The Determinants of Derivatives Activities in U.S. Commercial Banks

This paper aims to test the extent to which the tax regulatory and market discipline hypotheses determine derivative activities of U.S. commercial banks for the period starting 1992 through 2008. We employ Mansfield’s (1961) logistic diffusion model and we consider derivative activities as real financial innovation following a time trend diffusion curve. The model is modified to include regulator, non-regulatory/bank-specific factors and macroeconomic factors. The results reveal that derivative activities are real financial innovations that are increasing over time. Another major finding is that the regulatory tax hypothesis is not a major factor in determining derivative activities by U.S. commercial banks. The results also suggest that derivatives activities do not follow business cycle and economic conditions. However, derivatives are prevalently used where economies of scale is a viable outcome since they require highly specialized and qualified staff and are more likely available to large banks. The substitution effect is dominant between derivatives and loan ratio factor. Diminishing credibility of the bank will reduce derivatives activities. While derivatives are more likely to be an innovation, they are also determined by other factors such as technology and learning.