Banc One Case Analysis

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Evgenia Malinovskaya z5128912
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Introduction
Banc One Corporation started as First Banc Group in 1968 with its

headquarters located in Bank One Plaza in Chicago, Illinois. The bank started its

business as a holding company based in Columbus, Ohio. Through the spirit of

regional banking, Banc One acquired several small investment companies. It

controlled five state banks that also managed several subsidiary bank holding

companies. With its three-branched organisational structure, the bank quickly

grew to become the leading bank holding company in the Ohio region and the

eighth in the United States. The company later merged with JP Morgan Chase in

July 2004. Today, the headquarters of Banc One are called Chase Towers that

serve as the main offices of the Chases Retail Banking.

Synopsis
Banc One eventually grew to be the seventh-largest bank in the United

States. A major contributor to this growth was the third-prong of its business

strategy which sought to grow rapidly by acquiring profitable banks. Towards the

end of its powerful acquisition it acquired more than 100 regional banks

(Cunningham and Harney 2012, p.110). This phenomenal growth and their track-

record of having 25 straight years of steadily rising profits, was only possible due

to the stocks high prices. However, in 1993, this seemingly well-oiled machine

faced a major threat - a sharp decline in share prices which threatened their

acquisition streak and thus earnings. The fall in stock price was in response to

shareholders concerns with the firms use of derivatives. The problems started

when the banks holding organisation opted to introduce the use of swaps as a

financial tool to manage the risks associated with fluctuation in interest rates. It

was believed that when the corporation adopted the use of derivatives some
potential investors were hesitant to buy shares of the bank (Esty, Tufano, &

Headley, 2008). According to K. F. Puglisi, a Chicago banking analyst, this fear

was highly responsible for the declining share values of the company (Esty,

Tufano, & Headley, 2008). One reason why depositors were afraid of investing in

the firm was the concern they had about the speed, in which interest rate

derivatives grew over a short period. Puglisi argued that potential investors were

uncomfortable with the risk exposure of derivatives (Esty, Tufano, & Headley,

2008).

Despite the heated debate against the new idea, the management of Banc

One supported its move to bring in the use of swaps as its financial tool. The

companys Chief Investment Officer offered a presentation that proved the

importance of using swaps to manage contemporary risks. Thus, the

management faced a dilemma of whether to eliminate the use of derivatives or

to maintain using it. Due to the usefulness of swaps in regulating the risks

attached to fluctuating interest rates, the Chairperson and the CIO of the

company implemented a policy of educating investors about the importance of

derivatives.

Issues and Challenges

Banc Ones share price fell by a margin of $10 from a high of $48 to $36

within six months from April to November 1993. Different bank analysts have

proposed varying reasons to explain this trend in Banc One. One cause of the

falling stock prices was considered the investors concern over the banks large

and ever growing interest rate on the derivatives portfolio. It happened that Banc

One opted to use the derivatives liberally to attain its goals when dealing with

the companys asset and liability management. In 1986, it introduced the use of

swaps as a tool for managing risks related to fluctuating interest rates.

 The use of swaps and derivatives soon became a major concern to the

companys shareholders because it was a comparatively new financial tool in the

markets. John B. McCoy, the chairperson and chief executive officer of Banc One

Corporation, once argued that most of the investors did not know how swaps

operated, and this affected the value of the banks shares (Esty, Tufano, &

Headley, 2008). The use of derivatives also required high level financial

sophistication and high proficiency in quantitative analysis. Many bank analysts

warn that achieving these qualities may be hard, thus deterred many investors

(Odekon, 2015). Hence, the value of the shares continued to depreciate as fewer

people chose to invest in the companys stocks.

Another issue that Banc One Corporation faces is the negative comments

from equity analysts covering the company. Thus, K. F. Puglisi, a critic, argued

that many investors were not at ease with the exposure of derivatives (Esty,

Tufano, & Headley, 2008). The use of swap transactions with fixed rates exposed

the company to the counterpartys default (Esty, Tufano, & Headley, 2008).

However, Banc One mitigated the credit risk in three different ways. They

included the positive swap spread, using swaps investments where only the net

returns faced the default risk, and having strict regulations of controlling

counterparty exposure. Based on these three policies, the firm allowed such

derivative exposure that, as analysts believed, had scared some investors

(Fischer, Sharrott, & Calabro, 2013).

