Analyzing the effect of derivatives on the financial soundness of commercial banks in Italy: An approach based on the CAMELS framework

• Date: 01 July 2018
• DOI: http://doi.org/10.1002/rfe.1020
• Author: Mohamed Rochdi Keffala
• Published date: 01 July 2018

ORIGINAL ARTICLE

Analyzing the effect of derivatives on the financial soundness of

commercial banks in Italy: An approach based on the CAMELS

framework

Mohamed Rochdi Keffala

Department of Management in High

Institute of Computer and Management of

Kairouan, University of Kairouan,

Kairouan, Tunisia

Correspondence

Mohamed Rochdi Keffala, Department of

Management in High Institute of

Computer and Management of Kairouan,

University of Kairouan, Kairouan, Tunisia.

Email: mrkeffala@yahoo.fr

Abstract

Italian economy is among the biggest economies in the Europe which suffered

from the repercussions of the global financial crisis during this last decade. The

weakness of Italian banking system coincides with the common debate about the

implication of derivatives in the distress of banks’soundness. Thus, the aim of

our research is to examine the effect of derivative instruments on the banks’

soundness in Italy. To reach our goal, the CAMELS approach is employed to

define the soundness of Italian commercial banks. To overcome the endogeneity

issue of variables, an appropriate econometric procedure, namely the dynamic

Generalized Method of Moments (GMM system) is applied using data from 22

commercial banks in Italy over the period 2005–2015. Explanatory variables are

defined by derivative instruments (forwards, swaps, options, and futures), bank-

specific variable (bank’s size as non-CAMELS variable), industry-specific vari-

ables (CR3, CR5, and HHI as indicators of bank’s sector and market concentra-

tions), and country-specific variables (GDP and inflation). The main results reveal

that the majority of the CAMELS indicators are favorably affected by derivative

instruments especially forwards and options. The most important conclusion is

that using derivative instruments does not threaten the financial soundness of

commercial banks in Italy. As major implication decision-makers and experts—

after the global financial crisis—should not consider derivatives in part as respon-

sible of the fragility of the Italian banking system.

JEL CLASSIFICATION

G01, G21, G32

KEYWORDS

banks, CAMELS, derivatives, GMM, Italy, soundness

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INTRODUCTION

The CAMELS approach is considered by the IMF and World Bank (2005) as relevant framework for assessing the financial

soundness of a bank.

CAMELS approach is also recommended by many papers as measure of banks’soundness (Koetter et al., 2007; Rod-

ica-Oana, 2014; Chiaramonte, Poli & Oriani, 2015).

Received: 15 November 2017

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Accepted: 19 December 2017

DOI: 10.1002/rfe.1020

Rev Financ Econ. 2018;36:267–283. wileyonlinelibrary.com/journal/rfe ©2018 The University of New Orleans

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Special attention has been given by several studies to inspect the soundness of banks, particularly, in countries suffering

from the fragility of their banking system (



Cih

ak & Schaeck, 2010; Roman & Sargu, 2013; Sahut & Mili, 2011; Wanke,

Azad, & Barros, 2016a,b,c).

One of the examples of banking system distress is in Italy. In fact, as among the biggest econom y in Europe, Italy

has experienced a notable period of distress due to the recent economy collapse. In fact, the annual percentage change

in GDP was 0.931% in 2005 before the crisis which fell during the crisis to 1.1% in 2008 and 5.4% in 2009 to

finally reach 1.2% in 2015.

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This recession episode coincides with the global financial crisis provoked by the recent

subprimes’crisis. Many experts have accused derivatives to exacerbate the repercussions of the recent financial crisis.

Thus, scrutinizing the role of derivatives in the fragility of Italian banking system represents a central research’s ques-

tion.

In addition, a review of empirical works on the impact of derivatives on banks’soundness reveals a big gap in the liter-

ature. In fact, few studies were interested on this issue such as the paper of Minton, Stulz, and Wil liamson (2009). This fact

represents another main motivation to focus on the issue.

The last financial crisis of subprimes has negative repercussions on many banking systems around the world and partic-

ularly Italy. For this reason, a long period from 2005 to 2015 is chosen in order to consider the impact of derivatives on

Italian banking system before, during, and after the crisis.

Hence, the purpose of this study is to explore the impact of derivative instruments on Italian banks’soundness as

defined by the CAMELS indicators.

To this end, dynamic panel regressions are conducted using Generalized Method of Moments (GMM) estimator tech-

nique as developed by Arellano and Bover (1995) on 22 Italian banks over the period 2005–2015. The dependent variable

is one of the CAMELS indicators as measure of bank’s soundness. The explanatory variables are composed by derivative

instruments (forwards, options, swaps, and futures), bank-specific variable (bank’s size as non-CAMEL S variable), indus-

try-specific variables as Italian banking sector’s characteristics (“CR3,”“CR5,”and “HHI”), and finally country-specific

variables as Italian macroeconomic indicators (GDP and inflation).

This research not only offers several contributions for related literature but also for banking experts and decision-makers.

First, this study fulfills the huge gap in the literature by investigating the effect of derivative instruments on banks’sound-

ness. Second, this research is a pioneer in using CAMELS approach for this issue. Finally, this study tends to help experts

and policy-makers by clarifying the role of derivatives in the fragility of Italian banking system.

The major outcomes of this research divulge that using derivatives do not threaten the soundness of Italian banks.

The remainder of this study is structured as follows: Section 2 gives description of the sample based on statistics. Sec-

tion 3 provides review about CAMELS approach and review of literature. Section 4 presents the hypotheses. In Section 5,

the methodology is presented. In Section 6, results are analyzed and interpreted in addition to check-up of hypotheses.

Finally, Section 7 summarizes the main outcomes and provides imp lications.

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SAMPLE DESCRIPTION AND STATISTICS

The issue of this study lets us to examine the relationship between derivatives use and bank soundness in Italy. For this

reason, in this section, we are interested in statistics about Italian banking sector and in particular statistics about derivatives

use and banks’soundness.

The goal of this section is to verify probable correlation between derivatives use and bank soundness. To do that , we

choose 22 Italian commercial banks which satisfy the required data for the study. All the data are extracted from the web-

site of each bank listed in the sample over the period 2005–2015.

The section is divided into three subsections. The first subsection describes principally the volume of derivatives traded

by each sample bank. The second subsection classifies banks by soundness rank. In the third subsection, we discuss and

interpret the statistics.

2.1

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Statistics about derivatives

The aim of this subsection is firstly to deduce the most used instrument by sample banks, and secondly to find out the big

users of derivatives among banks of the sample.

The Figure 1 below exposes the part of each derivative’s instrument over tota l derivatives of the entire sample.

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KEFFALA