4. How did Banc One control the other risks associated with its derivatives portfolio?
4.1 Managing Basis Risk
Although the synthetic investments were effective in managing Banc One’s interest rate exposure, they created basis risk. Most of Banc One’s floating-rate assets were based on the prime rate, which changed infrequently at bankers’ discretion. However, most of conventional interest rate swaps and its AIRS used to reduce earnings sensitivity were based on the three-month LIBOR, which changed daily. The difference in the spread between these two rates created a basis risk. Figure 3 illustrates this mismatch of spread between prime rates and three-month LIBOR rates. Figure 3: Mismatch between prime rates and three-month LIBOR rates …show more content…
If the counterparty who entering a swap with Banc One defaulted, Banc One would have to raise cash from other sources to meet its forthcoming liabilities. In order to manage the liquidity risk, Banc One required all its counterparties to post collateral in the form of bank-eligible securities or cash at the initiation of swap equal to possible losses from an extreme one-month movement in interest rates. This strict collateral requirement ensured Banc One to have sufficient cash or liquid assets to repay its forthcoming liabilities. In addition, Banc One established Asset and Liabilities Management Committees (ALCOs), which were responsible for consistently managing interest rate risk, credit risk, liquidity risk and capital adequacy. In the ALCO process, the affiliated and state ALCO groups monitored local deposits and lending activities and their impact on the liquidity exposure, which effectively controlled Banc One’s liquidity risk.
Through the analysis of Banc One Corporation’s risk management process, we conclude that the bank has been successfully managing its interest risk and other risks by using derivatives. Changes in different types of swaps being included in its portfolio over time and improvements of its risk measurement system have constructed Banc One’s evolving risk management program which has the ability to meet its sensitivity policy requirements and to adapt to changing in legal or regulatory
4.1 Managing Basis Risk
Although the synthetic investments were effective in managing Banc One’s interest rate exposure, they created basis risk. Most of Banc One’s floating-rate assets were based on the prime rate, which changed infrequently at bankers’ discretion. However, most of conventional interest rate swaps and its AIRS used to reduce earnings sensitivity were based on the three-month LIBOR, which changed daily. The difference in the spread between these two rates created a basis risk. Figure 3 illustrates this mismatch of spread between prime rates and three-month LIBOR rates. Figure 3: Mismatch between prime rates and three-month LIBOR rates …show more content…
If the counterparty who entering a swap with Banc One defaulted, Banc One would have to raise cash from other sources to meet its forthcoming liabilities. In order to manage the liquidity risk, Banc One required all its counterparties to post collateral in the form of bank-eligible securities or cash at the initiation of swap equal to possible losses from an extreme one-month movement in interest rates. This strict collateral requirement ensured Banc One to have sufficient cash or liquid assets to repay its forthcoming liabilities. In addition, Banc One established Asset and Liabilities Management Committees (ALCOs), which were responsible for consistently managing interest rate risk, credit risk, liquidity risk and capital adequacy. In the ALCO process, the affiliated and state ALCO groups monitored local deposits and lending activities and their impact on the liquidity exposure, which effectively controlled Banc One’s liquidity risk.
Through the analysis of Banc One Corporation’s risk management process, we conclude that the bank has been successfully managing its interest risk and other risks by using derivatives. Changes in different types of swaps being included in its portfolio over time and improvements of its risk measurement system have constructed Banc One’s evolving risk management program which has the ability to meet its sensitivity policy requirements and to adapt to changing in legal or regulatory