The two primary issues that this bank faces have consequences to the

operations and welfare of the firm. One potential consequence of the reduced

share prices is intimidating potential investors. Potential investors of the

company may fear channeling their investments to a company whose rapidly

falling stock prices may signal distress. Apart from pushing away potential

investors, this problem might also prompt some of the current shareholders to
sell their current holdings and invest in other better valued shares from other

corporations (Odekon, 2015).

The falling value of shares and the lack of comfort among investors in

Banc One would also make the company go through a tough time when looking

for credit. Credit providers always look through the history of the business on the

stock market. Some credit providers might be frightened to offer their facilities to

a firm that has recorded declining stock prices.

Handling the problems of falling stock values and investors worries is

crucial to Banc One Corporation. The first issue is the fact that the companys

stocks influence the amount of capital available for the firm. Declined share

values would mean the business could collect little from the sale of assets to the

public. Another importance attached to the declining share values is the prestige

that the company is losing. Banc One would not enjoy the fact that it is not

ranked highly on the stock market. Finally, it is very important for these problems

to be handled professionally and in a timely manner to avoid the possibility of

the bank being taken over. If the stock price keeps going down, then a competing

bank may step in and decide to buy a big stake to acquire Banc One. Therefore,

the problem of falling prices is critical and it needs to be handled with urgency

(Odekon, 2015).

The banks Chief Investment Officer (CIO) and CEO worked towards finding

a balanced solution to these problems. McCoy, the CEO, expressed his concern

that the use of swaps was beneficial in managing interest rate risk but hurtful to

the companys share prices and lost the support of investors. The derivatives

scared away some investors who could not fully comprehend how they operated.

The CIO, Dick Lodge, prepared a presentation that aimed at showing investors

the usefulness of the derivatives and swaps. Lodge created the presentation pre-

empting the fear that the derivatives would create amongst investors. Further,
pressures from the SEC to provide better disclosure of its derivative position led

to Banc One compiling a 10Q report with a full added page of explanations. Even

with 33 years of experience on Wall Street, Peter Lincoln, an investment vice

president of United States Steel and Carnegie Pension Fund which owned about

$50 million of Banc One stock, says he gained very little from the 10-Q

explanation. (Loomis, C J 1994). In front of a group of New York analysts,

Chairman, John B. McCoy maintained that interest rate swaps are an integral part

of asset and liability management and that swaps do a better job at hedging

against swings in interest rates than the traditional method of using bonds

(Layne, 1993). The company released data showing how its $39 billion

derivatives portfolio boosted profitability in the third quarter with minimal risk.

Regardless of the reassurance of the company, the fears of investors were not

eliminated.

Case Analysis
Interest Rate Exposure:

Banc One has significant amount of fixed and floating-rate liabilities on its

balance sheet as well as fixed and floating-rate assets. This means that the

income of the bank is susceptible to changes in the interest rate in the market. In

order to ensure that the income is unaffected by the market movement, the bank

can match the maturity of its assets and liabilities. However, theoretically, this

may be possible. But, in real world, banks are generally involved in asset

transformation business. Banc One holds more long-term liabilities than long-

term assets and thus resorted to investing in treasury securities in order to

match the maturity.

Dick Lodge, the Chief Investment Officer, had a very conservative investment

strategy. The funds were parked in those investment vehicles which conserved

the principal amount while providing a low return. Liquidity was also a main

concern for the department. Initially, Banc One relied heavily on conventional

instruments such as short-and-medium term U.S Treasury securities, municipal

bonds and money market instruments. Gradually, the management of the

company started investing in interest rate swaps as a way to replicate returns on

other securities. The management was quick to realize the benefits associated

with synthetic securities and soon became heavily invested in such securities.

Collateralized mortgage obligations were introduced in 1983 and by the end of

the FY 1993, the total investment of the company in such securities amounted to $ 4.5 billion.

The management of bank resorted to replicating the payment structure of various instruments with the

help of derivatives and swaps agreements. If the bank wants to invest in fixed-rate securities, it could

sell a floating rate investment and buy a fixed rate investment.

After the global financial crisis, the regulators have enforced stringent capital requirements on

banking institutions in an attempt to provide a cushion for unexpected runs on the banks and adverse

market movements. The amount of capital the banks needs to hold was determined on the basis of the

risk-weighted assets on the balance sheet of the company. The falling capital ratio of the company

would prompt a capital injection which puts strain on the profitability of the company. Swaps are not

considered in the risk weighted assets and this prompted the management to heavily use swaps.

