Growth in financial derivatives: The public policy and accounting incentives

During the period 1995–2012, U.S. financial institutions had contributed significantly to the growth in financial derivatives. The notional amount of total derivatives held by the 25 largest U.S. bank holding companies grew eighteen times from $16.6 trillion in 1995 to $308 trillion in 2012, while the U.S. GDP merely doubled from $7.7 trillion to $16.2 trillion over the same period. In this paper, we examine three possible drivers of this growth: (a) the Gramm-Leach-Bliley Act of 1999, (b) the Commodity Futures Modernization Act of 2000, and (c) FAS 133 (now ASC 815), Accounting for Derivative Instruments and Hedging Activities, which became effective in 2000. Using a sample of U.S. bank holding companies, we find a temporal association between the passage of the two Congressional Acts and the abnormal growth in trading/over-the-counter derivatives. We also predict and find that the use of cash flow hedge accounting treatment helps reduce earnings volatility/equity risk, and that firms increase their use of non-trading derivatives when facing high level of earnings volatility/equity risk.