Banc One Corporation: Asset and Liability Management

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Introduction

Banc One Corporation was facing a decline in the share price between April and November 1993, which was a decline from a high of $48 ¾ to a low of $36 ¾. This resulted from the lack of investor support for the bank’s derivative portfolio that was large and increasing. The use of derivatives was a new strategy of managing the assets and liabilities in banking (Esty, Tufano, & Headley, 2008).

How did Banc One manage interest rate risks?

The bank was able to manage interest rate risks due to a large derivative portfolio. Therefore, it was able to cushion itself from changes in the interest rates. It used swaps, whereby the bank would receive a fixed rate when it paid a ‘floating rate of interest’ (Esty, Tufano, & Headley, 2008). The assets held by the bank were sensitive, as they depended on the market rates. On the other hand, its liabilities were fixed rates, such that they changed at a smaller margin when compared to the market indices. Therefore, the bank’s earnings increased as interest rates went up. Moreover, many of the banks it controlled were also highly asset sensitive. Banc One realised that interest rate risks could affect the bank negatively. Thus, analysing the risks involved and recognising the ease with which the interest rates were affected were important steps in coming up with strategies to protect itself (Esty, Tufano, & Headley, 2008).

Regulations that affected Banc One capital requirements

The Basel Accord of 1998, a regulation signed by central banks in industrialized countries, seeks to determine the amount of capital a bank can have, which is a fraction of their assets that have been risk-adjusted. This Accord affected Banc One’s capital requirements greatly. Banks were not required to have any capital on investments in the U.S. Treasury securities. Therefore, Banc One was involved in investments that it considered safe, such that its interest rate exposure would be at a manageable level. Moreover, the bank analysed its capital requirements to make sure they met the stipulations of the Basel Accord.

The case mentions risk-adjusted capital requirements for different categories of assets with different weights based on their risk. Do you think those are justified?

The risk-adjusted capital requirements of different assets cannot be justified based on their weight because the risk weights utilised in determining capital requirements tend to be inadequate. Therefore, the risk weights may be incorrect, thereby establishing awkward incentives for banks. The implied capital requirements can only be justified by calculating the true relative risk. Moreover, the relative risk associated with different assets cannot be compared to risk weights. For instance, the risk arising from different loans offered by a bank is diverse, yet the loan book has a uniform risk (Esty, Tufano, & Headley, 2008).

How did Banc One avoid capital requirements?

Capital requirements affected the investment strategies negatively. Thus, Banc One chose to invest in Treasury securities because the securities did not require banks to hold capital, thereby becoming an investment without risks (Esty, Tufano, & Headley, 2008). The bank also compared its transactions with the capital requirements to increase its inflows that were at a fixed rate. Banc One also used derivatives with its investments interchangeably. For instance, it borrowed within a floating rate to increase its investments in fixed returns. Thereafter, it would buy Treasury notes with a three-year fixed rate (Esty, Tufano, & Headley, 2008). Even though the outflow arising would be zero, the bank would grow its fixed rate portfolio.

Risks Banc One faced

Banc One faced many risks. One such risk was the credit risk of the counterparty. This type of risk arises when a bank gets the fixed rate in a swap transaction. Therefore, the bank becomes vulnerable to the counterparty’s default. Banc One also faced interest rate risk. It was able to gauge its exposure to the risk by determining the influence of interest changes on its reported earnings. As an illustration, a five percent increase in the bank’s annual base income would be realized if it had five percent earning sensitivity. This would result from a constant 1% rise in interest rates within the year. In this case, the bank would become sensitive to liabilities, leading to a drop in the income in case the rates went higher. Conversely, the bank would become asset sensitive and cause an increase in the income in case an increase in the rates occurred. If the bank would have a 0% earning sensitivity, then changes in the rates would not affect its earnings (Esty, Tufano, & Headley, 2008).

Impact of derivatives on bank management

Derivatives have proven to be a better choice for bank management. In the case of Banc One, it was able to gain collateral agreements with counterparties, more so those that had the AAA rating. In comparison, banks that had no derivatives could not acquire the agreements. Banc One was also able to improve its credit ratings and its portfolio. Initially, especially in late 1993, many banks that chose to use derivatives were scrutinised keenly by the public. This led to the creation of rules and regulations by the Group of Thirty, which comprised of major financial service institutions, to guide the use of derivatives. Initially, banks’ share prices fell, as investors were sceptical about the use of derivatives. Despite this, the use of derivatives proved to be an important method of managing interest rates and risks in banks (Esty, Tufano, & Headley, 2008).

Importance of Banc One stock price in its acquisition of other banks

The stock price matters, as it determines the assets of an organisation. Acquisitions enabled Banc One to grow, as it became a major corporate body with the ability to acquire other banks. Therefore, its stock price affected its acquisition strategies. For instance, Banc One would use undervalued stock during acquisitions, or banks in the acquisition program would pull out of the deal. Thus, a low stock price would result in an end to the acquisition program. Banc One established principles that guided its acquisition strategies. The principles proved beneficial to the company over the years. According to William Boardman, Banc One’s Executive Vice President, this meant that every acquired bank was supposed to grow its earnings at a similar rate to Banc One (Esty, Tufano, & Headley, 2008). This would happen in the context of a dilutive acquisition.

In conclusion, Banc One was able to apply an effective strategy in asset and liability management. The use of swaps and having a large derivative portfolio ensured that the bank was not affected by the changing interest rates in the market, especially from assets and liabilities. Moreover, the bank invested in assets that had low asset requirements, such as the Treasury securities that had zero risks. It also had an acquisition strategy that proved beneficial during its acquisition of other banks.

Reference

Esty, B., Tufano, P., & Headley, J. S. (2008). Banc One Corporation asset and liability management. Boston, MA: Harvard Business School Publishing.

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