Banc One HBS case Essay

Banc maven has a problem with the alignment of two of its important st respectgies (1) rapidly acquiring remunerative brims and (2) sustaining high returns while mitigating delight array encounter. Banc champion has been very self-made in acquiring entrusts, and much of this is done by means of the sale/ imparting of Banc iodins timeworn. This dodge relies heavily on Banc unitarys ability to chief(prenominal)tain a high stock price. The irregular st laygy high returns with mitigated please deem chance relies heavily on the part of sideline rate foxiness winds. This practice session of avocation rate changes has decease concerning to investors due to its complicated nature, off-balance plane activity, and distortions in earnings metrics which has negatively affected and continues to negatively affect Banc peerlesss stock price.Because both(prenominal) strategies be extremely successful, Banc One should not focus on abandoning every, and rather focus on educating investors round the use of pastime rate changes and their importance in not only sustaining high returns, but alike providing mitigated risk, which is a strategy investors generally seek. Rather, Banc One should follow a three-step solution. The first step is to continue educating investors through prospectus-type materials (in very simplified forms) and one after other informing fund repugnrs and analysts, who are easier to educate about these complex relationss. The second step is to allow for transparentness with flip-flop transactions. Although Banc One is only essential to disclose trade in information in the footnotes of its financial statements, Banc One should fork out very detailed and clear information about specific swap transactions, to reinforce the notion that Banc One has nothing to hide with these swap transactions. For the stick up step, Banc One should analyze its swap-trading procedures and identify simpler types of swap trades it could put one over. This would make reporting and educating on swaps easier.QUESTION 1How could Banc One manage its pursuit rate risk word-painting without using swaps? That is, how could it move from creation overconfident sensitive to being neutral or liability sensitive without using swaps?The reason why Banc One needs to use swaps is to cover the gap between the cartridge clip of its asset and liabilities and thus to mitigate its exposure to interest rate risk. Therefore, another representation for the bank to achieve this is byMatching the maturities of its assets and liabilities. Since the bank has to a greater extent long- term fixed-rate liabilities, it can add to a greater extent long-term fixed rate assets, such as Treasure Securities to its portfolio. This will match the maturities on both emplacements of the balance sheet and will make the bank neutral to win overs in interest rate. If judge change, an upward motility on one side of the balance sheet will offse t a downward movement on the other.Matching the duration of its loans and liabilities and making sure the impact of interest rate changes on both sides of the balance sheet would cancel severally other out. If the bank decides to take this approach, it can use instruments with different due date periods in order to neutralize its exposure to interest rate risk. In order to achieve this it has to match the return of initial investment periods of its assets and liabilities. take at a rootless rate and use the proceeds to procure long-term fixed rate assets in order to mitigate their asset interest rate exposure. In this case the bank secures future income payments at a certain fixed rate, which it can use to pay the interest on its long-term fixed rate liabilities. Similarly, it can use the income from its floating-rate assets to yield the income on its borrowed floating-rate instruments. Thus, it neutralizes its risk-exposure.Avoid long-term liabilities in order to reduce its ex posure to interest raterisk on the asset side. In this case, the bank can borrow only through short liabilities and thus changes in interest rates will not affect its liabilities side more than they will impact its assets side.Purchasing options, forward, or future contracts. In this means the bank can reduce the uncertainty in the future by entering into an agreement with set terms for a specific date. Thus, if the interest rate moves in an unfavorable direction, the bank has the option to use these tools in order to mitigate the impact of the change on its balance sheet.What are the advantages and disadvantages of using swaps rather than these other means?AdvantagesThere are no capital reserve needments specific to swaps. Swaps do not appear as assets on the balance sheet and thus they are not accounted for in the capital requirement calculations for the bank. This frees capital for the bank and at the aforesaid(prenominal) eon brings insurance against its interest rate expos ure.Swaps give flexibility and allow the bank to design the contracts in a way that fits its needs. Banks can tailor the durations, rates and other terms of the swap contracts and make it specific to the current positioning of the bank. Furthermore, they can easily communicate with other banks in order to work up contracts, which benefit both sides.Swaps can alike improve the banks liquidity It can invest in short-term instruments and thus vitiate locking in its funds in long-term securities. At the same time it can add swaps to its portfolio in order to mitigate several(prenominal) of the interest rate risk involved in the investment of short-term securities. In this manner the bank can make sure it has fair to middling funds to meet changes in demand and at the same time it does not have to be receptive to the accompanying rate change risk.Swaps are off-balance sheet agreements however, the income they generate is included in the companys financials. In this case swaps are not recorded as assets or liabilities, however, they still bring income, which is included in the companys interchange flow statement and accounted for in the performance ratios of the organization.DisadvantagesCreates difficulties for the market and for investors to tax the risk and financial situation of the bank. As banks use more and more swap contracts, assessing the risk exposure of the organization becomes increasingly complex. Thus, external investors have a harder time evaluating the banks current situation and usually require higher returns to compensate for the perceived higher risk.Gives opportunities for speculations- Even though banks use swaps in order to mitigate interest rate exposure, they can also use them as instruments for speculations and short-term gains. If managers think they can predict the rate movement for a future period, they can be tempted to use swaps in order to gain from this movement. Thus, banks have to be careful in their strategies and should make sure they monitor the decision making process involved in the purchases and sales