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PART I - SUMMARY OF THE CASE STUDY

Banc One Corporation as a regional bank was the largest bank holding company in
Ohio (headquarter) holding $76.5 billion in assets, and the eighth largest in the
USA. Operating across 12 states, it had a three-tiered organizational structure
controlling 78 banking affiliates.
According to its organizational structure, Banc One adopted a three-pronged
strategy:
-

Concentrating on retail and middle-market commercial customers;


Using technology to enhance customer service and to assists in the
management of banking affiliates; and
Growing rapidly by acquiring profitable banks.

Banc One complied with its cardinal rules of acquisition. It can only make
nondilutive acquisitions on the targets that had the similar growth rate.
Uncommon partnership, Banc Ones operating strategy, was guided by a strict
set of principles to decentralise people side of the business (local managers
complete autonomy in running banks) and to centralise the paper side (data
processing, record keeping, back office operations), by retaining existing
management in acquisitions and centralising operations of the affiliates. The
centralization fit well with Banc Ones growth strategy. The aim of this strategy
was to gain economies of scale advantage and also capitalised on Banc Ones vast
experience with computer system. Implementing the operating strategy required
investing heavily in technology and information systems. Management
Information and Control System (MICS) helped in financial data tracking and
communication among affiliates. The objective of this system was to encourage
competition and to share products and practices information. The system was one
of the best financial track records among other banks in the country.
Like most regional banks, Banc One was asset sensitive because a large proportion
of its assets were indexed to prime rate, which varied with market rates. However,
the liabilities side included mostly fixed-rate items (CDs). As Banc One was
exposed to interest rate changes, across the years it evolved the programme to
measure interest rate risk (Table 1). Banc One managed its interest rate exposure
by focusing primarily on interest rate impact on its earnings. It mitigated the risk
in various ways with more and high degree of sophisticated interest rate swaps
(Table 2). At the end of 1990, Banc One had only $4.7 billion in notional volume of
interest rate swaps, which dramatically increased to $37.7 billion in 1993. The
swaps portfolio saw a continuing increase because of the growing earnings (with
more commercial loans bank became more asset sensitive), as well as its
acquisitions (acquired banks were more asset sensitive and Banc One tried to
offset such an interest rate exposure).

Growing of swap portfolio raised a lot of criticism. As a result of this, Banc Ones
stock price dropped over 20% - from $48.3 to $36.3 within eight months (Chart
1). It affected both the situation of Banc Ones stock price (investors confidence)
and its ten pending acquisitions (The largest was Liberty National Bancorp). Due
to the deal being structured to be paid depending on the value of Banc Ones stock
price, its acquisition costs depended on the Banc Ones stock price.
Evolution of Banc One's programme to measure interest rate risk
Before 1980

No precise tool to measure interest rate risk. Limited investments in long-term maturity
securities due to liquidity.

1981

Maturity gap analysis - comparing maturity difference between assets and liabilities
adjusted for re-pricing interval.

1984

Asset and liability simulations by using exact asset and liability portfolios rather than
grouping of each asset or liability to measure how shifts in interest rate would affect
balance sheet and income statement; on-line balance sheet (with up-to-date information)
complemented the MICS process.

1993

On-line balance sheet extended to include a monthly down-load of discrete assets and
liabilities database on each customer.

Table 1: Evolution of Banc One's programme to measure interest rate risk


Banc One's interest rate management
1981

Added balancing assets to its investment portfolio - investments in U.S. Treasuries and
high-quality municipal bonds.

1983

Utilised interest rate swaps in investment portfolio.

1983

Utilised collateralized mortgage obligations (CMOs) in investment portfolio.

1986

Replaced municipal investments with mortgage-backed securities (MBSs).

Late 1980s

Replaced conventional investments with synthetic investments. Developed amortizing


interest rate swaps (AIRS).

