Risk Management at Wallstreet Bank: Deciding about "Megadeals" Company History, Operations, arid Strategy Founded in London in 1947, Wallstreet provided baliking services to Asian and African colonial outposts in the days of the British Empire. Between 1960 and 1990, it transformed itself into a global bank and aggressively grew its presence in North America and Europe. However, the 1989- 1992 European property and credit crisis wiped out most of its profitability and capital, leaving it with a market capitalization of a mere $151 million. Tlie bank was rescued by a handful of Asian investors in 1993 and a decade of strategic reorientation followed, during which the company refocused on its core markets in the emerging world and suspended non-core activities in Europe and North America In the 2000s, Wallstreet had been gradually resurfacing as a leading international bank again. In 2007. it was present in 55 countries in 2007, operating total dissets of $329 billion with a market capitalization of $51 billion-still a David'among the Goliaths of international banking. By 2008, through a string of acquisitions, it had expanded operations to 78 countries, focusing on growth opportunities in South Korea, India, Pakistan, and China. Wallstreet's main rival in Asia was Global Bank, with total assets in excess of $1.8 trillion. Wallstreet had two core businesses corporate banking, responsible for 58% of pre-tax profits and 72% of assets employed in 2007. and consumer banking, which contributed the remaining 42% of after-tax profits and 28% of assets employed in 2004, Wallstreet's management had identified both syndicated and leveraged loans to large corporate clients as areas of significant future growth for its corporate banking business Syndicated loans were provided to a borrower through the combined activities of several banks. The members of this consortium could reduce their overall exposure to the transaction, each bearing only a part of any loss. Syndicated loans allowed smaller bunks to participate in large transactions which otherwise would have exceeded their balance sheet constraints. Leveraged loans were extended to companies that already had considerable amounts of debt. Because these loans often carried a higher risk of default, a lender typically demanded a higher interest rate and intended to keep only a portion of the loan on its balance sheet, "selling down the rest of the exposure to other banks Most international banks orchestrated syndicated and leveraged loans through their investment banking businesses, but Wallstreet did not have an investment banking arm. Instead, it decided to expand its core corporate-banking business into these market segments. The corporate bank successfully recruited seasoned relationship managers from leading investment banks and hired an additional senior risk officer, Catherine Richards, also from an investment bank. Her job was to oversee the planned expansion from a risk perspective. Between 2004 and 2006, Wallstreet undertook almost 40 deals in the range of $500-750 million, making the bank a force to reckon with in the corporate finance business. Even though the bulk of its 6 million retail customers and 15 thousand corporate clients resided outside the United Kingdom, Wallstreet was still headquartered in London and was subject to the same set of regulatory and governance standards as any other U.K.-based bank. Wallstreet considered its "first-world compliance standards to be a key competitive advantage over local rivals in emerging markets . The importance of internal controls and risk management was widely recognized in Wallstreet. LIVET. EVET. crves to be commensurate with the riskiness of their activities. To this end, the regulators required banks to continually measure and monitor their risks and work out the capital requirements of their various business activities accordingly. Wallstreet's top management and board recognized that their risk profile was unique among U.K. banks and warranted risk-taking discipline. Chief risk officer Patricia Cromwell saw her task as central to the bank's strategy execution: We want to grow aggressively, but we want to grow aggressively with some balance. As we grow. we need to make sure that our risk infrastructure keeps pace with the business opportunities. Senior colleagues in the risk-management department echoed this view. Arthur Reynolds, responsible for Basel II implementation, saw the compliance challenge as mission-critical: Our business is growing fast. Risks come with acquisitions and the environment against which we ur operating is becoming more risky. Whether it is the regulatory risk, or whether it is credit risk or whether it is competition, or whether it is the overall complexity of products, we are growing ugainst a risky environment. Having good risk-management discipline is therefore key to our Success Risk Management in the Corporate Bank The Risk Management Function The relationship managers constituted the customer-facing "sales organization of the corporate cank. Their variable compensation was proportional to the amount of business they generated; they focused on delivering the bank to the client." In constant dialogue with existing and potential clients, they developed business credit applications and submitted these to senior credit officers in their country units. Senior credit officers looked at the proposals both from a revenue and a risk-management respective. While the relationship managers outlined the proposed client facility with the margins and fees that the bank would earn, the risk-management function undertook an independent risk wysis to make the proposal's risk and reward characteristics transparent. Chief risk officer Patricia Cromwell underlined the independence of the risk-management Lunction: The board wants the risk function to be independent of the business because they want someone who can challenge what the business wants to do. Sales