Pacific Coast Banking School The Premier National Graduate School of Banking™

Credit Risk Management Extension Assignment Grade Sheet

Group a: Due February 23, 2012

FOR GRADER USE ONLY:

Graded by Christine Corso for John Barrickman

GRADE:

CREDIT RISK Management

Extension Assignment

2011 Session Instructor:

John Barrickman

Group A: Due February 23, 2012

Biographical Summary

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Certificate of Originality

"I certify that this paper represents and contains my own work. I have placed all quotations from other sources in a form to indicate that they did not originate with me and I have cited the work from which the material was taken. I have included footnotes for all information and ideas that I have taken from other sources. I have not shared and will not share my completed work with any other PCBS student nor have I read the completed work of any other student. I understand that failure to comply with this policy will result in dismissal from Pacific Coast Banking School."

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PART A: Executive Summary (1 page)

Wells Fargo has accepted a substantial amount of risk throughout all of its different financial products and lines of businesses that it offers consumers. However, given the company's aggressive growth requirements, accepting such risks allows them to achieve the profitability that the company is looking for. Of the various forms of risks that the company accepts, transactions risks rate the highest and rest squarely in what would be considered a high level of credit risk. The intrinsic risk was found to be moderate but consistent with other firms in the industry. Wells Fargo can help to mitigate intrinsic risk by further refining internal procedures to identify and plan for risk. The company's concentration risk was found to be relatively low and is undoubtedly due to the diversification in the portfolio that the bank holds. It was further identified that the organization must implement credit risk management training and development throughout the entire organization. Credit risk management can only be furthered developed through a holistic approach that is built into the very fabric of the organization.

PART B: Strategic Credit Risk Management

Wells Fargo has an interesting strategic credit risk management position. The bank has an extremely aggressive growth trajectory and as a result they must also accept significant amounts of risk. As a result of exposure to risk, the bank is exceptionally vulnerable to economic volatility such as the risk of a recession. Wells Fargo holds a large portion of its portfolio in investments that are only marginally acceptable. This is a fairly risky position since these assets can be more sensitive to defaults in periods of economic volatility.

8-Point Risk Rating System

Portfolio

Outstandings

Weighted

Risk Rating

X

Weighting

X

Percent

Result

1

Minimal

1.00

1.38%

0.01

2

Modest

1.00

1.26%

0.03

3

Average

1.00

60.99%

1.83

4

Acceptable

1.00

9.99%

0.40

5

Marginally Acceptable

1.05

14.71%

0.77

6

Special Mention

1.15

3.00%

0.21

7

Substandard

1.25

8.06%

0.71

8

Doubtful

1.50

0.60%

0.07

4.03

Weighted Average Risk Rating (WARR):

4.03

TRANSACTION RISK PROFILE POINT:

34

Risk Rating

Profile Point

Risk Level

1.00 to 2.75

0-15

Low

2.76 to 3.75

16-30

Moderate

3.76 to 5.00

31-45

High

Furthermore, Wells Fargo is definitely geared towards an aggressive growth strategy through focusing on immediate returns. One reason for Wells Fargo's credit risk strategy is undoubtedly the fact that it competes with other top competitors such as Goldman Sachs and Bank of America. However, just recently there has been news that all of the top banks have been working to reduce their total risk exposure and pay out increased dividends instead of focusing on profitability; this includes Wells Fargo, Goldman, and JPMorgan while both Citi Group and Bank of America have only paid out marginal dividends (LaCapra, 2012). Since Goldman was one of the leaders in their aggressive strategy, this might be a signal that more economic volatility could be ahead.

PART C: Tolerance for Risk

Wells Fargo definitely has a healthy tolerance for risk. In Wells Fargo's retail lending division, for example, there is significant risk among the predictive risk elements such as the financial strength of the consumer base as well as the economic vulnerabilities associated with interest rates. The home equity line also has a significant amount of risk that is in inherent in this practice. Generally,...