Table 2: Banc One's interest rate management

Figure 1: Banc Ones stock price January 1993 November 1993

PART 2 - QUESTIONS
How could Banc One manage its interest rate risk exposure without using
swaps? That is, how could it move from being asset sensitive to being neutral
or liability sensitive without using swaps? What are the advantages and
disadvantages of using swaps rather than these other means of adjusting the
banks interest rate sensitivity? What is the impact of Banc Ones swaps
positions on its interest rate sensitivity, its accounting ratios and its capital
structure? Be sure to work through the Appendix in the case
Considering like other banks, the Banc One s basic portfolio was asset sensitive;
therefore, without using swaps, Banc One could manage its market interest rate
exposure through investment ways:
1. Banc One sells floating rate investments
OR
2. Borrows at floating rate and use this proceeds
TO
3. Buy a fixed rate asset, such as Treasury note (balancing asset).
4. Banc One reduces the offering of fixed-rate CDs, Thus decreasing the
proportion of fixed rate liability.
In summary, the potential target is to readjust the proportion among floatingrate
asset (decrease), fixed-rate assets (increase), floating-rate liabilities (increase)
and fixed-rate liabilities (decrease).

Figure 2: Adjustment of sensitivity using assets and liabilities management

Pros
1. Banks exposure to movements in interest rates decreases
Though usage of swaps, Banc One, which has more LT fixed-rate liabilities than LT
fixed-rate assets, could increase its fixed rate inflows while the periodic net
floating-rate inflows decreases. Therefore, if its assets and liabilities was perfectly
matched, then a rise or fall in interest rates would have equal and offsetting
impacts on both sides of the balance sheet.
2. Liquidity increases
By layering a receive-fixed swap onto this investment, the bank could obtain the
economics of the longer-term investment, while still enjoying the high liquidity of
the short-term instrument.
3. Off-balance sheet transactions
Swaps were off-balance-sheet transactions. It would be disclosed only in footnotes
in the financial statements, although the net income/loss still would appear on its
income statement. Therefore, traditional profitability measures such as a banks
ROE tend to be overstated.
4. Make Bank One get around the capital requirement
Under the capital guidelines, swaps contributed little to the risk-adjusted assets
against which the bank had to hold capital. (Instead of 20% or 50% weight, bank
needs to hold the value equal to: swaps positive market value + 0.5% of its
notional principal) * factor reflecting counterparty).
5. Swaps contracts enabled faster response to changes in market conditions
(Glitto et al, 1997).
6. Swaps can be customized for duration and other variables (Glitto et al, 1997).
Cons
1. Requiring a high degree of financial sophistication and quantitative expertise,
there is an understandable aversion to them on the part of many investors,
resulting in price reduction
2. Creating some sizable distortions in reported earnings, reported earning
assets and accounting ratios.
3. Swaps exposed Banc One to counterparty and basis risks, which still need
further methods to mitigate.
Impacts
1. Interest rate sensitivity - It decreases from the asset sensitivity to liability
sensitive.
2. Liquidity increase. (It has been discussed above in the pros of swap)

3. Capital ratio increase - Swaps contributed little to the risk-adjusted assets. If


denominator decreases, CAR increases.

4. Accounting ratio effects


Accounting ratio effects could be seen through building a hypothetical Banc
One without using the swaps (in $ billion) (Table 3).

Net Interest Margin


Return On Equity
Return On Asset

Using
Swap
6.22%
17.89%
1.53%

Without
Swap
3.86%
9.19%
0.63%

Asset / Liability

1.09X

1.074X

Increase

-3.30%

12.88%

Decrease &
Negative

Measures
Profitability
Ratio

Solvency
Ratio

Earning
Sensitivity

Liquidity
ratio

Capital

Percentage change in
net income in response
to a gradual 1% rise in
interest rate

Highly Liquidity Asset /


Total Liability not
including equity

Tier 1 capital /
Riskadjusted assets
Risk-Adjusted assets

Influences
Increases
Increases
Increases

Increase

10.4%

8.8%

Increase

$63.2

$74.1

Decrease

Table 3: Accounting ratio effects

What are AIRS? How do they work? Why is Banc One using them so
extensively?
Following its successful implementation of CMOs strategy, Banc One started
replacing many of its conventional investments with synthetic investments such