The use of swaps and derivatives by the management will reduce the liquidity risk exposure

of the company. The company still has significant commitments with regards to cash

payments, however, the company does not hold any long-term assets on its balance sheet. The

relatively long-term nature of the assets poses serious liquidity threats to the company. The

value realized in the actual market may be very different from the book value and it usually
requires considerable time to find the right price and the right buyer. The bank can meet

unexpected withdrawal demands, report higher liquidity ratios and has enough cash at hand to

cater to adverse market movements.

The management adopted earnings sensitivity value approach to determine the effect of

interest rate change on net income. Banc One had asset sensitive positions; an increase in the

interest rate will increase the income from assets more than its effect on liabilities and

overall, the income will increase. Initially, the bank did not have sophisticated technique to

measure its interest rate exposure. However, it introduced a method called maturity gap in

1980s. The assets and liabilities were categorized on the basis of repricing intervals and then

various buckets were analyzed to estimate the impact on net income. Unluckily, the

implementation of this method consumed a lot of time and management could not really

implement it. Later on, the departments used simulation to predict asset and liability values

for a certain range of interest rate changes and the respective positions were daily updated on

the portal by affiliates and subsidiary companies.

By the late 1980s Banc One had diverted its attention to synthetic investments

which were increasingly replacing their conventional investments by adjusting

floating rates to fixed rates (Schiller, 1994). For example, a medium-term U.S.

Treasury obligation could be replaced by a medium-term receive-fixed swap and

short-term floating-rate equivalents. The benefits of these synthetic investments

include:

- Improvement in the banks liquidity;

- Swaps were off-balance sheet transactions; accounting treatment would

lead to higher Return on Assets and Return on Equity

- Swaps have lower capital requirements;
 With the advantages of synthetic investments looking lucrative, Banc One

began searching for a synthetic CMO which would allow it to enjoy high yields for

taking on the added prepayment risk. The solution came about through the

development of Amortised Interest-Rate Swaps (AIRs). AIRs were extremely

popular in the 1990s and were the swap markets solution to the mortgage

market at this time. Since 1990 the market for the swaps grew to an estimated

$100 billion to $150 billion notional principal by late 1993 (Galaif 1993, pg. 64).

AIRs are interest rate swaps created such that the principal declines (amortises)

when interest rates decline (Veronesi 2010, pg. 474). When the AIR contract is

set out, it will contain an amortising schedule for the notional amount Appendix

Figure 1 (Galaif 1993, pg. 64) presents an example of an amortisation schedule.

Although the schedule is agreed to at the time the trade is execute, the actual

amortisation that occurs over the life of the trade depends on the path taken by

the reference rate of interest. There may also be a lockout period during which

no amortisation can occur. Figure 2 in the Appendix (Ranganatham and

Madhumathi, 2012) provides a simplified example of the cash flows for an AIRS.

When interest rates decline, AIRS amortise faster meaning banks would have to

reinvest when the market yields were low. Conversely if interest rates rose, the

maturity of the AIR would increase. This feature of the AIR is known as negative

convexity the rate of change of the duration is concave. As a result of the

convexity, not only was Banc One exposed to change in the interest rates but

also the rate at which interest rates changed that is it has accumulated

exposure to the delta and gamma sensitivity of interest rates. The embedded

option in the AIRS makes measuring in the inherent interest rate risk much more

difficult to measure. (Glitto, Gajendra, and Young, 1997)

There are several advantages associated with AIRS which led to Banc One

favouring the investment over traditional means of hedging.

Higher Yields

These swaps allowed for high yields in exchange for taking on prepayment

risk In 1993, AIRS produced the highest yields in comparison to a Treasury

security of the same maturity, CMO and also a standard swap of the same term

(Esty, Tufano, & Headley, 2008). Table 1 in the Appendix shows a comparison

between the yields of AIRS, CMOs and plain vanilla swaps. The higher yields of

AIRS result from premiums earned on options embedded in the swaps (Fernald

1993, pg.71). The increased yield is due to the amortizing feature of the notional

amount which decreases when there is a decrease in the interest rates. Since a

market swap rate is determined at time 0 such that the value of the swap with

maturity T is equal to 0 at initiation, we must increase the swap rate above the

market rate of plain vanilla swaps in order to make the value of the AIRS equal to

zero at time 0 (Veronesi 2010, pg. 474). In this way Banc One was able to

maintain the relatively high yields it previously received from Municipal bonds

while still compensated for the prepayment risk it was taking on.

