Patacsil, Jerwin Dave V.

Financial Risk Management

Case: Risk Management at Wellfleet Bank: All that glitters is not gold

I. Background/Introduction

Wellfleet Bank (The company) was founded in 1847 to provide banking services to Asian and
African colonial outposts in the days of the British Empire. It is currently situated in London.

For brevity on the company’s background, here’s the timeline of the its milestones:
• 1960 to 1990 – the company transformed itself into a global bank by expanding its
presence in North America and Europe
• 1989 to 1992 – the European and credit crisis substantially damaged the company
leaving it with only a $151 million market capitalization.
• 1993 – investors from Asia saved the company
• 2007 – The company expanded its presence to 55 countries with a total operating asset
of $329 billion and a market capitalization of $51 billion
• 2004 to 2006 – the company undertook almost 40 deals in the range of $500 to 750
million.
• 2008 – it continuously expands its operations, now into 78 countries with a focusing
growth opportunities in South Korea, India, Pakistan, and China. During this time that
the company expects to review over 300 proposal submitted to them. Each of these
large-scale credit applications counted as a mega-risk.

The company has two core businesses: corporate banking and consumer banking. The latter
takes of 58% of profits while the latter contributes to the rest. One strategy for the company to
capture more market is to offer Syndicated and Leveraged loans to large corporate clients.
Briefly, Syndicating the loan allows lenders to spread risk and take part in financial opportunities
that may be too large for their individual capital base. On the other hand, leverage loans are
extended to companies that are already ridden with debts. As such, leverage loans have a higher
risk of default which result to a higher interest rate. With this reason itself that portion of such
loans are being kept on its balance sheet, selling down the rest of the exposure to other banks.

It is worth noting that the company was subject to the same set of regulatory and governance
standards as any other U.K.-based bank specifically the Basel Accord and guidelines. To
enumerate:

• Basel I (The Basel Capital Accord) – sets a capital requirement for banks to hold to avoid
insolvency brought about the lending risks due to customer defaults and replacement
risk which is the risk that a party will not fulfill their end of a contract- in this case, the
bank’s customers defaulting on a loan. At least 8% of the Risk Weighted Asset (different
assets of the bank with the corresponding risk weight factor) have to be set aside for a
bank to remain solvent.
 • Basel II (The new Capital Framework) – emphasized the capital adequacy again but on
the context of having a cushion against losses brought about by credit risk, market risk,
and operational. This mandate is manifested by requiring the banks to have a risk
management process to address the risk posted and the banks must be able to quantify
and measure such risks involved through an external reporting system.

The company’s culture as to handling proposal is through a committee- Group Credit

Committee. They are the one approving deals of any size within the bank’s regulatory limits
through a hierarchy of credit officers, all of whom belonged to the risk-management functions.
If a loan request exceeded the credit officer’s limits, it will be passed further up the credit-
approval chain to a regional credit officer. Ultimately, the Group Credit Committee head has the
final say when it comes to large-scale credit applications. This approach was dubbed as the
Alpine Pass since it was time-consuming that it slowed down their response to clients. The
board of directors had no direct involvement with the process, apart from their periodic review
of the corporate loan portfolio after decisions had been made.

The risk management process of the company promotes independence as to this process due to
the board’s mandate that they want someone who can challenge what the business wants to
do. As such, the risk managers have two major functions: educating salespeople and developing
risk models that enable the company to make informed decisions about what is the appropriate
level of return that the company ought to get for the risk to be taken. The Group Credit
Committee operated along with seven other risk committees in which the danger arises that the
risk is being too compartmentalized.

Credit risk officers look at risk in both quantitative and qualitative manner. They also take in to
account the corporate credit ratings available from Moody’s, Standard & Poor’s, and other
rating agencies. The company’s risk management culture is to avoid overreliance on risk model
but rather ascertain the current economic landscape with changes in the industry.

II. Statement of the problem

In October 2008, Gatwick Gold Corporation (GGC), a South African gold producer that accounted
for 7% of global gold production, asked the company to underwrite a $ 1 billion loan to
refinance GCC’s existing facilities for general corporate purposes. This is on top of the CEO’s
worry about the risk-management practices adequate in the global financial crisis.

GGC operates 21 mining operations in 10 countries in which 41% of its production came from
deep-level hard-rock operations in South Africa. As of December 31, 2008, GGC had hedged 10.4
ounces of gold which made GGC unable to take advantage of rising gold prices in 2008. It was
reported that this hedging produced a mark-to-market loss of $800 million in 2007 by receiving
18% to 26% lower as to its gold price. In early May 2008, GGC had announced a $1.6 billion
rights issue to improve their financial flexibility.
 Based on the foregoing, it could be said that the statement of the problem is to whether accept
or deny GGC’s loan application given the current approval and risk management process of the
company.