people bring everything in from the street and the risk manager is the mmon-sense conscience saying: "This is not as good as it looks." is difficulty is to challenge sales without causing offence. So the risk manager has two major functions. One is to educate sales people. The second is to develop risk models that enable us to make informed decisions about what is the appropriate level of return we ought to get for the risk we take. Wallstreet's board of directors and top management demanded a "no-surprises culture." In the quarterly Group Risk Committee meeting, risk officers regularly reported to them on any significant changes in the bank's risk profile and any developments affecting large individual risk exposures. This executive forum questioned and approved proposed fending policies, guidelines, and limits and monitored newly accepted lending proposals to be sure they were compliant and had been approved at the right level of authority. If necessary, the committee initiated corrective action The fate of business credit applications in the corporate banking business was determined by a hierarchy of credit officers, all of whom belonged to the risk-management function. Regional and senior credit officers operated in the business locations and could sign off on certain types of business proposal, depending on the hierarchy and on their individual experience. Experienced senior credit managers were authorized to deal with riskier and larger loan requests than less seasoned colleagues. If a loan request exceeded the credit officer's limits, he or she was obliged to pass it further up the credit-approval chain to a regional credit officer. The Group Credit Committee was the highest forum of credit approval. The process required sign-off at each level of the hierarchy, so a credit proposal that was too big for anything but the Group Credit Committee nevertheless required sign- coff from a senior credit office and a ragionl credit officer before it got there. Relationship managers felt that this "Alpine pass" approach was time-consuming and slowed down their response to clients, There was no explicit upper limit to the Group Credit Committee's authority. It could approve loans of any size within the bank's regulatory limits. Its membership was determined by position; it was made up of the group chief credit officer, who served as chair, the deputy chief risk officer, ind the group head of client relationships, who represented the business viewpoint. To preserve the independence of the credit-approval process, the "Alpine pass" did not involve the most senior executive management (e.g., business CEOs) in the deal flow. Risk officers acted as analysts and reviewers not only of individual business proposals, but also of the corporate bank's entire portfolio. Richards explained: The portfolio is trimmed by how we make decisions. So the risk-management function sets the composition of the portfolio. The business units think they set it, as they tend to think that we just approve, but we don't. We watch what we approve, in the context of the structure and the volatility of the risk in the portfolio. For example, we worry about industry concentrations above 8% of risk-weighted assets, while the regulators would only start to worry around 13%. Unsurprisingly, the power of the risk management function caused tension in the corporate bank CEO Alastair Dawes explained: I think the challenge comes in ensuring there is an effective balance between the two sides. You don't want a situation where the business exerts so much influence and control that the risk function is pressured into doing things that they are really not comfortable doing On the other hand, the risk function can't be so powerful that we will never do anything because they don't like the risk putational risk, and business risks threatening the consumer bank and the corporate bank-to nake sure they remained below preset limits. Collectively, the eight risk committees operated under the Group Risk Committee, where the top executives were informed quarterly about risk trends. Separately, the chief risk officer reported quarterly to the board-level Audit and Risk Committee. Thomas Mayfield (promoted to deputy group chief risk officer in 2007) found these separate risk discussions counterproductive and advocated looking across the risk types: The danger is that we have compartmentalized risk too much. There is market risk, there is operational risk, there is reputational risk, there is credit risk-all separately discussed and managed. But the reality is: They all interact. At the Group Credit Committee, I look at deals from a credit-risk perspective, but I have to tell you, I'm certainly looking at country risk and reputational risk as well. Risk management is chemistry, not particle physics. You cannot separate the risks. Risk Assessment of Proposals Wallstreet's business credit applications were standardized and had been designed to provide a holistic picture of the risks associated with the proposals. They contained both quantitative and qualitative risk information. Risk analysts modeled credit risk for each client and applicant using the bank's proprietary internal rating models along with ratings from credit-rating agencies. The chief risk officer emphasized the importance of scientific risk measurement: We need to be able to measure the risk and we need risk models to enable us to talk scientifically thout the risk we're actually taking. Then we can look at the revenue and determine, based on scientific analysis, if the revenue compensates us for the risk. Three metrics gauged the impact and likelihood of a borrower's default: Probability of Default (PD): the risk function's estimate of the likelihood that a borrower would default in the next twelve months; the lower the PD, the higher the quality of the individual loan. Like most banks, Wallstreet developed its own internal loan-rating (PD) grades, ranging from 1A, the least likely to default, to 11B, the most likely. Loss Given Default (LGD): the percentage of the loan exposure that would not be recovered in the event of default. Exposure at Default (EAD): the total current outstanding credit to the borrower and the estimated future drawdown on the account prior to default. or each exposure, Wallstreet's risk models calculated the Expected Loss (EL), the product of the above three metrics: 1.