Review On The Banc One Finance Essay

Review On The Banc hotshot Finance EssayBanc One was founded in 1863 and headquartered in Columbus, Ohio. The curse has accumulated a total of $76.5 billion as tidy sums and stoold revenues of $4.3 billion by 1994, universe the eighth largest in the country.Banc One can be seen as a three ground directed organisation. The first tier controlling five state bank buildings and holding 42 subsidiaries, the second being a regional run group and holding 36 subsidiaries and finally ten non-banking organizations, varying from insurance to entropy processing. Its p bent connection employed around 100 workers, of which 12 were working in the plus and Liability circumspection which is passage to be explored in this report.(Kusy et al., 1986)How does Banc One dispense its stakes pass judgment exposure?In this question it go forth be necessary to determine how Banc One hedges itself against changes in by-line step levels and what the possible risks it faces from such changes.As a foreword, it has to be understood that if a bank was to be perfectly matched in terms of its pluss and liabilities, whence any change in the intimacy poses would make water offsetting preserves on both the asset and obligation side. Hence the bank would never feel the effect of changing interest regularises. til now, in a touchable world situation, especially for a bank this size with its big asset and liability portfolio (assets $76.5 billion), it is quite taboo(predicate) to be perfectly matched, nevertheless this must be attempted. (Saunders et al., 2006)Prior to 1980, Banc One was seen to be improperly quantity its interest rate exposure by trying to add assets to its investiture portfolio until it was felt that the meliorate rate investments offset the fixed rate liabilities. As well as to this, they were evading long term investments, in the popular opinion that such prolonged investments pass on bring pointless risks to its investment portfolio. (Esty et al ., 1994)By 1980, when the second oil jar hit hard and volatility exceeded in the market, Banc One finally understood that they have to adhere to the delegate of measuring their interest rate risk due to some investments bringing losses to the organization. Hence in 1981, they started measuring their maturity gap, which grouped all of its assets and liabilities into categories, adjusted to their repricing-adjusted maturities (amount of time an interest rate remains fixed on a contract). The repricing-adjusted maturities was split (12 months) and a value of assets minus liabilities derived to. This was a key figure for the bank to go steady their net interest margin, i.e. interest rate filld on assets minus interest stipendiary on liabilities and therefore earnings. This was great for the bank to play around with and to understand how interest rate changes could appropriate its earnings. However, a problem was faced, which was that this task was far too time consuming, taking a social class to produce a single gap management report which by the time of publishing would be come to the fore of date already. (Esty et al., 1994)In the same year, Banc One was generating 13% in m bingley market short-medium term investments, 21% in longer-term securities, such as municipal bonds, which had a larger spread due to no assess incurred.As of 1984, Banc One started victimisation asset and liability simulations to improve its prodigy for interest rate exposure.By indicating the exact asset and liability portfolios they were able to estimate how interest rate changes would affect their earnings. The procedure was that, firstly, a so called online balance sheet was created that contained the most recent information on its assets and liabilities, for typeface key features of each(prenominal) contract, the principal amounts, interest order, maturity dates and amortization of assets and liabilities, as well as historic information. Finally, when the model was comple te, they could seize how an interest rate change would affect its balance sheet and earnings. These predictions were being run monthly and outcomes helped the bank to make changes in its interest rate carriages. It was later developed further by introducing an automatic constitution which would download all of the available adds and deposits on each customer to derive to a better prediction on the banks exposure to interest rates.What role do derivatives play in its interest rate management?Banc One has been seen to start using interest rate swaps from the 1980s. An interest rate swap is an agreement amidst two counterparties in which mavin ships company swaps its fixed payment interest stream with the other party for a undirected payment stream that is linked to an interest rate benchmark, usually being the LIBOR.From 1983, Banc one began using interest rate swaps, the procedure was that first they bought municipal bonds and received a 9.5% yield, after which entered into a n interest rate swap which paid a fixed rate of 7% (LIBOR) and hence received a net position of LIBOR +2.5%.However, using interest rate swaps has ca usanced some of the financial data to be distorted, for example if the derivatives were included in the balance sheet then their margin would have been 1.31% lower and their mother on assets lowered by 0.2%.After they have started using interest rate swaps, it was seen that they would depend more on large short-term borrowings, also the swap positions affected the amount of risk-adjusted capital they held. The impact was also seen on the net interest margin, as well as the return on assets and equity.The bank presented a set of financials and compared these to two twin banks. One, which was exactly the same as Banc One except that it brought its swaps onto the balance sheet by replacing the nonional principal of its receive-fixed swaps with investments in fixed-rate securities funded by variable-rate borrowings. This bank would diffe r in its accounting performance, dependency on large liabilities, and capital levels. First, swaps improved Banc Ones lucidity. They also freed up capital for short term investment which provided cash when needed to repay liabilities such as CD withdraws. Second, the off-balance sheet accounting of swaps increased ROA and ROE. The receive fix rate swaps did not appear as an asset or a liability, but were disclose in footnotes to the financial statements. Yet gains and losses would still be placed on the income statement. If the bank were to use a traditional hedge, buying a fixed rate bond and selling a locomote rate security both would appear on the balance sheet the net result being to lower traditional profitability measures. Finally, the stress over meeting the minimum capital requirements was deduced as swaps did not use much capital.They started using swaps instead of conventional fixed-rate investments.swaps were attractive investments that lowered the banks exposure to m ovements in interest