similar leverage ratio (10 ). In terms of credit
risks CHARGEOFF, there was no statistically significant difference between user and
non-user agricultural banks before the end of the financial crisis: during the crisis, loan
charge-offs tripled for both user and non-user; however, in 2010 it decreased to
0.58 percent for non-user agricultural banks while it remained at 0.75 percent in user
agricultural banks. Compared to derivatives non-users, users had similar maturity gap
(capturing the interest rate risk) between their short-term assets and liabilities before
the financial crisis in 2006. However, the derivatives user banks had significantly
lower (6-7 percent lower) interest rate risks during and after the financial crisis
 73,2

300
AFR

Table I.
Summary statistics
2006 2009 2010
Variable (percent) Pool Usera Non-user Pool User Non-user Pool User Non-user

ROA 1.08 1.12 1.08 0.67 0.73 0.66 0.85 0.95 * * 0.83
(0.79) (0.55) (0.81) (1.09) (0.89) (1.11) (0.86) (0.83) (0.86)
MANAGE 93.23 93.79 * 93.19 89.50 91.37 * * * 89.32 88.85 90.90 * * * 88.61
(4.61) (2.61) (4.71) (7.95) (4.32) (8.20) (8.64) (5.03) (8.95)
ASSET 116.43 428.6 * * * 95.47 150.70 527.10 * * * 113.92 157.33 465.26 * * * 120.71
(US$ millions) (266.90) (909.60) (117.48) (373.50) (110.36) (139.55) (379.60) (102.97) (151.55)
AGLN 36.50 30.09 * * * 36.93 36.86 29.37 * * * 37.59 37.65 30.18 * * * 38.54
(18.05) (14.80) (18.17) (18.17) (12.36) (18.48) (18.26) (13.18) (18.58)
LEVERAGE 9.74 11.02 * * * 9.66 9.87 10.62 * * * 9.79 10.00 10.33 9.96
(2.62) (2.21) (2.62) (3.05) (2.43) (3.10) (5.30) (2.32) (5.55)
CHARGEOFF 0.28 0.27 0.28 0.75 0.79 0.75 0.60 0.75 * * * 0.58
(0.67) (0.61) (0.68) (1.33) (1.04) (1.35) (0.82) (0.95) (0.80)
GAP 38.42 37.65 38.47 43.12 37.66 * * * 43.66 38.57 31.82 * * * 39.38
(21.65) (19.76) (21.78) (23.03) (20.29) (23.22) (21.65) (17.95) (21.91)
LIQUID 29.62 24.08 * * * 29.99 31.99 26.45 * * * 32.53 33.65 28.50 * * * 34.26
(14.90) (10.42) (15.08) (15.76) (11.66) (16.00) (15.70) (11.78) (15.99)
BHC 85.33 95.45 84.65 86.95 97.11 85.96 86.59 96.27 85.44
(35.39) (20.9) (36.05) (33.69) (16.78) (34.75) (34.08) (18.99) (35.28)
Number of entities 2,447 154 2,293 2,337 208 2,129 2,267 241 2,026
Notes: Significant at: *p , 0.1, * *p , 0.05 and * * *p , 0.01; adifference from non-user banks is tested
(in 2009 and 2010). This suggests that the derivatives using banks use both Derivatives
on-balance-sheet and off-balance-sheet methods to manage interest risks, and their as risk
profitability should be less affected. During all years, derivatives users had fewer liquid
assets, which indicates higher liquidity risks. management
In general, compared to non-user banks, derivatives users are larger, more
profitable, have more diversified loan portfolio and efficient internal management, and
have lower interest risks but higher liquidity risks. Even with higher loan charge-offs 301
after the financial crisis, derivatives user banks still outperformed non-user banks.
This fact implies derivatives user agricultural banks were better at risk management.
While simple mean comparison is interesting, it does not tell if derivative use affects
agricultural banks profitability of more profitable banks use derivatives without
taking into account structure difference between derivatives user and non-user banks.

Empirical evidence
The empirical approach we describe allows for possibility that there might be
unobserved factors which affect both banks decision to use derivatives and sensitivity
to different factors and endogenous switching model is the appropriate model to
control the possible endogenous selection problem. Fortunately, we could test the
endogeneity assumption. In particular we test:
.
whether we have endogenous selection; and
.
whether the sensitivity to risk factors is different for user and non-user
agricultural banks.