as synthetic CMOs in order to benefit from higher yields in exchange for taking on
prepayment risk. This lead to the development of Amortised Interest Rate Swaps
(AIRS) and Banc One to become fixed receiver in IRS transactions (Esty et al,
2008).
AIRS are swaps in which the principal or notional amount decreases over
time (NASDAQ, 2015). They were mainly designed to forge the cash flows of
ABS. In case interest rates fell, notional amount of AIRS was reduced or
amortised at the pace of the fall. This motivated the bank to reinvest when
market yields were low.
Banc One has been excessively using AIRS because of numerous reasons:
AIRS provided lower capital requirements. Banks were required to hold
their capital against fifty percent of the principal value of MBS. However, with
AIRS under risk based capital standards, only market value of swaps and a
small amount, around five percent, was conditioned to capital requirements.
Because of the fact that amortization schedule dictated cash flows, AIRS
avoided the idiosyncratic portion of the prepayment risk (Glitto et al, 1997).
Due to the scope of AIRS market at the end of 1993 and unpredictable
payment risk, swaps were to provide higher liquidity than conventional
investments in mortgage related securities (Albertson, 1994). This was
particularly beneficial for a bank considering re-hedging its position.
AIRS provided higher yield compared to MBS and AIRS spreads were
approximately 120 basis points higher than Treasuries, which were 20 basis
points higher than that of CMOs (Table 4).

Treasuries

Yield (Y: 1993)

IRS (plain vanilla)

Yield of Treasury Security + 20bp

CMO

Yield of Treasury Security + 100bp

AIRS

Yield of Treasury Security + 120bp

Table 4: Derivatives and their yields

Amortization rates were governed by changes in long-term rates and


amortization rates on AIRS were governed by short-term rates. Short-term
rates such as LIBOR had been historically volatile meaning that volatility risk

of AIRS was plausibly higher. Thus, AIRS should not have been perceived as an
arbitrage opportunity for investors.
Usage of swaps did add value under the light of strategy and objectives of the bank
but it distinctly depended on the solidity of the interest-rate environment.
What are basis swaps?
Basis swaps are contracts to exchange interest payments based on
different reference interest rates such as the exchange of LIBOR-based cash
flows for Treasury bill rate-based cash flows (Marshall, 2000).
Why has Banc One recently significantly increased its basis swap position?
AIRS reduced Banc Ones earnings sensitivity but also engendered
sensitivity to intensified mismatches between basis risk or floating-rate
interest rates. This is due to the fact that Banc Ones most of floating rate assets
were based on the prime rate on the contrary to the conventional interest rate
swaps and AIRS, which were based on three-month LIBOR rates. In order to
withstand the basis risk, Banc One started using basis swaps, which diminished
the floating-rate mismatch (Esty et al, 2008). The mismatch is illustrated in
figure 3.
In basis swaps, the bank would pay a floating rate based on the prime rate
and get paid with a floating rate based on LIBOR of three months. This would
eventually neutralize the spread between three-month LIBOR and prime rates.
By doing so, Banc One could transform prime-based floating rate assets into
fixed-rate investment thus, decreasing interest rate risk to a large extent.

Figure 3: Mismatch between prime and three-month LIBOR rates

How might its derivatives portfolio be damaging the banks stock price?
What exactly are analysts and investors worried about?

Earnings, interest rates risk and volatility


Banc One used its derivatives portfolio as a hedging tool to guarantee its earnings
against changes in interest rates. The bank entered into numerous AIRS positions
to ensure a constant earning stream, assuming interest rates would not largely
fluctuate (within a range of 100 basis point) in the foreseeable future. Hedging its
position against small interest rates movements increased its exposure to
volatility to guarantee higher yields. The increasing number of AIRS proves the
point and it can be explained by two possibilities:
- Imperfect forecast of future interest rates fluctuation
- Intended assumption of volatility risk for higher return
The companys hedging position against changes in earnings over small changes
in interest rates exposed the firm to an increased risk in volatility, which has been
the main reason for stock prices to fall. Indeed, the interest rates increases by 175
basis points between November 1993 to the end of 1994 and caused earnings to
drop significantly, ultimately affecting the stock price. Future cash flows
decreasing and investors and few analysts assessing the cash flow as risky, they
require a risk premium increasing the discount factor, causing more downward
pressure on the stock value.

