RISK MANAGEMENT APPROACH
According to the Risk Management section of Wells Fargo’s 2011 Annual Report, to be successful they manage and control three major business risks: credit, asset/liability, and market risk. As for this paper, I’m only going to discuss about their credit and interest rate risk, which is managed under their asset/liability section. Wells Fargo has continued to invest in its risk infrastructure especially since it is a larger and more complex company than before it merged with Wachovia. Wells Fargo’s Senior Executive Vice President and Chief Risk Officer, Michael Loughlin states that they have three lines of defense for managing the risks:
“Our businesses own the risk, have their own risk personnel, and are the first line of defense. Corporate risk is the second line of defense. Internal audit is the third line of defense” (Loughlin PDF 6).
I have also read and analyzed Wachovia’s last Annual Report before the merger with Wells Fargo at the end of 2008. I believe the reason Wells Fargo is far more successful than Wachovia was is because while Wachovia believed their “proactive” risk management approach was a competitive advantage due to “greater customer satisfaction and enhanced reputation”, Wells Fargo believes that their competitive advantage comes from them taking risks only when they understand them (Wachovia Annual Report 37). In addition, Wells Fargo is very effective in managing and controlling their interest rate risk and credit risk.
INTEREST RATE RISK
As discussed in class, Wells Fargo defines interest rate risk as the probability that rates will rise or fall, which can affect their earnings. They believe interest rate risk “potentially can have a significant earnings impact” (WFC Annual Report 78). There are four reasons that Wells Fargo stated as to why they are exposed to interest rate risk. They are: * If interest rates are falling and assets are repricing faster than liabilities, then earnings will suffer a loss. * If interest rates are falling, the rates paid on checking and savings deposit accounts may be reduced by an amount that is less than the decline in market interest rates. In other words, assets and liabilities are being repriced by different amounts but at the same time. * The shape of the yield curve may affect new loan yields differently. * As interest rates change, the remaining maturity of different assets and liabilities may change as well. In my opinion, Wells Fargo does a good job of preparing for all scenarios. They take into consideration what would happen if rates are rising or falling as well as if the yield curve is flattening or steeping. They not only look at which direction the interest rates are moving but how they are moving.
Wells Fargo measures interest rate risk by comparing their earnings plan with several earnings simulations using the many stated interest rate scenarios above. These simulation estimates change with the size and mix of Wells Fargo’s balance sheet at the time of each simulation. Due to the differences in their duration of assets and duration of liabilities, Wells Fargo’s “earnings at risk in any particular quarter could be higher than the average earnings at risk over the 12-month simulation period” (WFC Annual Report 80). For example, Wells Fargo’s most recent simulation showed them having estimated earnings at risk at less than 1% over the next year under a range of both low and high interest rates. The higher average of their earnings at risk, of course, depends on the path of interest rates and their hedging strategies for mortgage servicing rights (MSRs). Wells Fargo’s hedging activities are intended to balance their mortgage banking interest rate risks. However, they understand that the instruments that they use to do this may not perfectly correlate with the values and income being hedged.
Wells Fargo uses exchange-traded...