III. Areas for consideration

The case will be solved with the following assumptions:

• The metrics will be used to gauge the impact and likelihood of a borrower’s defaults are
as follows:
o Probability of Default (PD)
o Loss Given Default (LGD)
o Exposure at Default (EAD)
o Based on the foregoing, the Expected Loss (EL) can be computed as:
EL ($) = PD x LGD (%) x EAD ($)
• In addition to the above formula, the company’s Internal Risk Model to assess the
risk/return profile will be used that includes the following:
o Risk-Adjusted Revenue (RAR)
o Economic Revenue (ER)
o Economic Profit (EP)
• The risks associated with GGC will be considered as follows:
o Commodity prices – low prices of gold would make GGC’s mines uneconomic
o Mining-costs inflation – electricity, labor, equipment, and all other costs were
affected with inflation.
o Political Risk – diversification of the GGC’s mines mitigates the political risk.
However, the Social, Economic, and Environmental (SEE) risk is exposed as to
the mine safety focus of South Africa both politically and operationally speaking.
o Black Economic Empowerment is also worth noting albeit GGC’s full compliance
therewith. This is to redress the inequalities within the region by providing a
stricter licensing grant and ownership requirements.
• The following ratios will also be used as an additional basis in making the decision:
 • The Gold Price trend1 will also be considered as follows:

IV. Alternative Courses of Action (ACA)

1. Accept the GGC loan proposal with the current risk management procedures that company
has in place.
a. Pros – accepting the loan could earn the bank arrangement and other fees from
related transactions and cross-sell opportunities.
b. Cons – the risk of default is relatively high for this risk with a PD of 22% and LGD of
52.5%.
2. Accept the GGC loan proposal but the risk management procedures will be changed by
relying more to credit risk models and risk-adjusted performance metrics with the key risk
decisions being made by individuals and not by committees.
a. Pros – in addition with those mentioned in ACA #1, having streamlined the process
of credit application can cater not only the GGC proposal but also the pending
hundred proposals which will result to more clients and a relatively more profits.
b. Cons – in addition with those mentioned in ACA #1, time constraint will be present
given the sudden change in the process in which the company might have a chance
to lose the proposal. Moreover, costs will be present given a tight time schedule
3. Reject the GGC proposal then direct the focus more on the pending proposals but the risk
management procedures will be changed by relying more to credit risk models and risk-
adjusted performance metrics with the key risk decisions being made by individuals and not
by committees.
a. Pros – the risk and high EL from the GGC proposal will not be borne by the company.
The company might be able to take advantage of other proposals and collectively, it
may be at par with the expected profit with the GGC proposal. Lastly, streamlining
the process will facilitate the acceptance of more proposals.
b. Cons – cost might arise as to the restructuring of the process with additional
personnel needed especially in the group credit risk committee.

1
Source: http://www.research.gold.org/prices/
V. Summary, conclusion, and recommendation

The company is a London-based global bank recently got a proposal to underwrite a $1 billion
loan to GCC, a South African gold producer. However, the management is also worried about its
risk-management processes.

ACA #2 will be chosen, which is to accept the GGC loan proposal, but the risk management
procedures will be changed by relying more to credit risk models and risk-adjusted performance
metrics with the key risk decisions being made by individuals and not by committees.

For the loan approval, it is also worth noting that the ER and EP are both positive with amounts
of $44.6 million and $32.16 million, respectively. It would be profitable on the part of the
company to accept such. In addition, given that the company would streamline its process
especially with its reliance to various credit risk models and having the approval to be on an
individual level instead of a committee level, the other proposals would be of merit and
considerations.

The following credit risk model could be used by the company:

• VaR models (e.g. J.P. Morgans CreditMetrics) are credit models based on the original
Value-at-Risk (VaR) concept to measure market risk. The focus is a VaR measure
indicating the maximum credit loss at a given confidence range. VaR models are built up
using rating matrices based on published ratings, as well as probabilities of upward or
downward adjustments of borrowers' rating within a given time frame of typically one
year.
• Insurance-inspired models (e.g. Credit Suisse First Bostons CreditRisk+), whereby credit
loss can be related to "incidents", in this case the borrowers' default. Each borrower has
a small incidence probability, but for the total portfolio within a certain period there will
be a certain number of borrower subject to "incidents". This type of model can be
compared with similar models which have been used for many years by insurance
companies to calculate the risk of loss on insurance.
• Option-based models (e.g. KMVs Portfolio Manager) are based on the company's capital
structure. The credit quality of the companies is determined by the difference between
the value of the company's assets and liabilities and the volatility of the asset values.
The asset value is stated as probability distributions derived from stock prices, while in
principle the debt is determined via information from the accounts.

Anderson (2001) studied that the application of credit models by the banks will be a tool in the
management of credit risk. Moreover, the models will make it possible to determine prices on a
more appropriate basis, so that to a higher degree the interest rates for various exposures
reflect variations in risk. This is because the use of credit models allows the credit risk to be
quantified.
References

Andersen, J.V. (2001) Models for Management of Banks' Credit Risk, National Bank Denmark