COLUMBUS, Ohio -- When John B. McCoy recently was asked why the stock of Banc One Corp. has lost some of its luster this year, he quickly fingered the company's heavy use of financial derivatives as one possible culprit.
Speaking at a Cleveland investor conference held by McDonald & Co., Banc One's chairman and chief executive acknowledged an outpouring of concern about the company's $31 billion in off-balance-sheet activities.
"We've got to do a lot better job of explaining that to the markets," Mr. McCoy said.
His response highlights the persistent controversy surrounding the banking industry's growing use of sophisticated financial contracts, such as options and interest rate swaps.
Salomon Brothers Inc. reports that the nation's 150 largest banking companies swelled the face value of their options portfolios by $400 million to more than $1 trillion during the two years ended Dec. 31, 1992.
In the same period, the 150 banks boosted their portfolios of futures and forward contracts by roughly $1 trillion, to a face value of $1.75 trillion.
Changes in interest rates drive the value of these financial instruments. The oft-spoken concern is that a rate shock might either send the entire derivatives market into a spasm or land certain participants in deep trouble.
No Clear Picture of Risks
Further muddying the waters, derivatives don't show up on bank balance sheets, and standardized supplemental reports have not yet been put into place. That often leaves everyone from accountants to analysts, investors, and regulators guessing about the risks being taken by an institution.
"You think you begin to understand, and then you hear something more, and then you look at the financial statements, and there is no real way to pull it out," said Henry Dickson, a banking analyst with Smith Barney Shearson Inc., New York.
Recent publicity has stoked fears by evoking visions of callow MBAs spitting out volatile financial contracts, using computers powerful enough to guide the space shuttle.
"Investors hear the word |derivatives' and think we must be rolling the dice, shooting up, and taking big risks," said Richard Lodge, chief investment officer at Banc One.
It is understandable that Banc One would command a fair degree of attention on derivatives, given its large position in such instruments and the highly visible ways in which the financial contracts have altered its reported performance characteristics.
In addition to the roughly $75 billion of assets held on its balance sheet, Banc One has roughly $31 billion of interest rate swaps. About a third of the book consists of forward swaps, or contracts whose performance will commence in future periods.
But Banc One is not alone in attracting greater investor scrutiny. Felice Gelman, a banking analyst with Dillon Read & Co., says North Carolina's First Union Corp. and Ohio's Society Corp. are spending more time explaining their use of derivatives.
The analyst says she has confidence in Banc One. But she says it still might get caught in a backlash if less experienced rivals get into trouble with derivatives. "If an explosion occurs, everybody will be rounded up," said Ms. Gelman.
The Majority of Banc One's contracts involve a pledge to exchange variable-rate interest payments for fixed-rate payments supplied by counterparties. In practice, the swap partners periodically exchange the net difference in the amount of pledged cash flows.
Falling rates and a steep yield curve have boosted the value of such contracts to the point that they are often viewed more as speculative investments than as risk management tools. For example, Banc One's swaps portfolio currently is bulging with more than $500 million of unrealized gains.
But Mr. Lodge says people who focus on derivatives in isolation are missing the point.
Banc One is typical of most banks, he says, in that it has heavy concentrations of variable-rate loans and fixed-rate deposits. That leaves it in a position where assets perennially are repricing more quickly than liabilities. This is precarious in an environment of falling rates.
In the traditional approach, Mr. Lodge says, in periods of falling rates banks counterbalance "natural" maturity mismatches by amassing a portfolio of long-term, fixed-rate securities investments, funded by short-term, floating-rate liabilities.
Two big problems with this approach, he says, are that gorging on securities strains capital ratios, and the assortment of securities available in the market may not be the most desirable. Transaction costs are a further drawback.
A Different Story
If Banc One had used traditional means in the achievement of its 69.1% ratio of net interest income to average common equity in 1992, for example, the company would have reported a markedly different balance sheet.
Instead of a reported 11.12 times average common equity, earning assets would have ballooned to a highly leveraged 13.02 times equity. Purchased funds - the "hot money" whose availability hinges solely on interest rates - would have soared to 25.4% of earning assets, from a reported 12%.
Perhaps most significantly, Banc One's vaunted net interest margin of 6.22% would have collapsed to 5.31%.
What About a Rate Spike?
The obvious question is whether all the apparent advantages offered by derivatives would be reversed in the event of a rate spike. And Mr. Lodge says this is the crucial point about Banc One's strategy:
If rates go up, he openly acknowledges, "the economic value of the derivatives book will fall." At the same time, he quickly adds, "the value of the core bank will rise, because assets reprice more quickly than liabilities in the core bank."
Assuming Banc One has done a good job of offsetting maturity mismatches in its core bank with interest rate swaps, says Mr. Lodge, profitability will be unperturbed if rates climb.
Failure to Pay Up
The larger short-term issue surrounding swaps, Mr. Lodge contends, is the risk that other parties in the contracts will fail to deliver on agreements which leave them on the losing end.
To address that possibility, Banc One has extracted collateral from counterparties that exceeds their liabilities under the financial contracts. In addition, Mr. Lodge said, the bank has obtained unsecured lines of credit with major swap partners.
These arrangements are crucial, Mr. Lodge says, given that Banc One's $500 million unrealized gain on such contracts represents an identical loss for counterparties.
"Everybody could fail today -- everybody -- and it would not affect the economics of our book," he said.
Of course, some larger questions remain about derivatives, even with respect to Banc One.
Banks already have been pinched with regard to their securities investments by the imposition of partial mark-to-market accounting.
Forced to recognize changes in the market value of securities investments, but barred from recognizing potentially offsetting changes in the value of liabilities, they are shortening maturities -- and forfeiting yield -- so as to avoid volatility in earnings statements.
Freedom from this accounting disparity with regard to swaps is what enables Mr. Lodge to say there would be a neutral effect on Banc One's equity if rates rise.
From the standpoint of reported results, it is easy to envision how the bank's risk management strategy could unravel if rising rates put his swaps book under water -- and accountants chronicle that event to the exclusion of corresponding appreciation in the value of the company's core bank.
"The Securities and Exchange Commission, some regulators, and the Financial Accounting Standards Board, I am afraid, are going to use mark-to-market accounting as the panacea for all the ills they perceive in the derivatives market," says Mr. Lodge. "That would inject a lot of volatility, so I am spending a lot of my time fending off accounting and regulatory reactions." [TABULAR DATA OMITTED]