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Financial Institutions Risk Management in Dominica: A Critical Review

Dominica, August 6, 2020 - A recent study published in The Journal of Finance has shed light on the intricacies of risk management practices among financial institutions. Researchers Adriano A. Rampini, S. Viswanathan, and Guillaume Vuillemey delved into how the net worth of these institutions influences their ability to hedge interest and foreign exchange rate risks.

Higher Net Worth Institutions Hedge More Extensively

According to the research, US financial institutions with higher net worth tend to hedge more extensively over time. Conversely, institutions with diminished net worth reduce their hedging activities. This finding is particularly noteworthy in the context of the 2009 housing bubble burst, where financial institutions experienced significant loan losses and many failed.

Data Analysis

The authors analyzed quarterly data from US bank holding companies between 1995 and 2013, comprising approximately 22,723 observations. The study found that interest rate and foreign exchange derivatives represented almost all the derivatives used by these financial institutions.

Key Takeaways

  • Regulatory capital does not drive hedging policy.
  • The level of net worth and changes in it play a significant role in determining the extent to which financial institutions hedge interest and exchange rate risks.
  • This has important implications for investors and investment professionals, as it highlights the potential for risk absorption capacity to fluctuate with changes in net worth.

Implications

The study underscores the importance of considering the balance sheet size and composition when evaluating the risk management practices of financial institutions. While institutions may appear financially strong on paper, reductions in hedging activities can lead to increased risk exposure.

Conclusion

This quantitative study provides valuable insights for researchers, policymakers, and investors alike. By better understanding the interest and exchange rate hedging behavior of financial institutions, stakeholders can make more informed decisions about risk management and mitigate potential losses.