Case Summary Banc One has a problem with the alignment of two of its important strategies: (1) rapidly acquiring profitable banks and (2) sustaining high returns while mitigating interest rate risk. Banc One has been very successful in acquiring banks, and much of this is done through the sale/transfer of Banc One’s stock. This strategy relies heavily on Banc One’s ability to maintain a high stock price. The second strategy – high returns with mitigated interest rate risk - relies heavily on the use of interest rate swaps. This use of interest rate swaps has become concerning to investors - due to its complicated nature,…show more content… Swaps are off-balance sheet agreements; however, the income they generate is included in the company’s financials. In this case swaps are not recorded as assets or liabilities, however, they still bring income, which is included in the company’s cash flow statement and accounted for in the performance ratios of the organization.
Disadvantages:
Creates difficulties for the market and for investors to assess the risk and financial situation of the bank. As banks use more and more swap contracts, assessing the risk exposure of the organization becomes increasingly complex. Thus, external investors have a harder time evaluating the bank’s current situation and usually require higher returns to compensate for the perceived higher risk.
Gives opportunities for speculations- Even though banks use swaps in order to mitigate interest rate exposure, they can also use them as instruments for speculations and short-term gains. If managers think they can predict the rate movement for a future period, they can be tempted to use swaps in order to gain from this movement. Thus, banks have to be careful in their strategies and should make sure they monitor the decision making process involved in the purchases and sales of swaps.
They carry a small risk that the opposite party might default on the contract and leave the bank exposed to interest rate risk.
