Executive summary

This report discussed the Banc One’s management of interest rate exposure and how
derivatives hedge the risks. The comparison between different tools and both advantages and
disadvantages of swaps are analyzed. The report also assessed why Banc’s derivatives
position harmed its stock price. Finally, recommendations and potential alternatives for
McCoy is also given.

Introduction
Banc one was a top 10 ranking bank in the US, with assets of $76.5 billion. The bank has
objectives to use technology to provide better service to retail and commercial consumers.
Given the asset sensitivity to interest rates, the bank used swaps to hedge. However, the large
investment in derivatives led to a decrease in its share price (from $45 to $35.5), resulting to
affect the pending acquisition.

Interest rate exposure management tools

Banc One managed its interest risk exposures by balancing the assets and liabilities on the
balance sheet. The bank holds asset-sensitive portfolios and most assets are floating-rate
assets while the rest are fixed-rate assets. Most liabilities are non-sensitive liabilities such as
demand deposits and fixed interest liabilities. Therefore, interest rates on assets runoff more
frequently than liabilities. The policy in the bank limits the impacts of a 1% change of
interest rate to the change in earnings should not exceed 5%. To measure the exposure of the
interest rates, the bank has to match the duration of the asset and liability.

In 1983, Banc one began to use interest rate swaps to hedge. The bank pays a fixed 7% to
receive a floating rate based on LIBOR. The swapes helped receive above-market yield and
created a net position of LIBOR+2.5% on municipal bonds.

Other than swaps, Banc one also introduces mortgage-backed securities (MBS), collateralized
mortgage obligation (CMOs), and Balancing assets. MBSs, backed by mortgage loans, are
substitutes for municipal bonds. This tool generates low yields and has exposure to decrease
interest rates because of the large number of repayments. CMOs are upgraded tools than
MBSs by dividing principals and interests into several buskets to lower the risks. Balancing
assets are used to balance the fixed-rate assets and fixed-rate liabilities. Banc one invested in
municipal bonds to achieve the goal. Compared with swaps, these long-term management
tools are rate-insensitive and would not suffer from the volatility of interest rate.

There are several advantages to swaps. Firstly, interest swaps help correct asset and liability
mismatch and prevent the bank from stuck in liquidity shortages trouble. For example, if the
bank pays a floating rate of their liabilities but receives fixed-rate payments of the loan, the
increase of the floating rate would be dangerous. Therefore, it is essential to swap the fixed-
rate payments to the floating rates higher than rates they should pay out to hedge the risk.
Besides, swaps improve the liquidity and enable banks to invest in short-term securities while
remaining stable principals. Banks could design specific swaps under the situation and
benefit both sides. Also, swaps are off-balance sheet items and do not need to disclose. Thus,
they are not included in the capital requirement calculations.

In addition to conventional swaps, Banc one started to use amortizing interest rate swaps
(AIRs) in the 1980s. The notional amount of the swap would be amortized if the interest rate
declines, which means the bank could only invest when the yield is low. Otherwise, the
maturity of AIS would be longer if the interest rate increase.

With derivatives investments of interest rate swaps and AIRs, there would give rise to basis
risks between LIBOR and the prime rate. Most floating-rate assets in Banc are based on the
prime rate, while swaps are built upon LIBOR. Exhibit 5 illustrates the difference between
the two ratios. To solve the mismatch, basis swaps are used. Rather than paying fixed-rate
and receiving floating, basis swaps are contracts that pay LIBOR-floating and receive Prime-
floating. In addition to basis risk, swaps may also have default risks. The floating rate is
complex and unpredictable. The bank may face default risks of the counterparties.

Damage of derivative position to share prices

Shown in Exhibit 1, the share price dropped massively late in 1933 from $45 to $35.5 given
the derivatives portfolio this year increased a lot. Both analysts and investors were unfamiliar
with derivatives and regarded negatively of a large number of swaps. At that time, the market
remained in the CMOS as interest rate management tools. Also, analysts may not agree with
Banc’s prediction that interest rate would fall in the future and their position to liability-
sensitive position as most other banks. Some investors and analysts are also worried that
derivatives expansion may be a sign that the strategy in the past was unappropriated and the
Bank wanted use derivatives to cover the mistakes.

Recommendation
Compared with tween A and B in the appendix, It is undeniable that derivatives are helpful to
manage interest rate risks. McCoy should improve the transparency of the strategies and
educate investors about how they use swaps to hedge interest rate risks. Besides swaps

Reference
Mitra, S., Date, P., Mamon, R., & Wang, I.-C. (2013). Pricing and risk management of
interest rate swaps. European Journal of Operational Research, 228(1), 102–111.
https://doi.org/10.1016/j.ejor.2012.11.032

Jermann, U. J., & Yue, V. Z. (2018). Interest rate swaps and corporate default. Journal of
Economic Dynamics and Control, 88(C), 104–120.
https://doi.org/10.1016/j.jedc.2018.01.022