Structure of Financial Institutions - Term Paper Example

Author’s Name Instructors’ Name Course Date Case Study: Risk Маnаgеmеnt at Wеllflееt Bank Introduction It is evident that financial institutions play a major role in enhancing lives in various ways. There have been tremendous changes, which have taken place over the past one century in the banking sector. Some of the notable aspect is the shift from full-service industry into relatively unregulated financial services including the integration of such as brokerage funds and mutual funds. For this reason, financial institutions have strived to come up with strategies in order to cope with the changing business trends. Further, in order to ensure that financial institutions are able to offer quality serves and that their customers are always satisfied, they have devised ways of sourcing for funds while at the same time making profit. In most instances financial managers, as well as Risks Faced by Wellfleet Bank Wellfleet Bank faces several risks in its faces daily activities. Some of the risks, which are related to the case study in Wellfleet Bank, include the market risk especially when there are some changes in the rate of interest, changes in exchange rates as well as other prices (Lombardo 2007). This scenario is observed especially in the case of for Wellfleet Bank since the management is considering underwriting a $1 billion loan to Gatwick Gold Corporation (GGC), which one of the gold largest gold producers stationed in South Africa. Further, the bank also faces operational risks, which are directly related to the daily operations of the bank. These activities include, among others, monitoring, auditing as well as support systems. For instance, operational risk faced by Wellfleet Bank could be observed when there is a disagreement on the proposal involving the group leader of customer relationships and the deputy group of the chief risk officer disagreed. This disagreement allows the Chief Credit Officer to decide on the mater that raises such controversy. In addition, it is clear that credit risk will be affected directly or indirectly by issues such as interest rates, exchange rates as well as the changing prices of gold. Further, there would be direct impact on the Wellfleet Bank's activities by both sovereign or country risk as well as the foreign exchange risk. This is because Wellfleet Bank’s is an international financial institution, which has now expanded its business to over 78 countries (Lange et al 2007). Furthermore, another risk that is faced by the bank includes the interest rate risk. This is so especially when there is a mismatch between the liabilities and maturities of the bank’s assets. In addition, off-balance-sheet risk could also be experienced due to the Wellfleet Bank’s contingent liabilities and assets. The bank also faces technology risk when because of investing in technology as well as Liquidity risk, which can be caused by sudden surge in withdrawals of liabilities. Finally, Wellfleet Bank is also faced with Insolvency risk when it fails to have enough capital, which can be utilized in to offsetting sudden declines especially in the bank’s asset value (Lange et al 2007). It is prudent to note that the bank’s operation strategy is to have various committees, which could be used in monitoring market risk, credit risk, compliance risk, operational risk, reputational risk, country risk, business risks that are threatening the consumer bank as well as business risk, which could be experienced in the corporate bank. The main objective is to ensure that these risks are separated and kept below the preset limits. Additional Risks to be introduced to the Wellfleet Bank The new focus of Wellfleet bank’s on large corporate deals is going to expose the banks to the to foreign exchange risk as well as the and country risk. This is because most of these corporate deals could be international in nature. For instance the the corporate deal of $1 billion loan to GGC is one of such examples that lead to additional risk of exposure since there would be expected changes in exchange rates . In addition, the governments’ interference may as well influence the outcome of these corporate deals (Hull 2012). There is no doubt that the bank will get profit from the mismatches, which occur from foreign currency trading, as well as positions of the foreign asset-liability. The same should be considered of a high probability of unexpected volatility and outcomes, which impose considerable losses too. In order to mitigate such risks Wellfleet Bank should invest in efficient strategies of hedging through matched foreign books of asset-liability, forward contracts as well as diversification of foreign liability and asset portfolio (Lange et al 2007). Further, according to Lange et al (2007), some foreign governments may decide to ensure that domestic borrowers are limited or prevented, in their jurisdiction, from repaying external lenders in the case of Wellfleet Bank, there are several strategies that it can apply in dealing with this risk that it is worth investing in , in order to develop internationally . A good application could invest in country risk analysis (CRA) models. This will help in the identification of good and bad current sovereign loans as well as sovereign loan applicants (Lange et al 2007). It would be a wise move if the Wellfleet Bank’s client relationship managers were involved important that directly in the process of the Credit Group Committee since the bank believes in large transformational