Banc One Interest Rate Swaps and Derivatives Strategy

Managing Interest Rate Sensitivity Without Swaps

If Banc One wanted to manage its interest rate exposure without using swaps, it had viable options available. The bank could attempt to match the duration of its assets with the duration of its liabilities. In addition, it would need to match the interest rate exposure of its assets and liabilities directly on the balance sheet. For example, if the assets on the balance sheet were predominantly fixed-rate while the liabilities were floating-rate, significant distortions to company performance could result if the floating rates were not properly offset on the asset side. In this scenario, in order to move from being asset-sensitive to neutral or mildly liability-sensitive, the bank would need to make more floating-rate loans to offset the floating-rate liabilities it is obligated to pay.

Through the use of interest rate swaps, this process is much easier and less time-consuming. This is particularly true for Banc One, which had a stated strategy of acquiring other banks while remaining relatively decentralized after each acquisition. The bank coordinated only its processes, reporting, and auditing standards with acquired institutions, allowing each acquired company to operate on a standalone basis. This structure made it difficult to match liabilities and assets on an individual basis across the entire organization. Swaps therefore enabled a more seamless and integrated approach to interest rate management across all subsidiaries.

The pros of using swaps over on-balance sheet adjustments include speed, flexibility, and ease of implementation — particularly important for a serial acquirer like Banc One. The cons include the complexity they introduce, the potential for investor confusion, and the regulatory and accounting treatment that can obscure the true financial position of the firm. On-balance sheet alternatives, such as shifting the loan portfolio mix toward floating-rate assets, are more transparent but slower to execute and may conflict with lending strategy or client demand.

How Swaps Affect Financial and Capital Ratios

When swaps are used, they have a positive impact on many of a company's reported financial ratios. However, in some instances, they negatively affect the underlying economic reality those ratios are meant to reflect. Swaps and other derivative contracts are considered "off-balance sheet" transactions. In many instances, companies are therefore not required to report the associated asset or liability on the balance sheet. As a result, any ratio involving debt will appear more favorable than it actually is, and capital ratios will similarly look stronger, since current capital rules favor the use of derivatives over on-balance sheet instruments.

The table below summarizes the relevant ratios with and without the use of derivatives for Banc One:

As the data illustrate, reported ratios are materially more favorable when swaps remain off the balance sheet. This divergence between reported and adjusted figures is a core source of investor concern about Banc One's true financial position.

Amortizing Interest Rate Swaps (AIRS) and Prepayment Risk

Amortizing Interest Rate Swaps (AIRS) are financial instruments used to simulate investments in mortgage-backed securities. Because the AIRS product is designed to replicate a mortgage security, Banc One is exposed to prepayment risk. Generally speaking, when interest rates fall, holders of mortgage securities face contraction risk — the risk that borrowers will prepay their loan obligations early, taking advantage of lower rates. This prepayment risk carries two consequences for Banc One. First, the proceeds received from early repayment must be reinvested at a lower prevailing interest rate. Second, the overall yield is lower than it would have been had the prepayment feature not existed. Within the AIRS structure, the notional amount is reduced — or amortized — as interest rates decline. Much like the mortgage-backed securities they mimic, the AIRS product amortizes faster as rates fall, forcing the bank to reinvest proceeds at reduced yields.

It appears Banc One was chasing yield in order to enhance its reported earnings. In prior periods, the bank entered into synthetic swaps to boost its yield on fixed-income securities. It appears to be pursuing the same objective with its AIRS product line. The swap spread over Treasury securities within the AIRS structure was approximately 120 basis points, compared to 100 basis points available through a collateralized mortgage obligation (CMO). Although the spread is higher, these more exotic derivatives carry significant prepayment risk. During the period in question, interest rates were declining. As a result, the AIRS product may have been amortizing faster than anticipated, progressively eroding its yield advantage.