($) - Probability of Default x Loss Given Default (%) x Exposure at Default ($) On average, this was the amount the bank could expect to lose on a particular loan. The revenue of in deal was adjusted accordingly. Wallstreet's risk-management function used its own internally developed model to calculate the risk-adjusted revenue (called Economic Revenue) and the risk-adjusted profit (called Economic Protit) of any deal Table A Sample Calculation of Expected Loss The following example illustrates Expected Loss and risk-adjusted performance metrics for a single counterparty Assumptions Calculations The counterparty is rated 5A by -EL - Probability of Default x Exposure at Wallstreet's internal rating model and Default credit committee. This translates to PD ($) Loss Given Default (%) = 0.22%. 0.22%#$147,318,182 * 60.86% = $197,247 Product type: syndication. Wallstreet Total Revenue = Interest Income + Fee Income expects to earn a margin of 0.575% (57.5 hasis points) on this loan, plus a one-off $147,318,182 57.5hp +$589,273 = $ fee of 500,000 ($589,273). 1-1,436,353 Booking location is the U.K., but the loan Risk Adjusted Revenue (RAR) is to be issued to the Netherlands (in Total Revenue - Total Expected Loss = euros) with a tenor of 1 year $1,436,353 - $197.247 = $1,239.106 The drawn amount would equal the Economic Revenue RAR-Net Capital limit, which is requested to be Charge 125,000,000 ($147,318,182) $1,239,106- $382,631 = $856,475 Wallstreet's model indicates that the Loss Given Default for this transaction would be 60.86% of exposure. Treasury assesses Capital Charge as Economic Profit Economic Revenue-Cost- $382,631. Tax $856,475- $143.353 . $217,114 - $496,008 Group Finance provides the following overhead allocations to the transaction: Total costs allocated $143,353 Tax = $217,114 Source: Company documents Wallstreet's senior risk executives cautioned against overreliance on risk models. Group chief credit officer Catherine Richards had spent 24 years in the banking sector and, as a member of the board of trustees of the Global Association of Risk Professionals, was a vocal advocate of the risk profession. But she saw it as an art as much as a science: I believe risk models are a valuable tool. You have to have a model not only of the individual corporate credit risk, but also of the aggregation of all of your risks so you can understand both geographical and industry concentrations, as well as the inter-relationships in the portfolio But there are times when risk models will cease to work because the assumptions on which they are built will no longer be true, either temporarily or permanently. The reality is thar you need sufficient data to be able with experience to judge where things are going. You have to look forward , not back. I say a model is a tool that you should be comparing with what you expect 10 Pinding oul a model doesn't work anymore isn't a good way of finding out that the see. a The Proposals Separated by two and a half years, Group Credit Committee chairs Mayfield and Richards each considered a proposal at a "relationship-defining moment." Each application had the potential to initiate a lucrative and long-term relationship with a new client. Each application also held the promise of multiple revenue streams. Apart from interest revenues, the bank could earn arrangement and other fees from related Transactions and cross-sale opportunities (e.g., selling down part of the loan by syndicating it to other banks). However, there was also in both cases a risk of default against which the bank would have to set aside reserves, an amount of capital that would be commensurate to the credit risk involved in the deals. Although the risk capital would help the bank absorb any losses in the event of default, setting it aside would tie up capital which could otherwise be productive Proposal 1: An $850 Million Facility to Ashar Industries for the Acquisition of Zellmont Relationship managers Rohit Chopra and Peter Tang had long been courting Ashar Industries, the world's largest steel producer (6% market share by volume). It had grown from relative obscurity into the world's leading producer in under 10 years as an industry consolidator through a debt-and paper- funded acquisition program. By 2005, Ashar Industries commanded a turnover of $28.1 billion, a dramatic rise from $5.4 billion in 2001. Yet Wallstreet had no relationship with Ashar. Production was split equally between developed markets (North America and Western Europe) and developing markets (Algeria, Eastern Europe, Kazakhstan, South Africa, and Ukraine). Ashar's revenue base was also diversified: 40% of sales came from North America (with 25% of sales from the U.S. automotive industry) and 33% of sales came from Europe. The company was controlled by founder Amit Ashar and his family and had a complex organizational structure which included several unconsolidated joint ventures (with Telmak Steel, for example) and associates with ownership of 50%. The company specialized in low-end commodity steels. Given that some two-thirds of its products were sold at spot prices, its performance was conditional on strong commodity prices, which had obtained in recent years. Ashar Industries sought a hostile takeover of the European steel giant Zellmont in order to create the world's largest and most global steel producer (with a global market share of 10% by volume). ellmont's footprint in multiple European jurisdictions (France, Spain, etc.) would add a complementary asset base