DERIVATIVES ACTIVITY AT TROUBLED BANKS

Because of moral hazard associated with deposit insurance, troubled ba nks that have a relatively thin capital cushion to absorb losses have an incentive to take speculative positions. Thus, the prevalence of pr oblem banks among those actively engaged in derivatives markets should be of concern to bank supervisors. However,we find no evidence that b ank supervisors take into account, either favorably or unfavorably, th e derivatives activities of troubled banks in their decisions to downg rade bank ratings or impose regulatory actions. The derivatives activi ty of troubled banks should raise the same concerns expressed about ba nks' on-balance-sheet positions, namely, that they may not be fully ex ploiting hedging opportunities or may be placing their remaining capit al at risk, intentionally or unintentionally.