To test the existence of endogenous selection, as suggested by Heckman (1976), we

need to test whether the selection is associated with the error 1i in the profitability
equations or H0: ri 0 in equations (11)-(14). If ri 0, the selection problem is not the
case and we could run simple OLS regressions on user and non-user banks
profitability, respectively. This could be done by simple t-test or Wald test after we
estimate the coefficients. Results in Table II show that estimates for riare statistically
different from 0 at the confidence level of 1 percent. Moreover, Wald test of
independent equations reject the null hypothesis of independence at the confidence
level of 1 percent which implies the identification of the selection problem. Further,
compared to the results from endogenous switching model, results from a simple OLS
regression with dummy variable to identify banks derivatives activities showed that
derivatives activities have no intercept effect on banks performance before the
financial crisis and the magnitude of the effects is much smaller for period between and
after the financial crisis.
We also test whether the sensitivities of profitability to various risk factors are same
for derivatives user and non-user banks. If the test fails to identify different coefficients
for users and non-users, as specified in equation (2), we could run OLS regression on
pooled data with a dummy variable which identify the banks derivatives activities. To
test the different sensitivity of user and non-user agricultural banks, Chow test is
performed and reject the null hypothesis that coefficients for user and non-user banks
are the same at the confidence level of 1 percent. Thus, endogenous switching model
is the appropriate model. Profitability ROA for derivatives users and non-users is
assumed to have different sensitivities to various risk factors and needs correction for
endogenous selections.
 73,2

302
AFR

Table II.
Regression results
2006 2009 2010
(1) (2) (3) (4) (5) (6) (7) (8) (9)
Selection User Non-user Selection User Non-user Selection User Non-user
Variables P(Duser 1) ROA ROA P(Duser 1) ROA ROA P(Duser 1) ROA ROA

ASSET 0.6368 * * * 0.6679 * * * 0.6055 * * *

(0.0573) (0.0499) (0.0457)
BHC 0.1407 0.2627 0.3631 * *
(0.2332) (0.2061) (0.1771)
CHARGEOFF 20.0507 20.1598 20.3049 * * * 20.0895 * 20.3472 * * * 20.4628 * * * 20.0016 20.4846 * * * 20.5069 * * *
(0.0627) (0.1303) (0.0742) (0.0463) (0.0955) (0.0401) (0.0680) (0.0485) (0.0376)
MANAGE 0.0193 0.0293 0.0116 * * 0.0076 0.0386 * * * 0.0243 * * * 0.0068 0.0357 * * * 0.0194 * * *
(0.0163) (0.0182) (0.0051) (0.0082) (0.0149) (0.0038) (0.0065) (0.0095) (0.0018)
AGLN 0.0015 20.0019 0.0014 20.0050 * * 0.0036 0.0039 * * * 20.0076 * * * 0.0070 * * 0.0023 * * *
(0.0028) (0.0044) (0.0010) (0.0025) (0.0038) (0.0009) (0.0025) (0.0033) (0.0009)
LEVERAGE 0.0558 * * * 20.0731 * * * 20.0074 0.0164 20.1088 * * * 20.0577 * * * 20.0280 20.0528 * * * 20.0287 * * *
(0.0189) (0.0270) (0.0126) (0.0143) (0.0327) (0.0132) (0.0192) (0.0141) (0.0080)
GAP 0.0001 20.0062 * * * 20.0048 * * * 20.0038 * 20.0081 * * 20.0001 20.0056 * * * 0.0011 0.0023 * * *
(0.0021) (0.0021) (0.0009) (0.0021) (0.0035) (0.0009) (0.0021) (0.0022) (0.0009)
LIQUID 20.0079 * * 0.0015 20.0024 20.0077 * * 0.0139 * * * 0.0043 * * * 20.0069 * * 0.0065 * 20.0002
(0.0033) (0.0042) (0.0016) (0.0032) (0.0042) (0.0013) (0.0030) (0.0035) (0.0011)
Constant 211.2170 * * * 20.2342 0.3396 29.6748 * * * 21.2731 20.9054 * * 28.3204 * * * 21.6037 * 20.5311 * *
(1.8164) (1.6492) (0.5472) (1.0059) (1.3823) (0.4004) (0.8333) (0.9626) (0.2131)
snonuser 0.7720 * * * 0.8194 * * * 0.7108 * * *
(0.0499) (0.0600) (0.0359)
suser 0.5216 * * * 0.6566 * * * 0.6125 * * *
(0.04259) (0.0570) (0.0684)
rnonuser 20.2960 * * * 20.2525 * * * 20.4122 * * *
(0.0487) (0.0586) (0.1306)
ruser 20.3499 * * 20.2884 * * 20.2480
(0.1360) (0.1338) (0.1601)