resulting in leading positions in major steel markets in North America, Western Europe, Africa, and South America. The major product categories would remain the automotive sector, construction, and appliances and packaging, Ashar management estimated relax cost synergies of $1 billion to be realized within three years of a takeover. Rohit Chopra had come to Wallstreet in 2005 from an investment bank. He was convinced that Ashar Industries would remain a major global corporation, offering profitable relationship banking opportunities to the financial institutions that supported it in its acquisition quest. Chopra found out that Wallstreet had so far avoided doing business with Ashar due to reputational concerns with Amit Ashar's past. However, through his business network, Chopra personally knew Amit Ashar and was also aware that Wallstreet's competitors were not worried about Amit Ashar's reputation and were developing profitable relationships with his company. "If Global Bank can do business with them," wondered Chopra, "why can't we?" Chopra requested Wallstreet's reputational risk committee to reexamine Ashar's status. The committee cleared the name, although not unanimously. Feeling that Wallstreet's "Alpine pass" process was too slow, Chopra turned directly to his boss' boss, the grouphead of client relationships (a member of the Group Credit Committee) and got his informal support. Chopra and fellow relationship manager Peter Tang threw themselves into negotiating the business credit application with Ashar's chief financial officer Kartik Ashar (the founder's son). Chopra and Tang prepared the business credit application (see Appendix 1) under considerable time pressure, with a one-week deadline before submission to the Group Credit Committee. The proposal indicated that the account would be highly profitable for Wallstreet. Chopra and Tang proposed that the facility should remain available even in the event that Ashar did not secure a 50% shareholding in Zellmont, to allow the company to restructure its debt profile. If the facility did not take place, Wallstreet would receive a 10bp drop-dead fee. Analysts in the risk- management function gave an independadt risk assessment. They relaxed the underlying assumption that Ashar would gain full control of Zellmont and provided a sensitivity analysis to determine the consequences if Ashar's bid were unsuccessful. In each of the scenarios, there was a positive cash flow for debt service, confirming the relationship managers' revenue estimates. Apart from the sensitivity analysis, the risk-management function also assessed the credit risk and raised some "broader issues including the risks of integration, corporate structure, and transparency as well as environmental and reputational issues which would need to be considered by the Group Credit Committee. Proposal 2: Refinancing Gatwick Gold Corporation's S1 Billion Convertible-Bond Financing Relationship manager Jaidev Kapoor, who had been with Wallstreet for 10 years, was surprised when Gatwick Gold Corporation (GGC), to which Wallstreet had committed a $50 million facility. asked to increase this limit by Sibillion. It was October 2008 and that was the amount GGC needed to refinance a convertible bond coming due on February 27, 2009. With a conversion price of $65, the current price was well out of the money at $18.40. GGC urgently needed to refinance and was facing a particularly challenging financing environment--a credit crunch which had begun in 2007 and was likely to continue into 2009. GGC was the world's third-largest gold producer, accounting for about 7% of global gold production. It operated 21 mining operations in 10 countries (Argentina, Australia, Brazil, Ghana, Guinca, Mali, Namibia, South Africa, Tanzania, and the U.S.) and conducted extensive exploration. Forty-one percent of its production came from deep-level hard-rock operations in South Africa As of December 31, 2007, GGC had hedged 10,4 million ounces of gold, nearly two years! production, a position which kept it from takitig advantage of rising gold prices in 2008. In anchgeu al aspects of the existing business model. sve all, the new team believed that the biggest task was to unwind the hedge book. They aimed receive 94% of the spot price in 2009 at $900/oz and 96% at $800/oz.. In early May 2008, GGC had announced a $1.6 billion rights issue in order to improve the company's financial flexibility and allow it to continue funding its principal development projects and exploration growth initiatives. The issue was successfully closed in July and was several times oversubscribed In October 2008, GGC's management team turned to Wallstreet Bank for a two-year bridging loan of $1 billion. Relationship manager Kapoor believed that GGC's new strategy would allow it to improve its performance by taking advantage of strong gold prices. At the same time, though, the company would be almost fully exposed to sudden declines in the volatile price of gold. Kapoor prepared the business credit application which indicated that the account would be highly profitable for Wallstreet. In addition, the bank could become a key relationship bank (a "primary Transaction bank") to GGC, with the potential for obtaining the business of restructuring the client's hedge book. However, the corporate bank's risk analysts raised a number of "broader issues"-including rapidly growing mining costs, reputational risk, and political risk (particularly in South Africa)--that the Group Credit Committee would have to consider. Required a) Given its strategy, what kind of risks does Wallstreet Bank face? b) What is your decision regarding the two credit proposals c) Calculate the Expected Loss, Economic Revenue, and Economic Profit for both proposals. What strikes you about the nature of risk quantification? d) Analyze the risk management process at Wallstreet Bank. What suggestions might you make to the CEO about improving the process? Risk