Aug 13, 2019 in Case Studies

Introduction

Bank One has been an asset and liability management company operating in the United States giving out loans and funding mortgage to its customers across the wide divide. It is headquartered in Columbus, Ohio with regional presence in 12 states. The bank operated with $76.5 billion in assets, which made it the eighth largest bank in the US and the largest holding bank in Ohio. The bank had 78 affiliates operating as subsidiaries and other 10 non-banking organizations in its business operations. The strategy of the company was to concentrate on the retail markets and the middle-market commercial customers; enhancing customer service and managing the affiliates using technology, and acquisition of new profit-making banks.

How did Bank One Manage Interest Rate risks? Cite and Briefly Explain one of the Examples given in the Case

Bank One had interests in the investment of the derivatives where it had taken more than the required amount with cases of overstating its margins and return on assets by 1.31% and 0.20% respectively. The Bank also was creating a decline in its tangible equity-to-asset ratio by 1.55% after adjustments were done. It had continued to grow its derivative portfolio risks with an increase from $23.4 billion to $31.5 billion within one quarter in its notional principal. The bank had a policy of acquiring other holding banks while maintaining their operations to add into its assets thus managing the interest rates. The bank had to match the asset maturity with its liabilities to control the interest rates (Esty, Turano & Headley, 2008, p.4). The bank had used the tactic of matching the interest rates with the contractual maturity of its financial commitments for over 24 years thus balancing the assets, and the liabilities ensured the interest rate was maintained. Keeping enough funds in liquid investments for quick reaction to cash demands, controlling exposed interest rates and earnings from swings, and controlling the bank’s capital when achieving its targets ensured the bank’s interests rates were in control. Measuring maturity gap was also used to detect and predict interest rates growing.

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What are the Regulations that Affected Bank One Capital Requirements?

The Tax Reform Act passed in 1986 had effect on the performance of financial institutions including Bank One. The tax reform enables the banks to scrap the deductions used as expenses on interests while financing municipal bond investment. There is the office of the US Comptroller of the currency that hives guidelines and regulations to national banks. The comptroller issued directives for swaps and other financial strategies used by the national banks. Another controlling body was the Financial Accounting Standards Board (FASB) that required minimal disclosure of the Bank’s swap portfolio as they acted like off-balance-sheet properties. Bank One had voluntarily disclosed the swap portfolios against the FASB regulation.

The Case Mentions Risk-adjusted Capital Requirements for Different Categories of Assets with Different Weights based on their risk. Do you think those are Justified?

Yes, they are justified as different assets may require different conditions in their financing. As quoted on page 5, Bank One’s basic portfolios were asset sensitive apart from its balance sheet. This indicated that changes in the asset dealing could translate to huge changes in financial gains or losses. Since most of the assets were indexed to the prime rate, any change on the Interest rate could bring large changes due to its sensitivity. To factor in the small changes, the risk-adjustment capital requirements had to be tailor-made to fit the situation. The use of simulations to cater for interest changes advocated for different risk-adjusted capital requirements. The difference in maturity of the assets and the liabilities called for the maturity gap analysis, which ensured that the interest margin is maintained, and therefore, the margin of earnings made secure from the transactions. There were advantages that Bank One had by using swap system for financial liabilities and assets. This enabled more and improved bank’s liquidity; the financial statements would appear convincing as the swap application would feature on the income statement but not on the balance sheet.

How did Bank One avoid Capital Requirements?

Bank One reduced the need of capital to further their objectives by adopting swap application. Swap, against the other conventional securities investments, reduces the amount needed to invest while meeting a set objective. The capital requirements arose from international agreement held at Basel referred to as Basel Accord, which had been signed by national and international bankers. Since swaps were off-the balance sheet transactions, the bank would use the swap money to invest and achieve its objectives while maintaining the required regulatory standards. The bank was also secured by using the swap money after meeting the deadlines set by the US banking regulations. The bank was comfortable with using swap, which resembled floating-rate capital. By adjusting the characteristics of the balancing assets, Bank One had the possibilities of matching the existing assets with the liabilities thus getting enough capital for investment. Another way to avoid capital requirement was to use derivatives and investments as substitutes for each other. For instance, selling floating-rate investment to earn or increase the share of fixed-return investments for other investments. The bank could also use the proceedings from other businesses to buy a three-year fixed-rate treasury bonds. Such action would leave the net flow at zero but with increased relative magnitude in the bank’s fixed-rate portfolio. Swap has been used as a tool for risk management with control of interest rates.

Briefly Discuss Some of the Risks, as per the Case, Bank One Faced

The risks set with the increased swap investments that are above the normal set standard. With higher off-balance sheet investments, any drastic change in the interest rates for both the assets and liabilities can bring huge changes in marginal returns. The bank also risks the falling of rates with more investment in the volatile derivatives that can bring effects of declining tangible equity-to-asset ratio that can lead to sensitive changes affecting operations of the company.

Are Derivatives Better for Bank Management? Discuss the Topic

Such derivatives as swap, CMOs (collateral mortgage obligation) and AIRS (Amortizing interest rate swaps) have been used in the financial sector to improve financial standings. Swap, for instance, provides many benefits for banking investments where the banks can increase their fixed-rate investments while not affecting their balance sheet. The derivatives have been supported by government and other financial institutions but with limited use. Another derivative, MBSs (mortgage-backed securities) that provides lower than expected after-tax yield has been used to replace municipal bonds and other non-responsive financial investments. If managed with regulations, the swap can help improve financial performance of banks. The case is compromised when imbalances in the invested assets and the liabilities do not match especially when they are based on the prime rates.

Why do you think Bank One Stock Price Matters for its Acquisition of other Banks?

It matters since the asset and the adopted capital should be used to generate more money and make the bank strong. The Stock price affects the public image where customers are sensitive lot who can forecast the changes in earnings per share and the interests. The changes lead to great changes including massive migration of customers. Dissatisfying stock performances create unstable market forces for the company thus harmonizing the new acquisitions with the Bank One’s stock prices is best to control any big marginal changes.

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