Capital Adequacy Requirements

Swaps offered substantial reduction in capital adequacy requirements

under risk-based capital standards, AIRS, have very low capital requirements

(Glitto, Gajendra, and Young, 1997). Banc One identified this to be a major draw

for the investment. Credit derivatives helped banks make use of their capital

more efficiently which was acknowledged by CIO Nick Lodge in a comment made

on the Wall Street Journal "Why in the world more banks do not use interest rate

swaps to preserve capital, I don't know...It's not an esoteric phenomenon

anymore," (Esty, Tufano, & Headley, 2008). If a bank were to use securities to

create the same exposure as a swap, it would be required to hold capital of up to

20% to 100% of the principal value of the assets (Esty, Tufano, & Headley, 2008).
On the other hand, swaps were considered to only contribute very insignificant

amounts to the risk-adjusted assets against which the bank had to hold capital.

Eliminates idiosyncratic prepayment risk

AIRS avoided unpredictable or idiosyncratic prepayment risk associated

with MBS and CMOs Idiosyncratic prepayment risk refers to the risk that is not

directly related to a change in interest rates. For example, prepayment may be

caused by a death as opposed to change in the interest rate environment. AIRS

eliminates this type of risk, and leaves only the portion of risk that is caused by

movements in the interest rate (Galaif 1993, pg. 69). This was an advantage MBS

and CMOs did not have.

Greater liquidity

AIRS are more liquid than traditional CMOs the markets for derivative

instruments such as swaps provide greater liquidity than markets for the

underlying security. A major advantage of AIRS over CMOs was the improved

liquidity provided by AIRS. This was extremely useful for Banc One if it came to

the position of considering to re-hedge its position (Esty, Tufano, & Headley,

2008).

Change to earnings sensitivity

Synthetic investments reduced Banc Ones earnings sensitivity to overall

shifts in interest rates like many regional banks, Banc Ones portfolio was asset

sensitive meaning that an increase in interest rates would increase earnings

(Esty, Tufano, & Headley, 2008). An asset sensitive corporation would see its

assets reset at a faster rate than its liabilities resulting in the increase in income.

Since Banc Ones growth was in-part driven by the acquisition of profitable banks

(who were also predominantly asset-sensitive), it began purchasing the interest

rate swaps to position itself such that the liabilities were re-pricing more quickly

than the assets (Klinkerman, Tomasula 1994).

Reported as off-balance sheet items

AIRS are off-balance sheet items and only reported in the footnotes -

However the income that the instruments create will be reported in the

companys financial statements. Thus the use of AIRS would inflate the

performance ratios of Banc One without appearing in the asset or liability

reporting. In contrast, if the company bought a fixed-rate bond and sold a

floating rate security, both of the securities would appear on the balance sheet.

Swaps only need to be included in the footnotes of the financial statements.

(Esty, Tufano, & Headley 2008, pg. 8)

Due to the above features of AIRS, Banc One used the instruments heavily

to hedge itself against interest rate risk. The company released data showing

how its $39 billion derivatives portfolio boosted profitability in the third quarter

with minimal risk (Layne 1993).

Other Risks
Other risks, associated with Banc Ones derivatives portfolio included

counterparty credit risk, interest rate risk, operations and systems risk, funding

risk and liquidity risk. To account for each of these types of risk, Banc One came

up with a certain strategy.

While swap contract counterparty risk has been well compensated by a

high swap yield and the exposure to this risk has been limited to the first net

payment, the risk of counterparty default existed and had to be managed. The

counterparty risk that the Banc One would expose itself to every time it engaged

into a swap agreement was almost completely removed by strict guidelines

managing this exposure. According to this policy, all of the counterparties had to

have at least single A rating, as well as to post collateral equal to Banc Ones

possible losses from extreme one-month interest rate swing. All counterparties,
including AAA- rated firms were to post collateral in the form of easily tradable

securities at the beginning of the swap transaction. In most cases, corporations

were reluctant to post any collateral at all, but Banc Ones counterparties were

ready to do so because of Banc Ones excellent credit rating and solid derivatives

portfolio.