deals with corporate clients. This will help in understanding their needs as well as assisting Wellfleet Bank to better satisfy the requirements of its clients and then preparing better avenues for future deals. Calculations of Expected Loss, Economic Revenue and Economic Profit for the Proposal It is estimated from both the Wellfleet's credit committee and internal rating model that the counter party has a rate of 5B. This means that the Probability of Default is about 0.39%. Form the study, it is expected that Wellfleet would earn a margin basis points of 425. This figure is expected to be record in the first six months. Thereafter, the bank would earn 525 basis points. Further, the upfront fee is about 30 basis points that results into $3,000,000. In addition, $1,000,000,000 is the requested limit, which equals the drawn amount. According to Wellfleet's model, it is shown that 52.25% would be the Loss Given Default for this transaction. It is assessed by the treasury that Capital Charge would be $3,800,000 The overheads below, as allocations to this transaction, are provided by the Group Finance: Cost= $500,000 Tax= $12,000,000 Formula for Expected Lost = Exposure at Default ($) × Probability of Default × Loss Given Default (in form of %) =$1,000,000,000 × 0.39% × 52.25% = $2,037,750 The Expected Total Revenue = Fee Income + Interest Income = ($1,000,000,000 × 0.3%) + {($500,000,000 × 4.25%) + ($500,000,000 × 5.25%)} = $3,000,000+ ($21,250,000 + $26,250,000) = $50,500,000 Further, Risk-Adjusted Revenue (RAR) = Total Revenue (TR) - Total Expected Loss (TER) = $50,500,000 - $2,037,750 = $48,462,250 Economic Revenue = Risk-Adjusted Revenue (RAR) - Net Capital Charge (NCC) = $ (48,462,250 - 3,800,000) = $44,662,250 Finally, Economic Profit = Economic Revenue(ER) - Cost - Tax = $(44,662,250 - 500,000 - 12,000,000) = $32,162,250 Assumptions Made and Interpretation by the Management Despite the fact that there is a considerable economic profit margin that the bank would get from the transaction, the Wellfleet bank’s management team need to take in mind that GCC, as the third largest producer of gold in the world, is extremely sensitive to adjustments in global prices. In addition, in 2007 their EBITDA was recorded at 800% in the previous year it was 200% and 130% in 2003. Further, the debt protection of the GCC is not such impressive as indicted in its EBIT where in 2007, its interest expense was standing at -3.1%. GCC, however, has applied deliberate efforts to try to diversify production base in order to become more efficient in the production process. This is specifically intended to ensure that the company plays in the 50% lower level of global cost curves in all its gold mines, on average. In addition, this deal would assist the corporate banking business of Wellfleet Bank's to grow (Lombardo 2007). The Wellfleet Bank's management team if it considers these factors would be in a position to see this as a positive stride in the bank’s future development initiatives. . Analyzing the Risk Management Processes at Wellfleet Bank and Suggestions to the CEO Risk management function of Wellfleet Bank has hierarchal structures, which are complex. The main objective is to ensure that the risk is maintained in the preset limits (Mikes 2009). However, according to Mayfield it may be difficult to maintain risk at some levels since they risk interact with each other (Mikes 2009). For instance, the changes in price can indirectly influence, at the same time, both the market risk as well as business risk. It is a great concern that Alastair Dawes, CEO is not included in the decision making process yet the Wellfleet Bank’s strategies involves transformational deals at a large-scale. Mikes (2009) contends that several competitors of Wellfleet Bank were no longer using committees in their decision-making process regarding corporate banking businesses; instead, these competitors relied mostly on the metrics of risk-adjusted performances. However, this method may not be suitable for Wellfleet Bank, but involving their CEO in decisions making especially in Group Credit Committee could assist in helping the Bank to concentrate on its organizational objectives (Sharma 2008). Finally, "Alpine Pass" process of the Bank could be counterproductive for the entire institution. It has been observed that too much hierarchical structures in management delay the processes of decision-making as well as problem solving, which results in inefficiencies (Pickford and Alexander 2001). One of the ways of dealing with this problems is by giving more responsibilities to relationship managers within the small credit as well as lower risk sectors. This means that credit officers can be able to concentrate on riskier and larger deals when smaller tasks are delegated to others management officers.   Bibliography Hull, J. (2012). Risk management and financial institutions. Hoboken, N.J., John Wiley & Sons. Lange, H., Saunders, A., Anderson, J. A., Thomson, D., & Cornett, M. M. 2007, Financial Institutions Management 2e, McGraw-Hill Higher Education. Lombardo, D. (2007). Wellfleet. Charleston, SC, Arcadia Pub. Mikes, A 2009, 'Risk Management at Wellfleet Bank: All That Glitters Is Not Gold', Harvard Business School Cases, p. 1, Business Source Premier, EBSCOhost. Pickford, J., & Alexander, C. (2001). Financial Times mastering risk. London, Financial Times Prentice Hall. Sharma, M. (2008). Management of financial institutions with emphasis on bank and risk management. Delhi, Prentice- Hall of India. Read More