Because both strategies are extremely successful, Banc One should not focus on abandoning either, but rather focus on educating investors about the use of interest rate swaps and their importance in not only sustaining high returns, but also 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 individually informing fund managers and analysts, who are easier to educate about these complex transactions. The second step is to provide transparency with swap transactions. Although Banc One is only required to disclose swap information in the footnotes of its financial statements, Banc One should provide 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 last step, Banc One should analyze its swap-trading procedures and identify simpler types of swap trades it could make. This would make reporting and educating on swaps easier.
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?
The reason why Banc One needs to use swaps is to cover the gap between the duration of its asset and liabilities and thus to mitigate its exposure to interest rate risk. Therefore, another way for the bank to achieve this is by:
Matching the maturities of its assets and liabilities. Since the bank has more long- term fixed-rate liabilities, it can add more long-term fixed rate assets, such as Treasure Securities to its portfolio. This will match the maturities on both sides of the balance sheet and will make the bank neutral to changes in interest rates. If rates change, an upward movement on one side of the balance sheet will offset 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 each other out. If the bank decides to take this approach, it can use instruments with different maturity 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.
Borrow at a floating rate and use the proceeds to buy 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 repay the income on its borrowed floating-rate instruments. Thus, it neutralizes its risk-exposure.
Avoid long-term liabilities in order to reduce its exposure to interest rate risk on the asset side. In this case, the bank can borrow only through short-term 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 way 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?
There are no capital reserve requirements 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 same time brings insurance against its interest rate exposure.
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 situation of the bank. Furthermore, they can easily communicate with other banks in order to construct contracts, which benefit both sides.
Swaps can also improve the banks liquidity It can invest in short-term instruments and thus avoid locking in its funds in long-term securities. At the same time it can add swaps to its portfolio in order to mitigate some of the interest rate risk involved in the investment of short-term securities. In this manner the bank can make sure it has enough funds to meet changes in demand and at the same time it does not have to be exposed 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 cash flow statement and accounted for in the performance ratios of the organization.
Creates difficulties for the market and for investors to assess 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 party might default on the contract and leave the bank exposed to interest rate risk.
What is the impact on interest rate sensitivity, accounting 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 hold more assets with longer durations causing the return on its assets to decrease relative to them using swaps. In the same scenario, the bank would have a lower return on equity due to the large amounts of assets needed. In addition, the Appendix shows that although the Twin B bank has higher risk adjusted assets, the Tier I capital to risk-adjusted asset ratio is lower compared to Banc Ones ratio.
Describe how AIRs work.
Amortizing Interest Rate Swaps (AIRS) at Banc One grew out of a desire to create a synthetic collateralized mortgage obligation (CMO) similar to swaps but with the additional returns characteristic of CMO investments.
Why is Banc One using them?
CMOs are desirable 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 best 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 desirable 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 120 bps over treasuries as compared to Banc One using a standard swap or comparable CMO that yielded 100 or 20 bps over similar treasuries, respectively.
What are basis swaps?
Basis swaps allow Banc One to transform prime-based floating rate assets to fixed-income investments.
Why is Banc One using them?
Banc One was still vulnerable to basis risk even 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 mismatched rates.
What 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 key 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 each counter-party and limited its exposure to any given company through strict guidelines. If the exposure exceeded the
specified amount according these guidelines, Banc One would reallocate its swap portfolio. Third, counter-parties were required to post additional collateral as the market value of the swap changed, similar to how a margin account works with stocks. If the swap value for the counter-party dropped, it would have to post additional collateral to cover the value of a potential default.
Why might Banc Ones use of swaps be damaging to the stock price?
The main problem Banc One is facing is a drop in investors confidence due to its increased use of interest rate swaps. As confidence in Banc One falls, 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 hand 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 minimal disclosure on the companies swap portfolio, and as Banc Ones portfolio increased, investors felt 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 further made investors uncomfortable 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 best 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 disbursement 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.