Therefore, even if these consumers have a good historic credit record, they may still be a default risk because their circumstances can sometimes change quickly or the effects of a recession make them vulnerable. Such events can make it difficult for people who have always paid their bills on time to continue doing so and makes Wells Fargo vulnerable as a consequence.
However, these banking services are also very profitable and can receive a market premium. This is exactly why credit risk management can often either make or break a financial institution. If these risks can be properly managed then the bank and receive high levels of profitability. However, on the other hand, if the risks are not managed well then there could be a high default rate and the company could lose substantially. Therefore various risks monitoring metrics have been developed so that Wells Fargo can maintain a close eye on where they stand in regard to their risk strategy. Through proper monitoring of the company's risk, Wells Fargo accepts high levels of risk in order to pursue an aggressive growth strategy.

PART D: Three Deadly Sins

The 3 deadly sins were applied to Wells Fargo's portfolio to illustrate their risk exposure. The first category of risk was transaction risks, which were high at Wells Fargo due to the nature of their portfolio and diverse holdings. Wells Fargo is a global financial institution that operates in a wide variety of different market segments. The level of diversity in business operations directly affects the level of transaction risk due to the exposure to fluctuations in the economy as well as transaction costs.

The intrinsic risk level was identified to be in the medium range. The three components of intrinsic risk include:

1) Historic Risk Elements - includes credit performance and job stability/Longevity/growth/change.

2) Predictive Risk Elements - which includes items such as the customer mix, economic vulnerability, competitive factors, political and regulation factors, natural/environmental.

3) Lending Risk Elements -- these elements include the term, type and of course collateral that is used in the financial package.

Finally, the concentration risk was the low crossed the board with the exception of Home Equity Portfolio and Mortgage Portfolio divisions. Consumers in these segments are more concentrated than in other areas of operations. However, when the entire operation is considered, including each of the various lines of businesses, the concentration risk is rather low due to the company's diversification efforts.

Figure 1 -- Credit Risk Profile Summary

PART E: Credit Risk Management Process

Banks have faced a plethora of issues over the last several years for a multitude of different reasons. However, the major causes of the serious banking problems can be attributed to weak credit standards, poor portfolio risk management, or lack of attention to fluctuating events in the broader economy (Coen, 1999). Credit risk can be thought of most simply as the potential that a borrower is either unwilling or unable to meet their obligations. Generally, these risks are manageable through sheer numbers. However, in the event of an external shock to the system, the risks are greatly elevated. For example, in the most recent global recession, all major banks faced difficulties because the number of borrows who were having financial difficulties expanded exponentially.

Each bank has its own unique set of operating standards by which they must meet their own internal requirements as well as the requirements imposed by the various regulatory bodies. Therefore potential customers have to these guidelines usually based on income, stability, and credit history. However, a borrower may just barely meet the criteria set and another may greatly exceed the minimum requirements. Therefore these borrowers would represent vastly different levels of risk although they might be interested in the same financial product. Thus the entire point of the credit risk management process is to tease out and refine risk metrics so that they can have a better picture of the real risk involved in their portfolios.

Furthermore, risk metrics must be applied to each and every line of business in which the bank operates as well account for various types of risks. Different geographical regions may also face different challenges that are unique to that location. For example, Wells Fargo must deal with various tax and regulatory environments in each of the local markets in which it operates. Each state as well as each city may have vastly different requirements which add considerable layers of complexity as well as increase risk in many cases. All of these risks must be analyzed and consolidated so that the bank can have an accurate account of their risk exposure.

Despite the levels of sophistication that have evolved in credit risk management, there are still many challenges. Since the economy is becoming increasingly globalized, this also adds credit risks to the system that creep in from unsuspecting places. For example, in many of the emerging markets it is incredibly difficult to identify the credit risks involved with potential clients because there is a complete lack of a credit culture (Altman, 2008). Therefore through international trade such risks can spread through the entire financial system. Accounting for risks is a challenging…