Wells Fargo
Risk Management

“Risk comes from not knowing what you’re doing.”—Warren Buffet

2014
Jovan Gonzalez
University of Texas at San Antonio
2/11/2014
Wells Fargo
Risk Management

“Risk comes from not knowing what you’re doing.”—Warren Buffet

2014
Jovan Gonzalez
University of Texas at San Antonio
2/11/2014

Overview
When it comes to managing key risks that financial institutions face such as, credit risk, asset/liability interest rate and market risks, Wells Fargo Board of Directors (Board) and senior management are ultimately responsible for managing these risks. Along with the help of different committees such as, The Board’s Credit Committee, who manages the annual credit quality plan, lending policies, credit trends, and high risk portfolios and concentrations. The Finance Committee manages the company’s major financial risks such as, interest rate, and market/price risk with the help of the Corporate Asset/Liability Management Committee (ALCO), who meet periodically with each other. Although there are much more committees that are in charge of overseeing other risks, for the purpose of this paper I’m mainly focusing on credit risk, market risk, and interest rate risk. According to Wells Fargo’s annual report, each Board committee receives reports and information regarding risk issues directly from senior management, who meets directly with the CEO every week to discuss strategic risk issues at the operational level. Wells Fargo also has a Chief Risk Officer (CRO), who among other things manages the company’s credit, market, and operational risks. Effective risk management is very essential to Wells Fargo success and growth moving forward.

Price Risk/Interest Rate Risk
Define- When interest rates change, it has an inconsistent impact on assets and liabilities causing a loss in net worth. This is especially true for banks such as Wells Fargo. For example assets and liabilities may mature or re-price at different times, short-term and long-term interest rates may chance by different amounts, and interest rates may have a direct or indirect effect on loan demand. So managing this risk is important to Wells Fargo because both sides of the balance sheet are sensitive to interest rates.
Measure- Wells Fargo uses different risk measures to value the frequency of a loss or gain and the severity of a loss or gain. The first measurement the company uses to assess interest rate risk is a scenario analysis. The company compares “different outcomes under various earnings simulations using many interest rate scenarios that differ in the direction of interest rate changes, the degree of change over time, the speed and the projected shape of the yield curve.” These scenarios require assumptions regarding how changes in interest rates and related market environments could influence drivers of earnings and balance sheet structure (prepayment speeds, deposit balances and mix). Some other risk measures the company uses specifically for assets/liabilities include net interest income sensitivity (interest earned on loans), interest rate sensitive noninterest income and expense impact. The company likes to refer to the combination of these exposures as interest rate sensitive earnings. Currently the company is positioned to benefit from higher interest rates, such that net interest income will benefit as their assets re-price faster than their liabilities, and if rates are low, assets will re-price downward faster than their liabilities. The main driver for interest rate sensitive noninterest income and expense impact is mortgage activity, which tend to move in the opposite direction of their net interest income. The degree to which these sensitivities offset each other depends upon the timing and level of changes in interest rates.

The chart above was taken from their annual report and just shows different scenarios of earning estimates at risk over the next 24 months, ranging from low to high interest rates. Another popular risk measurement that Wells Fargo uses is the Value-at-Risk (VaR). According to their annual report Wells Fargo defines VaR as a “statistical risk measure used to estimate the potential loss from adverse market moves on trading and other positions carried at fair value.” The VaR is used to measure the worst expected loss over a given time period and within a given confidence interval. Wells Fargo has a confidence interval of 99% and measure and report daily VaR based on actual changes in rates and prices over the previous year. A 99% confidence interval means that 1% of the time, Wells Fargo expects to lose a certain loss or more. The company uses an historical simulation approach to calculate VaR and is used to identify critical risk factors of a trading position regarding interest rates. These risk factors for each position are updated on a daily basis. The table below shows the company’s regulatory general VaR measures for 2012.

The last most common risk measurement the company use is stress testing. Stress testing is used to measure how well a firm’s assets and liabilities will do during an extreme market event. Wells Fargo runs different scenarios to estimate the risk of losses based on what management considers is abnormal but severe market movements. Some examples they use are severe credit spread widening or a large decline in equity prices. The stress scenarios are reviewed on a daily basis by senior management.
Mitigate- To help hedge themselves against interest rate risk, Wells Fargo uses over-the-counter (OTC) derivatives, and an available-for-sale portfolio, which consist of debt and marketable equity securities. Theses debts securities are highly liquid, screened on high quality, privately issued mortgage back securities (MBS), and corporate debt securities. The Board and Corporate ALCO manage these highly liquid assets with in capital risk limits. They also use futures, and interest rate swaps to convert certain fix-rate long-term debt to floating rates to hedge their exposure to interest rate risk.
For the asset/liability management process, Wells Fargo uses derivatives to minimize volatility in earnings. The use of these derivatives helps modify the re-pricing in assets and liabilities so that interest rate changes don’t have a significant effect on margins or cash flows.

Credit Risk
Define- Loans are considered a big chunk of assets on Wells Fargo balance sheet and to them, credit risk is the most important risk they manage. According to the company’s annual report Wells Fargo defines credit risk as “the loss associated with a borrower or counterparty default (failure to meet obligations in accordance with agreed upon terms).” As you can see in the table below, Wells Fargo has a total of almost $800 million in loans outstanding, so if customer were to default they would be in a lot of trouble.

Measure- The way Wells Fargo measures credit risk is by establishing in what they believe is a good credit policy for underwriting new business, while reviewing the performance on existing loans. This is known as an internal rating approach. The company pays close attention to their loan portfolio to track any overdue payments, collateral values, FICO scores, and economic trends. By doing this frequent monitoring, Wells Fargo is more able to identify if any risk are starting to develop. Thus, if any suspicion of risk, they can come up with an appropriate allowance for credit losses. To come up with a certain amount is based off forecast of the future (stress testing), and catastrophic economic events that may cause borrowers to default on their loans. The company has a statistical model and analytical tools that runs these different scenarios to calculate a specific amount. This process is critical to Wells Fargo financial results and condition.
Mitigate- The allowance for credit losses is essentially the amount (limit) the bank needs to try and reserve, which they charged to their earnings. For December 31, 2012, they believed an appropriate allowance for credit losses of $17.5 billion. To help minimize credit risk Wells Fargo invests mainly in Credit Default Swaps (CDS). By using derivatives, Wells Fargo exposes themselves to counterparty credit risk if counterparties to the derivative contracts underperform expectations. They manage this risk by entering into offsetting trades or by taking short positions (put options). The graph below shows derivative products they invested in so that they can protect themselves from credit counterparty risk.

Conclusion
After reviewing Wells Fargo’s risk management process, I believe that they are doing a good job in managing their risk. Although they have many models that run different scenarios, who’s to say that their numbers are right. They have seemed to be doing really well since the recession and after reviewing their risk management process I think they have learned from others mistakes.