Other risks have been managed by rigorous policies introduced by ALCOs

(Asset and Liability Management Committees). These committees came up with

a system that supervised Banc Ones and its affiliates assets and liabilities

management, or in other words their depositing and lending activities and the

resulting liquidity and earnings sensitivity. Committees made sure each affiliate

respected sensitivity boundary set at 4% within the banks and monitored that

other earnings sensitivity guidelines are followed. Refer to Table 2 in the

Appendix.

The process also controlled each banks use of derivatives, its investment

decisions as well as tactical and strategic decisions. This way, all of these

decisions had to be approved by a committee of senior executives before they

could be implemented. All investments of Banc One were executed by CIO Dick

Lodge, a member of working ALCO, and his team. ALCOs monitored each banks

compliance with the ALCO policy rules and controlled the exposure of each unit

to interest rate risk, market risk, operations and system risk, liquidity risk,

funding risk, credit risk and each states capital adequacy. This way, the activities

of the entire network of Banc One and its numerous affiliates were systemized

and analyzed regularly by three committees making sure no action within any

unit of Banc One goes unnoticed. This way, the risk of excessive exposure to

interest rates and the risk of having extreme earnings or liabilities sensitivity at

any branch have been mitigated. The whole network was put under the rigid

control of three main committees.

 ALCOs consisted of working ALCO, which constituted senior Banc Ones

executives, responsible for all important policy decisions; Corporate Funds

Management Activity Committee and the corporate ALCO committee, which

consisted of working ALCO and of Banc Ones holding companies board of

directors.

Each affiliate unit had their own committee presenting to the working

ALCO. This way, all Banc Ones holding companies had to report on their funds

management and cash positions on everyday basis. Each had their own

committee controlling states depositing and lending activities and analyzing

their effect on banks financial health. As Banc One had a very extensive network

of affiliate units it needed a powerful system to allow ALCOs have a timely and

easy access to information on each state. For this purpose, MICS has been

created.

Thus, with the use of MICS, ALCOs that met on a regular basis could

supervise the activities across the entire network of Banc One and its affiliate

units, controlling the use of derivatives and resulting liquidity and earnings

sensitivity at each institution as well as analyzing each tactical and strategic

decision of each unit before allowing it to be executed. Such strategy was proven

to be a great tool to manage risk across a vast network of institutions while

maintaining their financial health and earnings growth.

Recommendation and Conclusion

There are a number of possible solutions that the executives of bank

management can decide to engage in, in order to resolve Banc Ones falling

share price. These solutions have been separated into two categories for

analysis: strategies that do not require a change to Banc Ones current

derivatives portfolio and risk management policies; and strategies that do

require a change to the firms use of derivatives. There merits of each potential

solution will be analysed and discussed below, with a final recommendation

presented at the conclusion of this analysis.

NO CHANGE TO DERIVATIVES PORTFOLIO

Alternative #1 Status quo

The first alternative available to management is to continue to pursue its risk

management of the firm through its prudent derivatives investment policy, and

hope that over time investors will understand and realise the benefits of such

initiatives. The justification for continuing to pursue its current derivatives

practice is threefold.

[RD to add advantages of derivatives: liquidity, capital requirements]

There are two main downsides to undertaking this approach. The first is that this

approach is a medium to long term solution that is unlikely to satisfy Banc Ones

requirement to restore its share price comfortably above the $34.55 walkaway

price for the Liberty National Bancorp transaction to proceed in 2Q14. Further

elaborating on this, it is likely that it will take time for investors to understand,

process and gain comfort with Banc Ones complex interest rate derivatives

portfolio, and certainly a long time for this to be reflected in the firms stock

price. As one analyst noted since derivatives are relatively new financial

instruments, and since their use requires a high degree of financial sophistication

and quantitative expertise, there is an understandable aversion to them on the

part of many investors. Thus by pursuing this strategy, management are rather

optimistically relying on investors to change their opinions on the use of

derivative instruments, to realise that when used carefully, are actually helping

the firm to reduce its interest rate and basis risk.

The second downside of this approach is that it would be difficult to reverse the

negative public opinion of the use of swaps that was instilled by politicians
following the U.S. Comptroller of the Currencys issuance of a set of guidelines

for the use of swaps in October 1993. With widespread push back against the

use of derivatives from the industry, regulators, and politicians on the front

pages of leading newspapers, it would be hopeful to assume that investors would

see past this and be able to determine through their own research, the benefits

of such practices.

This leads to another proposed alternative designed to combat such negative

press and investor uncertainty by engaging and educating the public of the

sensible derivative policies that Banc One has in place.