of swaps.They carry a small risk that the opposite companionship might default on the contract and leave the bank exposed to interest rate risk.What is the impact on interest rate sensitivity, chronicle ratios, and capital ratios? Utilizing swaps, Banc One is more liability sensitive rather than asset sensitive. Without swaps, they would need to use its long duration assets to help control its interest rate sensitivity. Through its use of swaps, Banc One increases it return on assets. If they chose to manage interest rate risk by using methods mentioned above, the bank would bread and butter more assets with longer durations causing the return on its assets to decrease relational to them using swaps. In the same scenario, the bank would have a scorn return on equity due to the large amounts of assets needed. Inaddition, the appurtenance shows that although the Twin B bank has higher risk ad justed assets, the point I capital to risk-adjusted asset ratio is set about compared to Banc Ones ratio.Referenceshttp//www.federalreserve.gov/Boarddocs/SupManual/trading/200901/3000p2.pdfQUESTION 2Describe how directs work.Amortizing take Rate Swaps ( air out) at Banc One grew out of a desire to shape a synthetic collateralized mortgage obligation (CMO) similar to swaps but with the extra returns characteristic of CMO investments.Why is Banc One using them?CMOs are preferred investments because it allows investors to get the benefits from investing in mortgage securities and it also is structured so that investors can easily estimate speed of prepayment. AIRs work go around in low interest rate environments. With low interest rates, AIRS amortize faster and banks reinvest only when yields were low. AIRs have evolved to have their amortization schedule fixed by a formula instead of being tied to a group of mortgages. Another element of AIRs lovable to Banc One centered on the fixed rate or swap spread. In AIRs, Banc One would receive a fixed rate plus LIBOR. During this time period, Banc One could receive a swap spread of cxx bps over treasuries as compared to Banc One using a bar swap or comparable CMO that yielded 100 or 20 bps over similar treasuries, respectively.QUESTION 3What are basis swaps? stem swaps allow Banc One to transform prime-based floating rate assets tofixed-income investments.Why is Banc One using them?Banc One was still vulnerable to basis risk level off though synthetic investments partially shielded the bank from sensitivity stemming from shifts in interests rates. Between the two rates, LIBOR and prime, LIBOR changed frequently because it was traded daily while prime changed infrequently because it was governed by bankers. Basis swaps involved Banc One paying a floating rate based on prime while receiving floating rates based on three-month LIBOR and in addition Banc One would use an AIR to mitigate the risk posed by misma tched rates.QUESTION 4What is counterparty risk?Counter-party risk is the risk that the counter-party the other party in the transaction will default on its obligations.How does Banc One measure this risk?The signalize to measuring counter-party risk is to understand the counter-partys ability to pay, and this is done through a counter-partys credit rating. The higher the credit rating, the greater the likelihood that that counter-party would not default. There are other ways that institutions can assess this risk, such as through an independent analysis of the companys financial reports.How do they manage counter-party risk?Banc One managed this risk in several ways. First, it never dealt with an entity with lower than a single-A rating. Second, Banc One monitored its mark-to-market exposure to from each one counter-party and limited its exposure to any given company through unappeasable guidelines. If the exposure exceeded thespecified amount according these guidelines, Banc One would reallocate its swap portfolio. Third, counter-parties were required to post additional collateral as the market prise of the swap changed, similar to how a margin account works with stocks. If the swap time value for the counter-party dropped, it would have to post additional collateral to cover the value of a potential default.QUESTION 5Why might Banc Ones use of swaps be damaging to the stock price?The main problem Banc One is facing is a drop in investors say-so due to its increased use of interest rate swaps. As sanction in Banc One waterfall, so does its stock price. At that time Banc One has ten pending acquisitions, with Liberty National Bancorp being the largest and if its stock falls below the walkaway price of $34.55 Liberty National Bancorp will either cancel the deal or the acquisition will become dilutive in violation of the banks established rules.What are investors and analysts concerned about?On the one kick the bucket investors are concerned about the transparency and accuracy of Banc Ones financial reports. Since interest rate swaps were off-balance sheet transactions, they underestimated the banks assets and in turn overestimated its earnings performance (Net interest margin, ROA and E/A ratio). In addition, the regulatory bodies (Financial Accounting Standards Board) required stripped disclosure on the companies swap portfolio, and as Banc Ones portfolio increased, investors snarl they could not accurately assess the risk of the bank. On the other hand the fact that Banc One was acquiring heavily asset-sensitive institutions which required it to increase its interest rate swaps portfolio to adjust to mild liabilities sensitivity except made investors disquieting because they felt the growth of the portfolio might get out of control and could further cloud Banc Ones financial performance.How should Banc One respond to these concerns?The outdo path for Banc One is to educate investors about the banks use of derivatives. If Banc One does nothing, investors will likely become more concerned with Banc Ones practices and continue to withdraw from the stock, which will result in lower a lower stock price and major complications in Banc Ones investment strategy acquiring other banks. If Banc One limits its derivatives trading, it exposes itself and its stock holders (which it has a fiduciary duty to) to much greater levels of interest rate risk.Because Banc Ones current strategy is the most optimal strategy for higher returns with more limited risk, it must find a way to educate investors about its practices, and how these practices are in investors best interests. This could include the outgo of simpler educational materials (similar to prospectuses) and meetings with fund managers and analysts to inform them of the benefits of these trading practices. Banc One should also provide more transparency to investors about the types of derivatives trades it makes, adding more information about these trades rather than detail-limited footnotes in financial statements. Banc One should also research and implement (if possible) methods to trade swaps more simply.