Management at Wallstreet Bank: Deciding about "Megadeals" Company History, Operations, arid Strategy Founded in London in 1947, Wallstreet provided baliking services to Asian and African colonial outposts in the days of the British Empire. Between 1960 and 1990, it transformed itself into a global bank and aggressively grew its presence in North America and Europe. However, the 1989- 1992 European property and credit crisis wiped out most of its profitability and capital, leaving it with a market capitalization of a mere $151 million. Tlie bank was rescued by a handful of Asian investors in 1993 and a decade of strategic reorientation followed, during which the company refocused on its core markets in the emerging world and suspended non-core activities in Europe and North America In the 2000s, Wallstreet had been gradually resurfacing as a leading international bank again. In 2007. it was present in 55 countries in 2007, operating total dissets of $329 billion with a market capitalization of $51 billion-still a David'among the Goliaths of international banking. By 2008, through a string of acquisitions, it had expanded operations to 78 countries, focusing on growth opportunities in South Korea, India, Pakistan, and China. Wallstreet's main rival in Asia was Global Bank, with total assets in excess of $1.8 trillion. Wallstreet had two core businesses corporate banking, responsible for 58% of pre-tax profits and 72% of assets employed in 2007. and consumer banking, which contributed the remaining 42% of after-tax profits and 28% of assets employed in 2004, Wallstreet's management had identified both syndicated and leveraged loans to large corporate clients as areas of significant future growth for its corporate banking business Syndicated loans were provided to a borrower through the combined activities of several banks. The members of this consortium could reduce their overall exposure to the transaction, each bearing only a part of any loss. Syndicated loans allowed smaller bunks to participate in large transactions which otherwise would have exceeded their balance sheet constraints. Leveraged loans were extended to companies that already had considerable amounts of debt. Because these loans often carried a higher risk of default, a lender typically demanded a higher interest rate and intended to keep only a portion of the loan on its balance sheet, "selling down the rest of the exposure to other banks Most international banks orchestrated syndicated and leveraged loans through their investment banking businesses, but Wallstreet did not have an investment banking arm. Instead, it decided to expand its core corporate-banking business into these market segments. The corporate bank successfully recruited seasoned relationship managers from leading investment banks and hired an additional senior risk officer, Catherine Richards, also from an investment bank. Her job was to oversee the planned expansion from a risk perspective. Between 2004 and 2006, Wallstreet undertook almost 40 deals in the range of $500-750 million, making the bank a force to reckon with in the corporate finance business. Even though the bulk of its 6 million retail customers and 15 thousand corporate clients resided outside the United Kingdom, Wallstreet was still headquartered in London and was subject to the same set of regulatory and governance standards as any other U.K.-based bank. Wallstreet considered its "first-world compliance standards to be a key competitive advantage over local rivals in emerging markets . The importance of internal controls and risk management was widely recognized in Wallstreet. LIVET. EVET. crves to be commensurate with the riskiness of their activities. To this end, the regulators required banks to continually measure and monitor their risks and work out the capital requirements of their various business activities accordingly. Wallstreet's top management and board recognized that their risk profile was unique among U.K. banks and warranted risk-taking discipline. Chief risk officer Patricia Cromwell saw her task as central to the bank's strategy execution: We want to grow aggressively, but we want to grow aggressively with some balance. As we grow. we need to make sure that our risk infrastructure keeps pace with the business opportunities. Senior colleagues in the risk-management department echoed this view. Arthur Reynolds, responsible for Basel II implementation, saw the compliance challenge as mission-critical: Our business is growing fast. Risks come with acquisitions and the environment against which we ur operating is becoming more risky. Whether it is the regulatory risk, or whether it is credit risk or whether it is competition, or whether it is the overall complexity of products, we are growing ugainst a risky environment. Having good risk-management discipline is therefore key to our Success Risk Management in the Corporate Bank The Risk Management Function The relationship managers constituted the customer-facing "sales organization of the corporate cank. Their variable compensation was proportional to the amount of business they generated; they focused on delivering the bank to the client." In constant dialogue with existing and potential clients, they developed business credit applications and submitted these to senior credit officers in their country units. Senior credit officers looked at the proposals both from a revenue and a risk-management respective. While the relationship managers outlined the proposed client facility with the margins and fees that the bank would earn, the risk-management function undertook an independent risk wysis to make the proposal's risk and reward characteristics transparent. Chief risk officer Patricia Cromwell underlined the independence of the risk-management Lunction: The board wants the risk function to be independent of the business because they want someone who can challenge what the business wants to do. Sales