Alternative #2 Status quo with public engagement and education

A slight adaption to the above option to keep Banc Ones derivatives strategy in

place and hope that investors will understand these policies over time, involves

actively engaging with the public and educating investors on the benefits of

using derivatives to manage interest rate risk. In doing so, Banc One can seek to

combat the negative press being circulated in the media, by posing the

advantages of derivatives. It is suggested that there are three mediums that

management can effectively utilise to communicate to large audiences how the

firm uses derivatives to mitigate risk.

Management presentations

It is suggested that management hold management presentations that educate

an audience comprising equity analysts, the media, and the Banc One investor

base, of the benefits of using derivative instruments as a prudent way to manage

the firms asset and liabilities exposure. By doing this management are able to

keep the public accurately informed about the company and its policies, and

promote positive signals to the market that the firm is trying to instil the best risk

management practices, whilst being honest and open about its financial

disclosures. Furthermore, a presentation would allow Banc One to demonstrate

to equity analysts the merits of using swaps by comparing the bank to two

hypothetical twins that had no swaps. [RD additional analysis]

Company Reports

Banc Ones most recent quarterly disclosure presented the market with a

significant amount of detail on the banks swap portfolio. In addition to this, the

firm could add a section to its reports that provide a basic summary, aimed at

educating a novice investor, of what derivatives are, how swaps/AIRS/CMOs

work, how these instruments are used to reduce risk, the risks involved with such

instruments, how the firm deals with these risks through its ALCO committee

policies and guidelines. This basic level of education would go a long way to

helping investors better understand Banc Ones practices, however it is

inevitable that after reading this, there will be sceptics which question the

credibility and reliability of the companys reporting on this topic given that the

company has a self-serving interest in promoting its use of derivatives. In order

to dispel this skepticism, the firm could employ an independent expert to assess

the companys use of derivatives and derivatives policy, and to release a report

on its findings.

Newspaper & television interviews

Additionally, Banc One management could conduct interviews with journalists

and reporters on the firms derivative practices, and attempt to provide a

counter-argument to the negative articles covering the front pages of leading

newspapers.

The downside of engaging with the public through the above mediums, is that

the disclosure of even more information is not a guaranteed solution, and it may

result in no improvement to the share price - threatening the viability of the

Liberty National transaction. Furthermore, such an approach may draw even

greater attention to Banc Ones derivatives portfolio, which may elevate

investors concerns or increase their confusion. In such a case, the firm risks its

share price falling further.

Alternative #3 Change accounting treatment or improve disclosures

Equity analysts covering Banc One noted that:

The increased use of interest rate swaps is creating some sizeable

distortions in reported earnings, reported earnings assets, margins, and the

historical measure of return on assetsBuyers of regional banks do not expect

heavy derivatives involvementHeavy swaps usage clouds Banc Ones financial

image and is extremely confusingIt is virtually impossible for anyone on the

outside to assess the risks being assumed 1

This comment depicts the confusion of outside investors in attempting to assess

the true financial performance and risks of the company. Interestingly, an

analysis of Banc Ones financials in Exhibit 2 indicates that Banc One has

performed well in recent times with the firms net Income for the first three

quarters of 1993 at $854m, implying a run-rate of $1,139m for the full year

which represents a record result for the firm and a 45.8% improvement on 1992 2.

From analysing this performance, it can be inferred that the equity analysts view

is correct and that investors have punished the stock in part 3 due to the inability

of such investors to accurately understand and assess the risks of Banc One,

rather than due to the poor performance of the firm. Moreover, due to this

1 George Salem, Rating for Banc One Reduced to Hold from Buy Based on Confusion from Heavy
Exposure to Interest Rate Swaps, Prudential Securities, November 1993, p.2, as quoted by First
Call
2 It should be noted that whilst these 1993 net income figures are somewhat inflated by Banc
Ones increasing derivatives exposure (and subsequently derivate income) over 1992, the effects
of this are minimal, and the net income from traditional banking activities has clearly improved on
1992 figures. Additionally, the elevated net income figures over 1992 could be due to recent
acquisitions and the combination of earnings, although ROA and ROCE are higher than 1992,
indicating that the growth has not just come from an inorganic means.
3 Note that the Major Regional Bank Index is also down , and thus there are likely macroeconomic
or systematic reasons explaining the fall in Banc Ones share price
increasing uncertainty it would seem that investors have discounted their

valuation of Banc One.

