What are basis swaps?

Why has Bank One recently significantly increased its basis

swap position?

Basis swap is a specific kind of interest rate swap that implicates exchange of two
floating rate financial instruments. Unlike the classic interest rate swap where fix
interest rate is exchanged for variable (or vice versa), basis swap works as floating to
floating interest rate swap, where floating interest rates are referenced to different
basis. In the case of Banc One, bank would pay a floating rate based on prime rate
and receives floating rate based on LIBOR (three months). By doing this Bank One
neutralizes the spread between LIBOR rate and prime rate.

For example, if a bank is paying a floating rate on its liabilities, but it receives a fixed
payment on the loans it paid out, then it may face significant risks if the floating rate
liabilities increase significantly. As a result, the bank may choose to hedge against
this risk by swapping the fixed payments it receives from its loans for a floating rate
payment that is higher than the floating rate payment it needs to pay out.
Using synthetic investments (AIRS) and conventional swaps, Banc ne succeed to
mitigate interest rate risk rising from different interest rates basis (fix vs floating) in
assets in liabilities. But, with these investments in derivatives gave rise to basis risk,
because most of the Banc One floating-rate investments were based to prime rate,
whereas, AIRS and most of conventional interest rate swaps are related to LIBOR.
So, after AIRS transactions, there was not fix to floating rate mismatch, but there
was mismatch between floating rates basis. As, LIBOR is rate obtained on daily basis
as result of banks trading on London Interbank market, whereas, prime rate was
administered US rate based on target federal funds rate, that changes no so
frequently and on discretion of Federal Reserve Board. The target federal funds rate,
which serves as the basis for the prime rate, is the interest rate that commercial
banks charge each other for overnight lending.

Due to this differences in frequencies and method of determination, there is a

difference spread between this two rates. Exhibit 5 (of the case) graphically presents
the movements of prime rate and 3-months LIBOR. It shows that the spread had been
quite inconsistent for the period 1983 1993 and reached historical maximum in the
year 1993. Banc One was using LIBOR Prime Basis Swap, as described in Exhibit
3 of this case, to eliminate mismatch between these floating rates. So, by using basis
swap in combination with an AIRS, Banc One was transforming the prime-based
floating rate assets to fixed-rate investment. Large value of AIRS in the Banc One
portfolio and the need to protect from basis risk urged to dramatically increase basis
swap position.

How might its derivatives portfolio be damaging the banks stock price? What exactly
are analysts and investors worried about?

As depicted in exhibit 1, Banc Ones stock price dropped dramatically during the
latter half of 1993 from about $44 to a year end close of $35.5, which is nearly a 20%
decline. There are many ideas to explain why the stock price dropped and why
shareholder wealth suffered. Hereinafter, I will try to elaborate what might be
possible reasons for such a drop in stock prices.

What is obvious from Banc One reports (exhibit 4 and exhibit 7) is that derivative
portfolio massively increased during year 1993. But reason for that is extremely
confusing for analyst and investors (p.2). Additionally, as it is published in of analyst
report, it is impossible for anyone outside to assess the risk being assumed (p.2).
These criticisms, suggest that analyst announced negative views, maybe even
without true reason, only because that feel uncomfortable with growing derivative
portfolio. At that time, derivatives were relatively new financial instruments . so,
there is understandable aversion to them on the part of many investors (p. 14,15).
In the early 1990s the use of the derivatives was not fully understood, even by the
sophisticated specialist in financial products and markets, such as, financial analysts
and investors. The business world was still trying to sort out the issues associated
with using derivatives, especially synthetic swaps, to decrease interest rate risk. The
industry was comfortable with the use of CMOs and plain vanilla swaps as risk
management tools. The use of AIRS was not completely understood by many analysts
and investors; therefore, suspicions were arising of being speculative in nature. Banc
Ones derivative portfolio consisted of numerous AIRS and generated a large portion
of the firms income.
With the decision to be liability sensitive, Bank One management was making a bet
that interest rates will drop in future, rather than they will rise. Being liabilitysensitive means, that with an upward sloping yield curve, bank want to own longer
duration assets, and to fund them with shorter duration liabilities. Due to this, when
interest rates fall, liabilities will be repriced (adjusted to new lower rates) faster than
assets, and earnings will rise. One part of the analysts and investors do not prefer
banks to put bets on the future movements of interest rates, since they see that bank
business is to evade the risk, not to gamble. The second part of analyst and investors,
the ones that prefer more risk (risk lovers), might not have anything against Banc
One making a bet on interest rate movements, but they might expect interest rates
to move in opposite direction of the Banc One expectations. This might be one of the
reasons that pursued them to reduce their expectations for the Bank One future
earnings, which helped stock prices to decline.
On the other hand, investor and analyst might be worried by the intensive expansion
of derivative portfolio, since it could be sign of Banc One have missed something with
it strategy in the past, so now is trying to cover that mistake by hedging it position

with derivatives. Or, increase of derivatives portfolio might be signal of Banc One
speculating on the future direction of interest rates, especially because Banc One
holds liability sensitive position, whereas, majority of the banks have assets sensitive
position.

