Q1) How could Banc One manage its interest rate risk exposure without using swaps?

That is, how could it move from being asset sensitive to being neutral or liability sensitive without using swaps? What are the advantages and disadvantages of using swaps rather than these other means of adjusting the banks interest rate sensitivity? What is the impact of Banc Ones swaps positions on its interest rate sensitivity, its accounting ratios and its capital structure? Be sure to work through the Appendix in the case From the case it is evident that Banc One is asset sensitive because a large proportion of its assets , such as commercial loans, were tied to the prime rate and thus the returns on them fluctuated with the fluctuation in prime rates .On the other hand the liabilities consisted mostly of fixed rates CDs , deposits and fixed savings ,where the rates changed much slower compared to the change in the prime rate. One of the ways which Banc One could protect itself from the fall in interest rates , was to add fixed assets to its portfolio , such that the fixed assets could offset the fixed rate liabilities. They could invest in short term and medium term US treasuries and high quality municipal bonds. The additional tax benefits also made it look as a viable alternative. In 1983, Banc One initially started using Interest rate swap to lock in the yield of municipal bonds and as it grew confident about the use of swap they started using swaps as a proxy for its fixed rate investmentsit planned to enter pay floating and receive fixed swaps . Advantages of Swaps: 1) Liquidity: Banc One could use the payment on its swap for accommodating the customer withdrawals and also in repaying existing liabilities, such as CDs. Unlike previous occasions, Banc One would not have to liquidate its fixed rate investments, thus saving it from liquidity and timing risk . 2) Off Balance Sheet: Swaps were off balance sheet transactions. Banc One only had to disclose about the swaps in the footnotes of the financial statements and the balance sheet was left untouched. Because the income still appeared on the Income statement, measures such as ROA would be overstated. 2) Reduced Capital requirements: The use of swaps reduced the amount of capital needed to meet regulatory requirements. Banks were required to hold capital equal to market value of swap + 0.5 % for the notional principal. On the other hand, had Banc One to create a similar exposure using other investments, it would need to hold 20% to 100% of the principal value of the assets. Dis-advantages of Swaps: 1) Credit Risk: By entering into swaps, Banc One was suspect to any default from the counterparty. Unlike the US Treasury bond, which is guaranteed by the US government and thus having a zero chance of default, it could well be that some counterparties may not be able to make timely payments. 2) Basis Risk: Banc Ones floating rates were based on the prime rate, whereas the interest rate swaps and AIRS were based on the LIBOR, for the floating leg of the swap. Because of the difference in the prime rate and LIBOR, Banc Once could be exposed to swings in the prime LIBOR spread. 3) Higher Risk Premium: Though the use of exotic derivatives was gaining steam, the fact that investors were not used to it would lead to greater risk premium for Banc One. As evident from exhibit 6, the fact that Bankers trust was their largest counterparty increased the nervousness of the investors. Interest Rate sensitivity

After the use of interest rate swaps- where it paid floating and received fixed, Banc One essentially moved from being asset sensitive to liability sensitive in case of an interest rate rise , the floating rate payments on the swap would increase the interest expense while the interest income would remain constant. The greater use of swaps has to lead to a greater earnings sensitivity. (Exhibit 1: Earnings sensitivity Vs Swaps Outstanding) the high r squared value of 0.9076 , reinforcing the point . Accounting and Capital Ratios Return on Average Assets : From 1983 , the time when Banc One first started using IRS , we see a increasing trend in the ROA figures , with slight decreases in the years 1986,1987 and 1992. This can be mainly attributed to the off balance sheet accounting of swaps, which lowers the assets while the income received from the swap transactions still makes its way into the Income statement . Return on Common Equity: The ROE measure is much more fluctuating compared to the ROA measure , which was higher around 1983 , then dipped in the 1986 and 1987 , improved in 1988 a only to decrease in the late 80s . This could be mainly attributed to the fall in net income , which could related to higher interest rates, as Banc One would have a higher interest expense while its interest income would be constant.