This uncertainty of Banc Ones true financial performance stems from the

accounting treatment of swaps. Unlike traditional investments and borrowings,

swaps are off-balance sheet transactions. For example, if Banc One were to

purchase traditional instruments such as a fixed-rate bond and sell a floating-

rate security, both would appear on its balance sheet, and the spread between

the two would be noted as income. However, if the firm enters into a receive-

fixed swap with the same cash flow implications, the swap does not appear on

the balance sheet, but is rather disclosed in the footnotes. This practice of

categorising swaps as an off-balance sheet asset or liability is in itself not a

problem. The issue arises because the net income from the swap transaction

appears in the reported earnings in the income statement, and is used to

overstate traditional profitability measures such as the banks return on assets.

It is thus suggested that in order to get investors comfortable with Banc Ones

financial disclosures, that Banc One report its traditional profitability measures,

such as reported earnings, margins and return on assets, on an adjusted basis

that excludes the impacts of the accounting treatment noted above. For clarity, it

is recommended that Banc One still report the earnings from its swaps positions

in the income statement, but this should be separated as a new line item from its

earnings from traditional borrowing/lending activities. Moreover, profitability

measures such as return on assets should be calculated as the earnings from

traditional borrowing/lending activities dividend by the on- balance sheet assets

of the firm. In doing so, Banc One will provide investors with a more accurate

depiction of the firms performance, and better allow such investors to accurately

assess the risks and outlook for Banc One. Given that Banc Ones performance to

date has been solid, it would be expected that investors would now more
accurately price this in without any discounts for uncertainty resulting in an

elevated share price.

CHANGE TO DERIVATIVES PORTFOLIO

Alternative #4 Shift focus of balancing assets from derivatives to

more conventional money market instruments and longer-term

securities

A further, and somewhat more drastic alternative that management could pursue

would be to abandon or severely limit their derivatives portfolio, in favour of

more conventional money market instruments and longer-term securities. For

example, if the bank wanted to increase its holdings in fixed-return investments

to balance its fixed return liabilities, it could purchase fixed-rate treasury notes,

rather than entering into receive-fixed for floating swaps. There are two main

advantages of Banc One pursuing this approach. Firstly, traditional money-

market securities are more widely understood by retail investors than the more

complex derivatives instruments. As such, retail mum and dad investors with

little knowledge of derivative instruments, can better assess and understand the

firms risks and profitability measures. If Banc One were to announce that it was

to unwind its derivatives exposures over the next few years, there may be a

positive share price reaction. The second advantage of this approach is that Banc

One would not be nearly as exposed to counter-party risk, as the counter-party of

traditional investments was generally the US government with theoretically zero

credit risk. However, entering into a swap transaction on the other hand,

exposed Banc One to the default of its counterparty.

There are however two main disadvantages of adopting this approach:

Liquidity

The first is that the banks balancing investments are no longer as liquid as they

are with using swaps. Investing in long-dated securities reduces the firms ability
to liquidate these positions, and if liquidation is necessary it might expose the

bank to a large loss in principal. This becomes a problem in the event that a bank

may need to generate cash suddenly, possibly due to unexpected losses

sustained from credit, interest-rate or operational risk, or driven by increased

customer withdrawals. In contrast, by using swaps the bank can obtain the

economics of the longer-term investment, while still preserving the high liquidity

of the short term instrument.

Capital requirements

If Banc One were to use money-market instruments and longer-term securities to

create a similar exposure to the swap, under the Basel committees risk-based

capital standards it would need to hold between 20% to 100% of the principal

value of its assets. In comparison, swaps require a lower amount of capital to be

set aside for the same notional exposure, and are thus more attractive and

efficient in their use of capital.

FINAL RECOMMENDATION

In determining a final recommendation to the Executives of Banc One from the

list of proposed alternatives above, it is first necessary to adjudicate on whether

Banc One needs to change its derivatives portfolio in order to improve its

dwindling share price.

[RD to finalise recommendation

Eliminating its derivatives portfolio would leave the bank with greater interest

rate exposure

When managed correctly, the use of derivatives can be a prudent method of

managing interest rate risk]

Two additional considerations:

Prior to implementing any of the above alternatives, Banc One should consider

two other strategic considerations:

Consideration #1 Pursue a buyback of its shares

Banc One should consider pursuing a buyback of its undervalued shares,

assuming that it has the balance sheet capacity to undertake this initiative, and

that its capital cannot obviously be invested at higher rates of return elsewhere.