Last but not least, Banc One was focused primarily on earnings volatility risk and
had a strategy of entering into swaps which would enabled them to reduce their
exposure to asset interest rate sensitivity. Based on their analysis, Banc One
determined that an interest rate fluctuation of more than + 100 basis points was
unlikely. Given this assumption, the decision was made to enter into AIRS to take
advantage of higher yields for such low interest rate volatility. This strategy
theoretically allowed Banc One to gain an additional 100 basis point advantage over
Plain Vanilla Swaps (PVS). This swap strategy essentially guaranteed them constant
positive earnings over the next ten years in the range of + 100 basis points. By
effectively securing in earnings over this very small range, Banc one exposed itself to
large volatility risk.
Moreover, because stock value is the sum of all expected future cash flows discounted
back with the current discount rate, its value is affected by changes in expected cash
flow and the discount rate. As interest rates increased by 175 basis points between
November 93 and October 94, above the +/- 100 basis points that were expected,
Banc Ones earnings decreased drastically. That means that at the same time the
nominator future cash flows decreases over time, and in the same time, increased
interest rate caused denominator - discount factor, to increase. Mathematically both
have helped in the same direction stock price to decrease.
=

(1 + )

What should McCoy do in your opinion? Please elaborate around transparency and
risk appetite and governance items we covered during the seminar.

Alternatives to current Banc One model of managing interest rate risk exposure
trough derivatives are described in the appendix of the case, where in parallel
through balance sheet and income statement are presented two alternatives. First
alternative so called tween A, is similar to actual Banc One with single difference
that swaps are brought in balance sheet by replacing notional principal of receivefixed-swap, with investments in fixed-rate-securities, founded by variable rate
borrowing. With second alternative called tween B, instead of using
derivatives/swaps Banc One invests in in floating rate assets founded with floating
rate liabilities.
Analyzing the financial results and performance matrix presented in appendix to the
case, several advantages of derivative based approach that Banc One was exploiting,
can be identified:

Derivative based solution results in better profitability, since, bank deliver the
products in accordance with customers wishes and need, and then adjust resulting
net exposure using derivatives. Alternatively, with non-derivative management of
liquidity and interest rate risk, banks have to create and offer products that meet
needs for adjusting the exposure, but are not appropriate to customers needs.
Earnings and ratios are higher with derivatives-alternative, because earnings are
presented in income statement, while underlying assets swaps are recorded as
off-balance transactions (notional principle) (p.8).
Derivatives alternative significantly improves bank liquidity (p.8)
Using derivatives also could reduce the amount of capital needed for capital
adequacy regulatory requirement.

Due to above, Banc One should not have stopped using derivatives, as it has many
advantages over presented alternatives.

The success of banks and its strength depend critically on how they take risks. A
banks ability to measure and manage risks creates value for shareholders. For risktaking to maximize shareholder wealth, a bank has to have the right risk
management but also the right governance, the right incentives, and the right
culture.
In the case of Banc One there is a sufficient evidence of good governance of market,
counterparty and liquidity risk. It means there is enough evidence of existence of
policies in place, that are defining the intentions and goals, that are desired to be
achieved, as well as, boundaries that are supposed to protect the shareholders from
misconduct of the management. Of particular importance is existence of such
framework in management of derivatives positions and other investments, as well as,
assets and liability management, where unpredictability and figures of individual
transactions are so large, that any misbehavior can certainly threaten the future of
the bank.
The process was governed by policy document which outlined exact system of control
and oversight of banks ALM policies (p.12). In addition to establishing and
implementing this framework, there was established organization of decision
making, reviewing and monitoring of compliance with guidelines, defined through
ALCO processes towards consistency in management of interest rate risk, credit risk,
funding risk and capital adequacy.

In addition, Banc One also, has implemented management information system,

whose major contribution was timely and appropriate evidence for the milestones of
the established risk policy.
Risk appetite of the Banc One was measured along single dimension: Earning at risk.
Precisely, exposure to interest rate risk was defined as impact that changes in
interest rate would have on the reported earnings by calculating earnings
sensitivity. At first (1986) Banc One policy was to stay within a 5% earning sensitivity
boundary for an immediate 1% shock to interest rates. Later it was changed to
gradual 1% change in the level of the interest rate during the year, and new boundary

was defined at 4% earnings sensitivity. Lately, ALCO set the guidelines in more
details. Nevertheless, the focus was primarily on the effect of the changes in the
interest rates on the earnings, although, Banc Ones advanced MICS allows, impact
on capital at risk and economic capital to be measured and demarcated, as well. Apart
from exposure to interest rate risk, also credit risk is covered with determined policy,
measures and controlling system, since it is mentioned that the credit rating of the
counterparties entering into arrangements with, cannot be lower that single A.
Second, Bank One constantly monitored its mark-to-market exposure to each counter
party. Total derivative and direct lending exposure to any one counter party was
limited by in-house guide lines. Finally, Banc One required that each counter party
post collateral in the form of securities or cash against the credit exposure.

Furthermore, even for the interest rate risk, it was clearly defined, monitored and
revised, but there is no evidence that it was communicated with shareholders, other
stakeholders, analysts and potential investors. So, lack of transparency possibly was
the reason that headed to reservations among the analyst about the approach and
the intentions of Banc One in the risk management and using the derivatives, even
though there was proper system and governance framework in force. A statement of
risk appetite is an effective way to communicate an organization a sense of acceptable
risks. The Board also has a responsibility to ensure that the bank clearly
communicates its risk appetite outside the organization, to all stakeholders and other
external parties that may be affected, such as investors, regulators, depositors, and
the general public. Banc One case is good example of how lack of transparency can
lead to troubles and significant reduction of stock prices.
In that manner, the most important thing McCoy should do, is to improve
transparency around the whole idea of using derivatives, why and how are used and
for managing of what kind of risks. It could be done by educating investors through
prospectus-type materials and individually informing fund managers and analysts,
who are easier to educate about these complex transactions. Further step is to provide
transparency with swap transactions. Although Banc One is only required to disclose
swap information in the footnotes of its financial statements, Banc One should
provide very detailed and clear information about specific swap transactions, to
reinforce the notion that Banc One has nothing to hide with these swap transactions.