Investors uncomfortable feeling and analysts perception


In the early 1990s, the use of derivatives was not entirely understood and still
mostly perceived as being a speculative instrument rather than a tool to manage
risks, leading Banc Ones management to think investors and analysts aversion to
derivatives were the main cause in the companys stock price decline. This
aversion resulted from the low level of acceptance of the companys position on
derivatives. Moreover, Banc One overlooking the large volatility issue in its
disclosure made investors to questions this leer of perfect investment
opportunity, bringing a further negative distortion to the firms future cash flow.
Analysts expressed concerns over the use in derivatives in accounting reporting.
Derivatives were known to distort earnings and other measures of the companys
profitability. They assumed swaps were distorting accounting measures by
inflating the earnings, capital ratios but also offsetting the declines in other
segments of the company (Albertson, 1994).
Also, Banc Ones revealing counterparties and associated information in its swaps
positions shown firms (Bankers Trust, Merrill Lynch) involved in dubious events,
and partly discounted the effort of Banc One to provide convincing information.

AIRS provided Banc One with a higher return than IRS and CMOs. The return on
IRS involved credit risk while return on CMOs incorporated both credit and
prepayment risks. As a result, besides credit and prepayment risks, AIRS also
included the risk of short-term volatility (James, 1994). Thus, the increasing and
extensive use of AIRS has been one of the reasons for investors concerns.
What should McCoy do?
Educating investors and informing analysts
Banc Ones disclosure session to educate investors about swaps and inform
analysts on their hedging position was the most prevalent option to take (James,
1994). However, in 1993, the company had already been using derivatives for
almost a decade. Banc One acknowledged the public that using hedging techniques
with derivatives required a high degree of financial sophistication and
quantitative expertise. However, while explaining its position, it brought more
confusion to the investors (Albertson, 1994). Instead, they could have made the
explanation more adequate by making information, which was only available to
internal users apparent to the public as well. This would make it easier for
stakeholders to evaluate the value added.
Investors expectations and position
Through the case study, it appeared clear that investors expectations were not
turned towards the highest yield achievable but rather get a reasonable yield with
weighted risks. Investors were aware that high yield comes with greater risks
(Glitto et al, 1997). Using swaps as a hedge for interest rates risk exposure
remained a new tool for a majority of investors and, at the time, had been
overlooked as speculative tool rather than a hedging technique (Heisler, 1994).
Hedge volatility
Notwithstanding the situation, Banc One should not have stopped using
derivatives unless an alternate safer and non-derivatives solution was found in
order to manage its interest rates risks exposure. Nonetheless, the company could
find an appropriate balance between the spread gained by investing in AIRS and
the amount of interest volatility the company was exposed to. It should have
reassessed its volatility exposure to expect a corresponding yield and hedge its
fixed rate portfolio to reduce its volatility and seek satisfaction in a lower yield to
satisfy investors (Glitto et al, 1997).
References:
Albertson, R. (1994). Commentaries on Banc Ones Hedging Strategy. Journal of Applied
Corporate Finance. Vol. 7, pp-52-54.

Esty, B., Headley, J., and Tufano, P. (2008). Banc One Corporation. [Online] Harvard
Business Review. Available at: https://hbr.org/product/banc-one-corp-assetandliability-management/294079-PDF-ENG [Accessed: 1 February, 2015].
Glitto, M., Tulsian, G., and Young, R. (1997). Banc One Corporation. An analysis of
Hedging Strategy. [Online] University of Florida. Available at:
http://www.afn.org/~afn05451/banc_one.html [Accessed: 7 February, 2015].
Heisler, E. (1994). Comments on Banc One. . Journal of Applied Corporate Finance. Vol. 7,
pp-59-60.
James, C. (1994). The Use of Index Amortising Swaps by Banc One. Journal of Applied
Corporate Finance. Vol. 7, pp-55-59.
Marshall, J. (2008). Dictionary of Financial Engineering. Hoboken, NJ: Wiley.
NASDAQ. (2015). Amortizing Interest Rate Swap. [online] Available at:
http://www.nasdaq.com/investing/glossary/a/amortizing-interest-rate-swap
[Accessed: 7 February, 2015].