1.What is the problem? Why might investors be so concerned about the bank’s derivative use?
The problem is that Banc One’s stock price has gone down nearly 25% due to analyst and investor concern that increased derivative use has inflated key accounting margins and ratios. The derivatives (interest-rate swaps) do not show up on the balance sheet as assets/liabilities, but do show up on the income statement. Therefore, metrics such as ReturnOnAssets may not accurately reflect the underlying business.
Derivative use was concerning to investors mainly because they did not fully understand the complex swaps, and saw them as risky. Banks had not typically invested so heavily in swaps, so investors felt that Banc One’s enormous ramping of derivative use in early 1990s obscured the risk the company was taking. Investors feared that without prudent management of the derivative portfolio, the company could be suffering huge risks (interest rate for example) for revenue gains. Investors also feared that the use of derivatives made the company’s revenue growth appear greater than it was.
2.How does Banc One manage its interest rate exposure and what role do derivatives play in its interest-rate risk management?
Banc One managed exposure to interest rate fluctuations by performing deals that would allow it to get fixed rate payments in exchange for floating rate payments. The deals would make the bank more liability-sensitive, so a decrease in interest rate would increase earnings. This offset the asset sensitivity nature of its business and acquisitions.
Banc One initially managed to do this by balancing its assets. It would sell floating rate liabilities and buy fixed-rate assets (municipal bonds for example), until its exposure was equaled out (or where they felt comfortable). They later used interest rate swaps as the primary method to balance fixed and floating rate assets/liabilities. These derivatives, mainly...