people bring everything in from the street and the risk manager is the mmon-sense conscience saying: "This is not as good as it looks." is difficulty is to challenge sales without causing offence. So the risk manager has two major functions. One is to educate sales people. The second is to develop risk models that enable us to make informed decisions about what is the appropriate level of return we ought to get for the risk we take. Wallstreet's board of directors and top management demanded a "no-surprises culture." In the quarterly Group Risk Committee meeting, risk officers regularly reported to them on any significant changes in the bank's risk profile and any developments affecting large individual risk exposures. This executive forum questioned and approved proposed fending policies, guidelines, and limits and monitored newly accepted lending proposals to be sure they were compliant and had been approved at the right level of authority. If necessary, the committee initiated corrective action The fate of business credit applications in the corporate banking business was determined by a hierarchy of credit officers, all of whom belonged to the risk-management function. Regional and senior credit officers operated in the business locations and could sign off on certain types of business proposal, depending on the hierarchy and on their individual experience. Experienced senior credit managers were authorized to deal with riskier and larger loan requests than less seasoned colleagues. If a loan request exceeded the credit officer's limits, he or she was obliged to pass it further up the credit-approval chain to a regional credit officer. The Group Credit Committee was the highest forum of credit approval. The process required sign-off at each level of the hierarchy, so a credit proposal that was too big for anything but the Group Credit Committee nevertheless required sign- coff from a senior credit office and a ragionl credit officer before it got there. Relationship managers felt that this "Alpine pass" approach was time-consuming and slowed down their response to clients, There was no explicit upper limit to the Group Credit Committee's authority. It could approve loans of any size within the bank's regulatory limits. Its membership was determined by position; it was made up of the group chief credit officer, who served as chair, the deputy chief risk officer, ind the group head of client relationships, who represented the business viewpoint. To preserve the independence of the credit-approval process, the "Alpine pass" did not involve the most senior executive management (e.g., business CEOs) in the deal flow. Risk officers acted as analysts and reviewers not only of individual business proposals, but also of the corporate bank's entire portfolio. Richards explained: The portfolio is trimmed by how we make decisions. So the risk-management function sets the composition of the portfolio. The business units think they set it, as they tend to think that we just approve, but we don't. We watch what we approve, in the context of the structure and the volatility of the risk in the portfolio. For example, we worry about industry concentrations above 8% of risk-weighted assets, while the regulators would only start to worry around 13%. Unsurprisingly, the power of the risk management function caused tension in the corporate bank CEO Alastair Dawes explained: I think the challenge comes in ensuring there is an effective balance between the two sides. You don't want a situation where the business exerts so much influence and control that the risk function is pressured into doing things that they are really not comfortable doing On the other hand, the risk function can't be so powerful that we will never do anything because they don't like the risk putational risk, and business risks threatening the consumer bank and the corporate bank-to nake sure they remained below preset limits. Collectively, the eight risk committees operated under the Group Risk Committee, where the top executives were informed quarterly about risk trends. Separately, the chief risk officer reported quarterly to the board-level Audit and Risk Committee. Thomas Mayfield (promoted to deputy group chief risk officer in 2007) found these separate risk discussions counterproductive and advocated looking across the risk types: The danger is that we have compartmentalized risk too much. There is market risk, there is operational risk, there is reputational risk, there is credit risk-all separately discussed and managed. But the reality is: They all interact. At the Group Credit Committee, I look at deals from a credit-risk perspective, but I have to tell you, I'm certainly looking at country risk and reputational risk as well. Risk management is chemistry, not particle physics. You cannot separate the risks. Risk Assessment of Proposals Wallstreet's business credit applications were standardized and had been designed to provide a holistic picture of the risks associated with the proposals. They contained both quantitative and qualitative risk information. Risk analysts modeled credit risk for each client and applicant using the bank's proprietary internal rating models along with ratings from credit-rating agencies. The chief risk officer emphasized the importance of scientific risk measurement: We need to be able to measure the risk and we need risk models to enable us to talk scientifically thout the risk we're actually taking. Then we can look at the revenue and determine, based on scientific analysis, if the revenue compensates us for the risk. Three metrics gauged the impact and likelihood of a borrower's default: Probability of Default (PD): the risk function's estimate of the likelihood that a borrower would default in the next twelve months; the lower the PD, the higher the quality of the individual loan. Like most banks, Wallstreet developed its own internal loan-rating (PD) grades, ranging from 1A, the least likely to default, to 11B, the most likely. Loss Given Default (LGD): the percentage of the loan exposure that would not be recovered in the event of default. Exposure at Default (EAD): the total current outstanding credit to the borrower and the estimated future drawdown on the account prior to default. or each exposure, Wallstreet's risk models calculated the Expected Loss (EL), the product of the above three metrics: 1.