Observations 2,447 2,337 2,267

Log Likelihood 23,216 23,328 22,982
2
Wald test (x (2)) 39.45 20.96 10.34
Notes: Significant at: *p , 0.1, * *p , 0.05 and * * *p , 0.01; robust standard errors in parentheses
Effects of risk factors on derivatives user and non-user agricultural banks Derivatives
Table II presents the endogenous switching regression results for agricultural banks as risk
profitability with the control for the selection bias, by years. The first three columns include
the results for the year before the recent financial crisis (2006), the next three columns management
include the results for the period during the crisis (2009), and the last three columns include
the results for the year after the crisis (2010). The first column for each year (columns 1, 4
and 7) presents the results of the banks choice to use derivatives and the next two columns 303
presents the results for profitability for user and for non-user agricultural banks,
respectively. To control for the potential heterogeneity and autocorrelation problems,
Huber-White robust standard errors are used and presented in the parenthesis.
Liquidity risk and bank size are the main factors expected to have an impact in the
derivatives market participations. Agricultural banks are more likely to participate in
the market when they are larger and face higher liquidity risks (smaller liquid assets).
The small size of agricultural banks creates a natural barrier for the participation in the
derivatives market, but this barrier has been broken by a wave of consolidation and
merger and acquisitions after 2008. Alhough agricultural banks were still small, those
which are part of BHCs were more likely to hedge using derivatives. About 90 percent
of all agricultural banks are part of BHCs with 85 percent of non-user banks and
96 percent user banks are part of BHCs. Results suggest another factor which affected
banks decision to use derivatives before the financial crisis was financial leverage.
Banks with higher financial leverage, or higher portion of banks assets to debt, were
more likely to use derivatives before the financial crisis. But financial leverage did not
affect banks decision to use derivatives during and after the financial crisis.
During and after the financial crisis, banks with more diversified loan portfolio
(less AG loans) and balanced short term assets and liabilities (less interest rate risk) were
also more likely to participate in the market but these two factors were not relevant to the
banks decision of risk hedging before the financial crisis. Loan charge-offs negatively
associated with the decision to use financial derivatives only during the financial crisis,
while this decision was not affected by charge-offs in other years. This is likely so
because during the financial crisis, the triple increase in loan charge-offs in agricultural
banks and the large losses due to structured financial products (such as MBS and ABS)
in large banks made them more cautious about derivatives activities.
The results show that various risk factors impacts on profitability and their
magnitudes are different for user and non-user agricultural banks. In both user and
non-user banks increased credit risks or loan charge offs was associated with lower
ROA. User banks ROA was less affected by increased credit risks or loan charge-offs
and not even affected before the financial crisis when non-user banks profitability was
lower by 0.3 percent by one percent increase in loan charge-offs. During the crisis when
loan charge-offs tripled in both user and non-user banks, the magnitude of the negative
effect of increased credit risks on ROA is 24 percent lower in user banks than that in
non-user banks. Since credit risk and other risks, especially interest rate risk, are
highly correlated, hedging interest risks also manage partially credit risks. These
results imply that the derivatives activities have helped mitigate a part of the negative
effects from credit risks or loan charge-offs.
Similarly, improved management quality (MANAGE) for user banks was associated
with profitability almost twice as large for non-user agricultural banks than for
non-users during and after the financial crisis. The increase in ROA for user banks was
AFR 0.04 percent but only 0.02 percent for non-user banks. User banks profitability is not
73,2 affected by management quality before the financial crisis. However, the decrease in
profitability due to increase in financial leverage or decreased equity capital is larger for
user banks with 1 increase in financial leverage for user agricultural banks associated
with 0.11 percent decrease in ROA but about half the decrease or 0.06 percent for
non-user banks during the financial crisis and similar but smaller impact after the
304 financial crisis (0.05 and 0.03 percent for user and non-user, respectively).
Liquid assets usually have lower yield than other assets and increased holding of
liquid asset is expected to affect banks profitability negatively. However, our results
show small but positive association during the financial crisis. Results show that
banks with healthier balance sheet performed better during the financial crisis. Both
user and non-user agricultural banks performed better with lower liquidity risk (more
liquidity asset) during the financial crisis, even though profitability was not affected by
liquidity risk prior to the crisis. After the crisis, only in user banks more liquid asset
had positive association with profitability.
The impact of interest rate risk (GAP) is also different for derivatives user and
non-user agricultural banks. Before the financial crisis, non-user agricultural banks
profitability was negatively affected by interest rate risk, but there was no impact
during the crisis and positive impact from the increased short-term maturity gap after
the financial crisis. This result suggests that even though the net short term asset or
liability position helped non-user agricultural banks benefit from the interest rate
fluctuation after the recent financial crisis, the interest risks were not perfectly managed
and that it is possible that profitability can hurt by unfavorable interest rate fluctuations
if the composition of short-term assets and liabilities is not accordingly altered. On the
other hand, for the user agricultural banks, even though their profitability is adversely
affected by the interest risks before and during the financial crisis, such risks did not
affect their profitability after the recent financial crisis, which suggests interest rate
risks hedging techniques are effective in user agricultural banks.
Finally, consistent with previous findings that agricultural banks were in a better
position to do well in the aftermath of the financial crisis, we find that all agricultural
banks with higher proportion of agricultural loans had higher ROA. After the financial
crisis, in derivative user agricultural banks, an additional percentage increase in the
proportion of agricultural loans to total loans was associated with 0.7 percent higher
ROA, which is more than twice that effect in non-user banks (0.23 percent). In non-user
banks, this variable had a similar effect during the crisis (0.39 percent) but in no effect
in derivative users. Prior to the crisis this variable did not affect ROA in either group.
Our results suggest that though small in size, new to the derivatives market, and
more potentially vulnerable to inappropriate hedging strategies, agricultural banks not
only mastered but also benefited from OBS risk management strategies through
derivative. In particular, derivatives activities at agricultural banks helped mitigate, at
least partially, the negative effects of credit risks and interest rate risks.

