Bank One Case

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1. What are Banc One’s problems and why is share price decreasing? The problem with Banc One is that their stock price is going down and is hurting their core growth strategy of acquisitions. Compared with the financial results of the country’s largest 25 bank holding companies, Banc One has been very successful during the decade since 1982. It has the highest and most consistent ROA, ROE and EPS. Its EPS has been consistently growing for the last 24 years which none of the other banks have been able to imitate. The reason behind the success of Banc One has been a three pronged approach: * retail and middle market commercial customer focus

* Superior Technology
* Rapid growth by acquisition
They acquire retail regional market leader banks which has a solid management team. They centralize the operations with their strength in technology integration and can generate economies of scale which leads to profitability. Since 1969, it had been able to complete 76 acquisitions involving 139 banks which has been the central reason for their growth. The stock market has been able to value this strategy and has consistently rewarded them with better stock prices so that they can complete accretive acquisitions in turn creating shareholder value. This leads to a winning cycle which they have been consistently using. But they face a problem now! They can’t acquire Liberty Mutual as their stock price has gone down. If they do an acquisition with their low stock price, their acquisition will lead to the destruction of their shareholder’s value which will lead to further reduction in stock price. The stock price of Banc One is going down because:

(1) Since 1983, Banc One has exposed themselves to different forms of derivatives – MBS, CMOs (2/3 of their investment portfolio was CMOs) to gain high yield. They have also started interest rate swaps to hedge their long term risk to generate short term liquidity which has further increased their exposure to derivatives. All these swaps are off balance sheet activities which doesn’t show up on their assets and hence inflate the Return on Assets and Earnings Ratios which is seen negatively by the market. (2) Investors are uncomfortable because of Banc One’s exposure to derivatives. Increase in the complexity of Banc One’s investment portfolio because of the use of derivatives makes it hard for the outside investors to assess the risk being assumed. (3) Investors of Regional Bank stocks do not expect heavy derivatives involvement. In second quarter only, their derivative portfolio has grown from $23.4 billion to $31.5 billion in notional principal and some of the investors are not ready for so much of derivatives exposure and they are exiting the stock. (4) Since these swaps were used to control banks earnings sensitivity, higher the earning grew, Banc One had to buy more swaps. (5) Because Banc One has moved to liability sensitive position from assets sensitivity position, it is now exposed to increases in interest rates, flatter yield curve and dramatic shifts in yield curve.

2. Why is the management using derivatives?
The management was using derivatives for risk management and to gain a steady flow of yield. (1) Derivatives as a tool for asset-liability management Banks borrow short to lend long. Their assets are floating rate and long term fixed rate assets. Their liabilities consist of floating rate liabilities and long term fixed rate liabilities. As such, their reported earnings are exposed to interest rate swings which makes asset and liability management one of the most important activity of the bank. Most commonly, banks have relatively more long term fixed rate liabilities than they have long term fixed rate assets. To mitigate this disequilibrium, they complement their loan portfolio with fixed rate investments called balancing assets, such as Treasury securities. Adjustment of the balancing assets leads to better Asset and Liability...
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