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Derivatives at Banc One

In 1993, Banc One shocked analysts with the discovery of their $30 billion position in
derivative interest rate swaps. The 25-year steady growth produced by Banc One came to a halt
in 1993 as the price in shares dropped and future acquisitions stopped. This severe reaction in the
markets stemmed from confusion as to the choice CEO John McCoy made while engaging in
swaps to hedge against the exposure of any fluctuations in interest rates. Analyst George Salem
studied McCoy’s position in swaps and came to the determination that Banc One is attempting to
speculate instead of hedge. Banc One was predicting interest rates to decline, while many
investors expected rates to be on the rise. Therefore, McCoy held a position of “betting” on these
declining rates. Banc One disagreed with Salem and argued they were, in fact, hedging.
Banc One worked similarly to other banks, except they were more aggressive and
specialized in mid-market business banking, which included business loans, home mortgages,
auto loans, trust services, and credit cards. Banc One rapidly expanded across Ohio as the
recession of 1981 weakened and by 1985 crossed state lines to acquire the Purdue National Bank
of Indiana. This movement soon led to a domino effect throughout the late 80’s across the United
States, causing Banc One’s acquisitions to total to $22.5 billion in assets. By 1993, Banc One
had affiliated banks in 13 states and was the eighth largest bank in the U.S. Through the Riegle-
Neal Act in 1994, President Clinton made interstate branching possible by eliminating most
restrictions on interstate bank acquisitions. As Banc One began expanding across the United
States, earnings per share grew by almost 31% per year.
Interest rate exposure is created because the interest rates on deposits change at a
different rate than that on loans. There are two common ways that interest rate risk can be
assessed: frequency of repricing and duration. In studying the frequency of repricing, the speed
of which assets and liabilities respond to changes in interest rates is considered. For example,
Banc One is asset-sensitive because the interest rates on their assets adjust more frequently than
those on their liabilities. In addition to considering the speed of the adjustments, Banc One must
also measure the sensitivity of the value of the asset or liability (duration) because this sensitivity
will affect the price.
In calculating Banc One’s duration gap, we must define the following relationship: an
fixed interest rate asset and a maturity of n years falls in value by nearly n% with a 1% rise in
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interest rates. Assets have a shorter duration than liabilities because they reprice more frequently.
In Exhibit 2, we see that Banc One’s duration for total assets is 1.45 years and for total liabilities
is 1.84 years. Thus, their duration gap in 1993 was 1.45-1.84 = -0.39. As a result, the value of
their assets was reduced by $79.919*1.45% = $1.159 billion, and the value of their liabilities was
reduced by $72.885*1.84% = $1.341 billion. This led to a net gain of about $1.341B - $1.159B =
$0.182 billion.
To manage their exposure, the bank used interest rate swaps – a financial derivative.
These swap contracts are made between two parties to exchange their cash flows but no principal
amounts. Interest rate swaps are alternative measures to manage interest rate risk because they
reduce or increase vulnerability to fluctuations in interest rates. Furthermore, interest rate swaps
can help a firm secure a lower interest rate.
In a “plain vanilla” interest rate swap, two parties make an agreement to exchange a fixed
interest rate for a floating rate on a fixed notional amount. The notional amount is the amount of
money that the exchanged interest payments are based on and it will never be exchanged; only
the interest rate payments are exchanged. An amortizing interest rate swap (AIR) is essentially
the same as a plain vanilla interest rate swap, but it has one exception: the notional amount
amortizes with the short-term interest rate. The notional amount is often tied to a mortgage,
whose principal amount decreases over time. Therefore, the notional amount of the exchange
declines and any resulting cash flows are exchanged.
There is more risk in using amortizing interest rate swaps because it is tied to a financial
instrument that has a decreasing notional amount. Some risks include: price, hedging, liquidity,
and credit. However, the greatest risk to an investor in an AIR is price risk because interest rate
risk is heightened. For example, if short-term rates rise, the amortization will be delayed and the
investor who will receive the fixed rate will have a potential negative cash flow. The AIRs have
the added risk of losing cash flows due to the amortization schedule of the underlying financial
instrument. Amortizing swaps are often used for increasing or reducing interest rate exposure
and we believe that Banc One uses them to for that purpose. Banc One could exchange their
floating rates for a fixed rate, which reduced the speed that their assets repriced. Furthermore, the
AIRs helped increase Banc One’s net interest margin because the spread goes straight to their
bottom line.
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Basis swaps are also swap contracts that help manage interest rate risk exposure. In a
basis swap, two counterparties agree to exchange a floating rate for a floating rate. This allows
for the parties to fulfill interest rate payments that are based on different interest rates. Generally,
the basis swaps are designed to minimize the risk they incur from lending and borrowing at
different rates. By using basis swaps, Banc One receives LIBOR while paying the prime loan
rate (the rate commercial banks charge their least-risky customers). Banc One increased its basis
swap position because the bid-ask spread was larger and that went directly to the bank’s bottom
line. The bank also used the basis swaps to control its asset-sensitivity. The swaps are off-
balance sheet transactions and have no credit risk. Due to this, the swaps did not significantly
impact the company’s capital position.
