Banc One Case Study
Banc One's share price has been falling recently due to analyst and investor concern over the bank's heavy use o...
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 One’s 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 One’s growth strategy. The aim of this strategy was to gain economies of scale advantage and also capitalised on Banc One’s 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 One’s stock price dropped over 20% - from $48.3 to $36.3 within eight months (Chart 1). It affected both the situation of Banc One’s 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 One’s stock price, its acquisition costs depended on the Banc One’s 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.
Maturity gap analysis - comparing maturity difference between assets and liabilities adjusted for re-pricing interval.
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.
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.
Utilised interest rate swaps in investment portfolio.
Utilised collateralized mortgage obligations (CMOs) in investment portfolio.
Replaced municipal investments with mortgage-backed securities (MBSs).
Replaced conventional investments with synthetic investments. Developed amortizing interest rate swaps (AIRS).
Table 2: Banc One's interest rate management
Figure 1: Banc One’s 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 bank’s interest rate sensitivity? What is the impact of Banc One’s 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 bank’s 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: swap’s 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
Decrease & Negative
Measures Profitability Ratio
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
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).
Yield (Y: 1993)
IRS (plain vanilla)
Yield of Treasury Security + 20bp
Yield of Treasury Security + 100bp
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 One’s 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 One’s 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 bank’s 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 company’s 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 One’s management to think investors and analysts’ aversion to derivatives were the main cause in the company’s stock price decline. This aversion resulted from the low level of acceptance of the company’s 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 firm’s 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 company’s 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 One’s 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 One’s 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 One’s 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].