Effects of derivatives activities on the profitability

After estimating the profitability equation for derivatives user and non-user agricultural
banks, we estimate counterfactual effects of derivatives activities for both user and
non-user agricultural banks according to equation (15) and (16) for the difference
in profitability. These results are presented in Table III. We find that in general, the
 Derivatives
Predicted ROA for derivatives user Predicted ROA for derivatives non-user
ROA ROA ROA ROA as risk
Year (Duser 1) (Duser 0) Difference (Duser 1) (Duser 0) Difference management
2006 1.12 0.71 0.41 * * * 1.50 1.08 0.42 * * *
(0.24) (0.26) (0.01) (0.31) (0.25) (0.005)
2009 0.73 0.27 0.46 * * * 1.11 0.66 0.45 * * * 305
(0.62) (0.57) (0.02) (0.82) (0.75) (0.01)
2010 0.95 0.30 0.65 * * * 1.31 0.84 0.47 * * *
(0.57) (0.54) (0.01) (0.66) (0.51) (0.01)
Table III.
Note: Significant at: *p , 0.1, * *p , 0.05 and * * *p , 0.01 Counterfactual effects

profitability of agricultural banks if they use derivatives to manage risks is higher than if
they do not use derivatives and the difference is statistically significant. For example,
in 2010, compared to actual ROA of 0.95 percent, the predicted ROA for the derivatives
user banks if they did not use derivatives is only 0.30 percent, which is around 1/3 of
their actual profitability. This difference in profitability for derivatives user banks is
increasing over the sample period from 0.41 to 0.65 percent. Because, as we argued
previously, in agricultural banks derivatives activities are mainly for risk management
due to their limited ability to fund such activities, they could improve the banks
performance when used properly. The above results suggest that the risk management
via derivatives contracts is effective and the derivatives activities help agricultural
banks improve their profitability.