The interest rates on assets and liabilities adjust at various speeds and this describes the
interest rate sensitivity of Banc One’s balance sheet. Banc One faced interest rate risk or the risk
of “repricing” of interest rates on assets and liabilities. The difference between rate-sensitive
assets (RSAs) and rate-sensitive liabilities (RSLs) is Banc One’s GAP and it measures the
interest rate exposure. Exhibit 1 shows Banc One’s calculations of GAP, indicating they are
asset-sensitive due to the $14,388B difference between total year one’s assets of $51,854B and
liabilities of $37,466B. Because the bank is asset-sensitive, a rise in interest rates theoretically
raises earnings and value of the firm. Banc One’s calculations are accurate, but an assumption
made is the bank’s assets and liabilities are repriced at the same time. If not, there is a change in
net interest income (NII) because the NII is interest revenue less interest expense. When GAP =
0, changes in rates have no impact on NII, when GAP > 0, Banc One is asset-sensitive, and when
GAP < 0, Banc One is liability-sensitive.
If Banc One has more RSAs than RSLs, this causes a problem for their NII because the
interest revenue decreases faster than interest expense. If Banc One has more RSLs than RSAs,
this means that they are borrowing in the short-term market and lending in the long-term. Banc
One managed interest rate risk regarding derivatives by allowing a small liability-sensitivity to
raise net income but not expose interest rate risk. To quantify the effect on NII due to a change in
rates, we can consider Banc One’s one-year GAP of $14,388B as calculated above. If rates rose
by 1.5%, the change in NII would be $14,388B*1.5% = $215.8 million. Conversely, if rates
declined by 0.7%, the change in NII would be $14,388B*(-0.7%) = - $100.7 million.
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Upon analyzing the facts of this case, we are not sure if it makes sense for Banc One to
hedge with such a heavy amount of their possible interest rate risk in swaps. According to Banc
One, engaging in these swaps created a small liability-sensitivity of 3.3%. This percentage, in
theory, will contribute to increases in net income without the worry of interest rate risk. This
scenario is favorable and common in banks that do not take any derivative positions. Therefore,
Banc One could have increased their “wholesale liabilities” (CDs/commercial papers), as larger
banks do, to naturally move to a modest liability-sensitivity without swaps. The alternative of an
additional wholesale liability would create an increase in demand on the bank’s management
liquidity as well as cutting down the net interest margin. On the other hand, an interest rate swap
will produce a little effect on the bank’s capital position. The benefit of engaging in an interest
rate swap is the elimination of risking the notional amount. Banc one made an argument that a
swap was the best way to reduce the company’s asset sensitivity as opposed to other options.
In 1993, Banc One’s stock price fell from $48 per share in April to $36 per share later
that year. Although it is difficult to attribute the loss of shareholder confidence and subsequent
decline in stock price to any one single factor, the case suggests that their derivative position had
the biggest impact. The expansion of Banc One’s derivatives portfolio combined with the general
lack of understanding (from both investors and analysts) as to how the swaps were being used to
manage interest rate risk can best explain the reason for the declining price movements in their
stock price. As Banc One’s interest rate derivatives portfolio grew, so did investor concerns. The
case cites that, “Only an experienced bank analyst could have understood what Banc One had to
say.” Also, falling share price was influenced by the fact that investors simply were not
comfortable with so much exposure to derivatives and they were unaware of how swaps could be
used to manage interest rate risk and basis risk since they were such a new concept. The
uncertainty from analysts and investors was spearheaded by the complexity of derivatives and
the level of difficulty with conveying the risk/reward to investors is what led them to undervalue
Banc One’s stock price.
Derivatives portfolios can be damaging to the bank’s stock price because as they continue
to increase the number of swaps they are using, accurately assessing the risk exposure becomes
harder and harder to do. This can make it very difficult for investors or analysts to determine the
risk and/or overall financial situation of Banc One. Derivatives also expose the risk of the
opposite party defaulting on a contract, leaving the bank with exposed interest rate risk.
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As Banc One continued to increase the number of “asset-sensitive” bank acquisitions

they were making, they also increased their use of swaps in order to reduce their exposure to
interest rate fluctuations. Their increased use of swaps also brought much skepticism from
analysts as they speculated they were using their derivatives portfolio to distort their reported
earnings and trick the public into believing earnings were higher. The overestimation of earnings
was a concern for both investors and analysts.
We believe that there are 3 main options that McCoy can take moving forward are:
1. Do nothing. If McCoy takes this route, Banc One can hope their stock price recovers
over time and investors realize the benefits of derivatives usage. Although, the option
of not doing anything does not prove well for the public perception.
2. Banc One can halt the growth of their interest rate derivative portfolio (or severely cut
back) and wait for the stock price to rebound on its own. A disadvantage is greater
interest rate exposure left with the bank.
3. Banc One should incorporate increased financial statement transparency and better
educate investors/analysts.
Option 3 is the best option for McCoy. A greater emphasis is needed on increasing financial
statement transparency. Swaps are off-balance sheet agreements, so the income they generate
does get included in the company’s financials. Because Banc One is only required to disclose
this information in their financial statements footnotes, we highly recommend Banc One
provides an additional report that contains all the financial information pertaining to their swaps.
Disclosing all information related to derivatives clearly in their 10-K will convey a positive
message and settle any investors’ or analysts’ concerns surrounding any uncertainty with regards
to potentially manipulated reported earnings. Making financial statements more transparent will
lessen the confusion investors run into regarding derivatives.
Banc One needs to pursue a course of action that will relieve any investor fear and
improve communication to the market on their risks/rewards pertaining to the derivative strategy.
Banc One’s strategy is essentially trivial unless the market perceives it positively; any market
reaction will effect movement in share prices. To ensure this is positive, it will be accomplished
by sending investors and analyst informational documents that clearly explain how derivatives
are used within the company.
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Exhibit 1
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Exhibit 2