This would serve to do two things. Firstly, it would send a signal to the market

that Bank One believes that its risk management practices and use of derivatives

are sound and that the market has unduly discounted the firms value. Such a

signal would drive demand by investors to purchase the stock and increase Banc

Ones share price. Secondly, a buyback would serve as a takeover defense

strategy, by making the company more expensive (as the share price will rise

due to buyback at a premium) and less attractive to any potential bidders. The

rationale for implementing takeover defense strategies will be outlined further

below.

Consideration #2 Takeover defense strategies

As an additional consideration for management, it is also suggested that Banc

One consider takeover defense strategies to shield the firm from an opportunistic

acquisition by a rival bank.

[RD to comment about poison pill, golden parachute, buyback, bullish

management forecasts]
References
Esty, B., Tufano, P., & Headley, J. 2008, Banc One corporation: Asset and
Liability Management, Havard Business School Journal, vol. 7, no.3, pp.
33-52.

Fischer, R. H., Sharrott, D., & Calabro, J. 2013, CLS Bank v. Alice
Corporation: En Banc Federal Circuit finds financial services Patents invalid
under 35 USC 101 as patent ineligible, Intellectual Property &
Technology Law Journal, vol. 25, no.10, pp. 24-28

Odekon, M. 2015, Booms and busts: An encyclopedia of economic history

from the first stock market crash of 1792 to the current global economic
crisis, 3rd edn, Taylor and Francis, 2011

Layne, R. 1993, Banc One Discloses Details of Giant Swaps Portfolio,

American Banker, 2 December viewed 8 October 2016
< http://www.americanbanker.com/issues/158_142/-33094-1.html>

Cunningham, J.P. and Harney, B.M. (2012) Strategy and strategists. Oxford:
Oxford University Press, USA

Galaif, L. N. 1993-1994, Index Amortizing Rate Swaps Federal Reserve

Bank of New York, vol 18, no. 4, pp. 63-70

Fernald, J.D. 1993-1994, The Pricing and Hedging of Index Amortizing Rate
Swaps Federal Reserve Bank of New York vol. 18, no.4, pp.71-74

A newspaper article with a named author:

o Loomis, C J 1994, The risk that won't go away, Fortune Magazine 7
March 1994, viewed 15 October 2016.
<http://archive.fortune.com/2008/09/25/magazines/fortune/loomis_s
wamp.fortune/index.htm.>

Schiller, Z 1994, Banc One Faces a Rock Act Two, Bloomberg 5 December,
viewed 7 October 2016.
< http://www.bloomberg.com/news/articles/1994-12-04/banc-one-faces-a-
rocky-act-two>

Veronesi, P. (2010) Fixed income securities: Valuation, risk, and risk

management. Chichester, United Kingdom: Wiley, John & Sons.

Ranganatham, M. and Madhumathi, R. (2012) Derivatives and risk

management. India: Pearson Education India.
 Glitto, M., Gajendra, G. and Young, R. (1997), Banc One Corporation: An
Analysis of their Hedging Strategy, viewed 15 October 2016
< http://www.afn.org/~afn05451/banc_one.html>

Klinkerman, S and Tomasula, D, 1994, Banc One Still Struggling to Regain

Investors' Faith. American Banker, SourceMedia Inc. 1994, HighBeam
Research 29 August, viewed 12 October 2016
<https://www.highbeam.com/doc/1G1-15761136.html>
Appendix
Figure 1

Figure 2

Table 1
Earnings Sensitivity Policy Nov 1993 - Banc One Position
1st-year impact for a +1% rate
(4.00)% (3.30)%
change
1st-year impact for a +2% rate
(9.00)% (8.00)%
change
1st-year impact for a +3% rate
(15.00)% (13.20)%
change
2nd -year impact for a +1% rate
(4.00)% (1.30)%
change
 2nd -year impact for a +2% rate
(9.00)% (7.90)%
change
1st-year impact for a -1% rate
4.00% 4.00%
change

Table 2
Treasuries
Plain Vanilla Swap (Interest Rate Swap)
Collateralised Monetary Obligation
Yield - 1993
Yield of a Treasury Security + 20 basis
points
Yield of a treasury security + 100 basis

(CMO) points
Yield of a treasury security + 120 basis
Amortised Interest Rate Swap (AIRS)
points