($) - Probability of Default x Loss Given Default (%) x Exposure at Default ($) On average, this was the amount the bank could expect to lose on a particular loan. The revenue of in deal was adjusted accordingly. Wallstreet's risk-management function used its own internally developed model to calculate the risk-adjusted revenue (called Economic Revenue) and the risk-adjusted profit (called Economic Protit) of any deal Table A Sample Calculation of Expected Loss The following example illustrates Expected Loss and risk-adjusted performance metrics for a single counterparty Assumptions Calculations The counterparty is rated 5A by -EL - Probability of Default x Exposure at Wallstreet's internal rating model and Default credit committee. This translates to PD ($) Loss Given Default (%) = 0.22%. 0.22%#$147,318,182 * 60.86% = $197,247 Product type: syndication. Wallstreet Total Revenue = Interest Income + Fee Income expects to earn a margin of 0.575% (57.5 hasis points) on this loan, plus a one-off $147,318,182 57.5hp +$589,273 = $ fee of 500,000 ($589,273). 1-1,436,353 Booking location is the U.K., but the loan Risk Adjusted Revenue (RAR) is to be issued to the Netherlands (in Total Revenue - Total Expected Loss = euros) with a tenor of 1 year $1,436,353 - $197.247 = $1,239.106 The drawn amount would equal the Economic Revenue RAR-Net Capital limit, which is requested to be Charge 125,000,000 ($147,318,182) $1,239,106- $382,631 = $856,475 Wallstreet's model indicates that the Loss Given Default for this transaction would be 60.86% of exposure. Treasury assesses Capital Charge as Economic Profit Economic Revenue-Cost- $382,631. Tax $856,475- $143.353 . $217,114 - $496,008 Group Finance provides the following overhead allocations to the transaction: Total costs allocated $143,353 Tax = $217,114 Source: Company documents Wallstreet's senior risk executives cautioned against overreliance on risk models. Group chief credit officer Catherine Richards had spent 24 years in the banking sector and, as a member of the board of trustees of the Global Association of Risk Professionals, was a vocal advocate of the risk profession. But she saw it as an art as much as a science: I believe risk models are a valuable tool. You have to have a model not only of the individual corporate credit risk, but also of the aggregation of all of your risks so you can understand both geographical and industry concentrations, as well as the inter-relationships in the portfolio But there are times when risk models will cease to work because the assumptions on which they are built will no longer be true, either temporarily or permanently. The reality is thar you need sufficient data to be able with experience to judge where things are going. You have to look forward , not back. I say a model is a tool that you should be comparing with what you expect 10 Pinding oul a model doesn't work anymore isn't a good way of finding out that the see. a The Proposals Separated by two and a half years, Group Credit Committee chairs Mayfield and Richards each considered a proposal at a "relationship-defining moment." Each application had the potential to initiate a lucrative and long-term relationship with a new client. Each application also held the promise of multiple revenue streams. Apart from interest revenues, the bank could earn arrangement and other fees from related Transactions and cross-sale opportunities (e.g., selling down part of the loan by syndicating it to other banks). However, there was also in both cases a risk of default against which the bank would have to set aside reserves, an amount of capital that would be commensurate to the credit risk involved in the deals. Although the risk capital would help the bank absorb any losses in the event of default, setting it aside would tie up capital which could otherwise be productive Proposal 1: An $850 Million Facility to Ashar Industries for the Acquisition of Zellmont Relationship managers Rohit Chopra and Peter Tang had long been courting Ashar Industries, the world's largest steel producer (6% market share by volume). It had grown from relative obscurity into the world's leading producer in under 10 years as an industry consolidator through a debt-and paper- funded acquisition program. By 2005, Ashar Industries commanded a turnover of $28.1 billion, a dramatic rise from $5.4 billion in 2001. Yet Wallstreet had no relationship with Ashar. Production was split equally between developed markets (North America and Western Europe) and developing markets (Algeria, Eastern Europe, Kazakhstan, South Africa, and Ukraine). Ashar's revenue base was also diversified: 40% of sales came from North America (with 25% of sales from the U.S. automotive industry) and 33% of sales came from Europe. The company was controlled by founder Amit Ashar and his family and had a complex organizational structure which included several unconsolidated joint ventures (with Telmak Steel, for example) and associates with ownership of 50%. The company specialized in low-end commodity steels. Given that some two-thirds of its products were sold at spot prices, its performance was conditional on strong commodity prices, which had obtained in recent years. Ashar Industries sought a hostile takeover of the European steel giant Zellmont in order to create the world's largest and most global steel producer (with a global market share of 10% by volume). ellmont's footprint in multiple European jurisdictions (France, Spain, etc.) would add a complementary asset base