rates.Instead of investing in medium-term U.S. Treasury obligations, it could simply enter into a medium-term receive-fixed swap and put its specie into short-term natation-rate cash equivalents.Interest rate swap in which it paid a floating rate of interest and received a fixed rate in return this would increase a banks fixed-rate inflows and mow its periodic floating rate inflowsThe second would invest in floating-rate loans and investments (instead of fixed-rate investments) and in floating-rate assets financed by floating-rate deposits (instead of swaps). This bank did not manage its interest rate sensitivity.exposure to interest rate risk is determined by simulating the impact of the prospective changes in interest rates in the results of operations. Management seeks to insure that over a one year period, net income will to be impacted by more than 4 percent and 9 percent by a gradual change in market interest rates of 1 percent and 2 percent, respective ly.The chief Investment Officer did not understand why everyone was unhappy about swaps which was an investment which lowered the banks exposure to movements in interest rates and in 1993, they held a In 1993, a meeting took place after the $10 drop in Banc Ones stock price. Banc one did not understand why everyone was criticizing their use of derivatives (swaps). Many of the investors and market players did not really understand how to use swaps and thought that this was a risky investment, however Banc One grasped this investment style and was using it very well to their own proceeds in their asset and liability management.The bank was faced with three options. First, not to do anything and hope that pct price will recover over time as investors would realised that derivatives were helping the bank manage interest rate and basis risk. Second, they could number their derivative position. Thirdly, they could attempt to educate investors about the use of derivatives by showing mo re of their positions. None of these three is what Banc One decided on, what they did was create a financial drumhead and presented it to the market presented on the next slide.Swaps instead of investing in medium term US exchequer obligations it would enter into a medium term receive-fixed swap and put its money into short term floating rate cash equivalents. (this way they improved liquidity with s duck principal values also swaps are off-balance sheet transactions for receive-fixed swap this way banks return on assets would be overstated also swaps reduce the amount of capital needed to meet regulatory requirements)Why is Banc One liability-sensitive?In the 1980s Banc One was seen to be asset sensitive which was mostly to do with its acquisition scheme, where their acquired portfolio reached more than 75 banks which were all spunky asset sensitive banks. Asset sensitivity is the name given to a position where the deposit (liability) is fixed, whilst the loan (asset) top execu tive be changing.In the 90s, this has changed and the bank seemed to have turned liability-sensitive due to the use of interest rate swaps in which a floating rate was paid and a fixed rate in return was received. These transactions were giving the impression on the balance sheet that the bank was earning a floating rate liability and at the same time investing into a fixed rate asset. Banc One, being a liability sensitive bank, indicates that their loans (assets) are fixed, whilst the deposit (liability) is moving up or down. Therefore only a drop in interest rate will bring a higher net interest margin, as the spread between the fixed deposit and the floating dropped loan would widen, creating more profit for the bank. However if an interest rate rise was to incur, then this would mean that its floating rate payments would alter its financial data by boosting the interest expense, and with interest income staying on the same level this would set Banc One as a liability sensitive b ank.Should it be liability-sensitive?Banc One has turned liability-sensitive as it may have been anticipating that the interest rates would drop and and so profit could have been made, as is shown in the liability sensitive bank table in the last column where the interest rate has dropped. However, if their prediction is wrong and the interest rate goes up then they will make a loss, as shown in the same table, column 3 from left.A bank can restructure its position whichever way it wants, if a bank bets that interest rates will go up then it could turn asset sensitive and fix its deposits (liabilities) and use a floating rate for their loans (assets) in order to make profits. For a bank which bets the opposite, a liability sensitive position can be taken by using the same method described as for the asset sensitive, just reversed, such that was taken by Banc One.From the graph shown below (Interest Rate and Spreads) it is now clear why Banc One has become liability-sensitive from i ts previous position. This is due to the fact that prior to the 90s the bank would fix its deposits, either using the LIBOR 3 month or the 2 year US Treasury, however then it was more preferent to lock the deposits in the 3 month LIBOR as the rate was lower and a more liquid position could have been sustained. However, after the drop in the rates in 1984-1986 and 1989 and thereafter Banc One would have been facing problems if to continue sustaining its position at the fixed deposit level, as the loans were under the deposit level and the bank could not get out of its obligatory 3 month or 2 year position. Therefore it started using swaps, and with undertaking swaps, this has reversed its position to swapping its loans from floating to becoming fixed, as they received a fixed return or with deposits becoming floating, as they paid a floating amount, whichever was more preferable. In Banc Ones campaign it seemed that swapping the fixed deposit, into a floating deposit would be viabl e as they had to get out of a loss making position, if the market was dropping.Deriving from the above mentioned, Banc One should be liability-sensitive in the case where it is making a loss on its current positions due to changing interest rates and thus utilising a swap, however its original positions undertaken in the beginning (before the interest rate moved out of favour) might be still as of an asset-sensitive bank, therefore it can be said that swaps distort the banks image. (Esty et al., 1994)ReferencesEsty B., Tufano P., Headley J., (1994). Banc One Corporation, Asset and Liability Management, Harvard Business School.Saunders A., Cornett M. M, (2006). Financial Institutions Management A Risk Management Approach, McGraw-Hill.Kusy M.I., Ziemba W. T., (May-June 1986). Operations Research, A savings bank Asset and Liability Management Model, Vol. 34, No. 3, pp. 356-376, Informs.Bitner J. W., Goddard R. A., (1992). Successful bank asset/liability management a guide to the futur e beyond gap, John Wiley Sons.