Conclusion
This paper studies the effect of financial derivatives on agricultural banks
profitability. We estimate an endogenous switching model of bank profitability
which allows to control for the endogenous selection of banks into derivatives user and
non-user, and to compute counterfactual effects. We find that derivatives activities help
mitigating the negative effects of credit risks and interest risks before, during and after
the 2008 financial crisis and help boosting the positive effects of improved internal
management in derivatives using agricultural banks. Agricultural banks have
successfully hedged with derivatives even though they were relatively new to the
market. The estimated benefits are substantial, as we find that for 2010, use of
derivatives is associated with increase of 0.6 percent in returns on assets. Moreover, the
difference in profitability for the derivatives user banks was increasing over time.
These results are consistent with results by Avery and Berger (1991), who found that
financial derivatives use increases profitability in small banks.
While large commercial banks suffered losses in the recent financial crisis and much
of which is attributed to speculating with financial derivatives, our results show that
derivatives improved profitability of agricultural banks. Since participation in the
derivatives market has high fixed cost, small banks, such as agricultural banks,
typically have limited funding and are much more likely to face financial difficulties
when hedging is not effective, we conclude that agricultural banks have master the
skill of risk management with derivatives and use it properly. Risk management with
derivatives at agricultural banks is effective.
AFR Notes
73,2 1. Farm Credit East state in annual report that The Association is party to derivative financial
instruments, primarily interest rate swaps, which are principally used to manage interest rate
risk on assets, liabilities and anticipated transactions and derivatives are designated as fair
value or cash flow hedges to (1) a portion of our long-term variable loans on the balance sheet
or (2) firm commitments or forecasted transactions. Farm Credit Bank Funding Corporation
and Farmer Mac state clearly in their annual statements that derivatives are used for risk
306 management only not for trading or speculation purposes. Federal Farm Credit Banks
Funding Corporation stated in annual report that each bank relies on derivative financial
instruments to hedge against interest rate and liquidity risks and to lower the overall cost of
funds. Farmer Mac has similar statements in their annual report as well.
2. Riegle-Neal Interstate Banking and Branching Act of 1994 removed the interstate branching
limit and made possible affiliation of small agricultural banks with large banks and BHCs. In
1996, the guidance (SR 96-17) issued by the Federal Reserve indicates that banks could use
credit derivatives to reduce capital requirements. This created incentives for banks to
participate in credit derivatives. The Gramm-Leach-Bliley Act of 1999 allowed consolidation
of commercial banks, insurance companies, security firms and investment banks, making it
possible for the commercial banks to benefit from economies of scope.
3. The endogenous switching regression is estimated with the users written commands
movestay in Stata.
4. The CAMELS rating system stands for capital adequacy, asset quality, management,
earning, liquidity and sensitivity to market risk.
5. US subprime lending crisis started in 2007 and the crisis spread to the other sectors of the
economy in 2008. In order to avoid the noise of the market turmoil, we choose 2006 as the
year before the financial crisis.
6. Agricultural loans include agricultural production loan and real estate loans secured by
farmland.

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Appendix

Variables Calculation Predicted signs in profit function

Dependent variable
Net Income
Profitability ROA
Total Asset
Explanatory variable
Total Asset
Capital Adequacy LEVERAGE Negative
Equity Capital
Current Asset
Liquidity Risk LIQUID Negative
Total Asset
Charge 2 Offs
Default Risk CHARGEOFF Negative
Total Loan
jNet Short 2 term Assetj
Interest Risk GAP Negative or positive
Earning Asset
Earning Asset
Management MANAGE Positive
Total Asset
Control variable
Agricultural Loan
Diversification Risk AGLN
Total Asset
Scale ASSET ln(Asset) Table AI.
Empirical model
Note: Data used in this study are from FDICs Reports of Condition and Income (call reports) variables

About the authors

Xuan Shen is a PhD candidate at Auburn University, Auburn, Alabama, USA. Xuan Shen is the
corresponding author and can be contacted at: xzs0005@tigermail.auburn.edu
Valentina Hartarska is a Professor at Auburn University, Auburn, Alabama, USA.

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