resulting in leading positions in major steel markets in North America, Western Europe, Africa, and South America. The major product categories would remain the automotive sector, construction, and appliances and packaging, Ashar management estimated relax cost synergies of $1 billion to be realized within three years of a takeover. Rohit Chopra had come to Wallstreet in 2005 from an investment bank. He was convinced that Ashar Industries would remain a major global corporation, offering profitable relationship banking opportunities to the financial institutions that supported it in its acquisition quest. Chopra found out that Wallstreet had so far avoided doing business with Ashar due to reputational concerns with Amit Ashar's past. However, through his business network, Chopra personally knew Amit Ashar and was also aware that Wallstreet's competitors were not worried about Amit Ashar's reputation and were developing profitable relationships with his company. "If Global Bank can do business with them," wondered Chopra, "why can't we?" Chopra requested Wallstreet's reputational risk committee to reexamine Ashar's status. The committee cleared the name, although not unanimously. Feeling that Wallstreet's "Alpine pass" process was too slow, Chopra turned directly to his boss' boss, the grouphead of client relationships (a member of the Group Credit Committee) and got his informal support. Chopra and fellow relationship manager Peter Tang threw themselves into negotiating the business credit application with Ashar's chief financial officer Kartik Ashar (the founder's son). Chopra and Tang prepared the business credit application (see Appendix 1) under considerable time pressure, with a one-week deadline before submission to the Group Credit Committee. The proposal indicated that the account would be highly profitable for Wallstreet. Chopra and Tang proposed that the facility should remain available even in the event that Ashar did not secure a 50% shareholding in Zellmont, to allow the company to restructure its debt profile. If the facility did not take place, Wallstreet would receive a 10bp drop-dead fee. Analysts in the risk- management function gave an independadt risk assessment. They relaxed the underlying assumption that Ashar would gain full control of Zellmont and provided a sensitivity analysis to determine the consequences if Ashar's bid were unsuccessful. In each of the scenarios, there was a positive cash flow for debt service, confirming the relationship managers' revenue estimates. Apart from the sensitivity analysis, the risk-management function also assessed the credit risk and raised some "broader issues including the risks of integration, corporate structure, and transparency as well as environmental and reputational issues which would need to be considered by the Group Credit Committee. Proposal 2: Refinancing Gatwick Gold Corporation's S1 Billion Convertible-Bond Financing Relationship manager Jaidev Kapoor, who had been with Wallstreet for 10 years, was surprised when Gatwick Gold Corporation (GGC), to which Wallstreet had committed a $50 million facility. asked to increase this limit by Sibillion. It was October 2008 and that was the amount GGC needed to refinance a convertible bond coming due on February 27, 2009. With a conversion price of $65, the current price was well out of the money at $18.40. GGC urgently needed to refinance and was facing a particularly challenging financing environment--a credit crunch which had begun in 2007 and was likely to continue into 2009. GGC was the world's third-largest gold producer, accounting for about 7% of global gold production. It operated 21 mining operations in 10 countries (Argentina, Australia, Brazil, Ghana, Guinca, Mali, Namibia, South Africa, Tanzania, and the U.S.) and conducted extensive exploration. Forty-one percent of its production came from deep-level hard-rock operations in South Africa As of December 31, 2007, GGC had hedged 10,4 million ounces of gold, nearly two years! production, a position which kept it from takitig advantage of rising gold prices in 2008. In anchgeu al aspects of the existing business model. sve all, the new team believed that the biggest task was to unwind the hedge book. They aimed receive 94% of the spot price in 2009 at $900/oz and 96% at $800/oz.. In early May 2008, GGC had announced a $1.6 billion rights issue in order to improve the company's financial flexibility and allow it to continue funding its principal development projects and exploration growth initiatives. The issue was successfully closed in July and was several times oversubscribed In October 2008, GGC's management team turned to Wallstreet Bank for a two-year bridging loan of $1 billion. Relationship manager Kapoor believed that GGC's new strategy would allow it to improve its performance by taking advantage of strong gold prices. At the same time, though, the company would be almost fully exposed to sudden declines in the volatile price of gold. Kapoor prepared the business credit application which indicated that the account would be highly profitable for Wallstreet. In addition, the bank could become a key relationship bank (a "primary Transaction bank") to GGC, with the potential for obtaining the business of restructuring the client's hedge book. However, the corporate bank's risk analysts raised a number of "broader issues"-including rapidly growing mining costs, reputational risk, and political risk (particularly in South Africa)--that the Group Credit Committee would have to consider. Required a) Given its strategy, what kind of risks does Wallstreet Bank face? b) What is your decision regarding the two credit proposals c) Calculate the Expected Loss, Economic Revenue, and Economic Profit for both proposals. What strikes you about the nature of risk quantification? d) Analyze the risk management process at Wallstreet Bank. What suggestions might you make to the CEO about improving the process