REPORT

Subject: Management of Commercial Banks (MCB) Course: MBA Tech. (Finance) College: Mukesh Patel School of Technology Management and Engineering, NMIMS Mumbai Group 1: 109 Ghanshyam Gupta 301 Balagopal Padmakumar 302 Harbir Singh Banga 402 Rishi Bajaj 503 Anirwan Bhattacharya

Case Study: Risk Management at Wellfleet Bank: Deciding about Megadeals Contents: Introduction What kind of Risk does Wellfleet Bank face? Overview of Proposal 1 and 2 Evaluation of Proposal 1 and 2

MCB Report Group 1: Wellfleet Bank Megadeals

Introduction
Wellfleet Bank was founded in London in the year 1847. In the days of British Empire the bank provided its services to Asian and African colony. However, during the period 1960 to 1990 the bank developed a global presence providing its services in North America and Europe. The banks profitability & capital were significantly reduced owing to the European property/credit crisis in 1989-1992. The bank later focused on its core markets in emerging economies while suspending its non-core activity in North America and Europe. In 2007, the bank operated in 55 countries (2007) with total assets of $329 billion and market cap of $51 billion. The bank had presence in about 78 nations by 2008 on account of several acquisitions it had undertaken. Wellfleet main competitor was Global Bank. Corporate Banking and Consumer Banking were the two main businesses the bank had undertaken which accounted for 58% and 42% of its Pre-Tax profits respectively. The bank focused more on the syndicated and leveraged loans segment to its large corporate clients. Syndicated loans were provided to a borrower through combined activities of several banks. Members in this consortium could reduce their overall exposure, each bearing only a part of any loss. Syndicated loans help small banks to participate in large transactions which otherwise was not possible for them. Leveraged loans were extended to companies that already had considerable amount of debt. As these loans carry a higher risk of default, the lender usually charged a higher interest rate and kept only a portion of loan on its Balance Sheet and transfers its exposure to other banks by selling down. Syndicated and Leveraged loans are carried through by Investment Banking division but Wellfleet did have an IB division, so it carried this business through its corporate banking division. The corporate bank worked as an IB and recruited relationship managers from leading investment banks and hired a senior risk officer, Catherine Richards. This gave Wellfleet a risk perspective while analysing its proposals. Between 2004 and 2006, the bank took around 40 deals in range of $500 - $750.
MCB Report Group 1: Wellfleet Bank Megadeals

Wellfleet was based in London even though majority of its customers resided outside UK. Wellfleet considered its first world regulatory compliance helps it to gain competitive edge over rivals in emerging market. Wellfleet Bank gave importance to internal controls and risk management as it considered them to be very crucial part of banking.

MCB Report Group 1: Wellfleet Bank Megadeals

What kind of risk does Wellfleet Bank face

Wellfleet Bank strategic intent was to pursue large transformational deals through its corporate banking segment. The group had a decision making forum consisting of three members namely the group chief credit officer, deputy group chief risk officer & group head of client relationships. As per the mantra of the bank: If a billion dollar deal went wrong it could sink the ship. As the deals pursued by the bank were of large scale in nature, these large scale credit applications itself counted as a mega risk facing Wellfleet Bank.

One important risk that the bank is facing is that there is no Risk Appetite Statement which defines the tolerance level the Group Credit Committee has the powers to approve deals of any size (upper limit for Group Credit Committee authority not defined). Further, the CEO/Board of Directors only reviews the corporate loan portfolio and do not have any direct involvement with the process. The Board has delegated responsibility for management of credit risk to the Group Credit Committee and hence do not control their decision. The Group Credit Committee does not report to the Board/Group Risk Committee. Group Credit Committee is the highest forum of credit approval.

MCB Report Group 1: Wellfleet Bank Megadeals

The bank had identified leveraged loans and syndicated loans as the future growth segments. However as leveraged loans are provided to borrowers with existing high debt the risk of default is high which could affect the bank significantly.

It is mentioned in the case that if the deputy group chief risk officer & group head of client relationships disagreed over a proposal then the Chief Credit Officer would take the ultimate decision. There lies a degree of operational risk in view of granting someone this kind of an ultimate authority.

Other risk that the bank is facing is there is a lack of a risk appetite statement to set the level of tolerance for corporate banking loans.

Broadly, the bank is facing the regulatory risk which is compliance with the Basel II standards, credit risk, increasing competition as well as the risk from acquisitions.

Concentration Risk - The bank has a very high concentration on its Corporate Banking Group. As per the case, Wellfleet corporate banking group constituted 58% of profit before taxes and 72% of banks assets in 2007 while the remaining portion is attributed to its consumer banking group. The consumer banking group accounted for bad debt provisions of $611 million in 2006 as compared to $214 million in 2004.

The structure of the bank (as shown in the figure above) was such that the credit officers would process a loan application and sign off the application in case the limits were under their powers. However in case the limits exceeded the credit officers powers then the proposal had to be passed on to the next level (to the regional credit officer) in the hierarchy. Likewise the Group Credit Committee was at the apex of the hierarchy. Also, the loan application had to be signed off at each level in the hierarchy (i.e. up to the level at which the loan is approved by the decision making authority)

The Risk Management Function at the bank consisted of the Relationship Managers who were responsible for generating leads and they viewed the proposal from the point of view of margins/fees that the bank could earn from

MCB Report Group 1: Wellfleet Bank Megadeals

the deal whereas the Senior Credit Risk Officers viewed the proposal both from its risk and reward perspective. There lies a challenge to manage these relationship managers/sales people in cases where the proposal is not lucrative for the bank. Other important aspect is that the bank has compartmentalized risk greatly. The various types of risk such as market risk, operational risk, reputational risk, credit risk, country risk, compliance risk etc all are managed and controlled by separate risk committees. However these different types of risk are all interrelated to each other and thus cannot be separated. The bank had its own internal credit risk assessment model summarized as
EL ($) = Probability of Default x Loss Given Default (%) x Exposure at Default ($)

EL ($) is the expected loss on the loan amount lent out by the bank. A risk here is that bank officials over-relied on these models to make a decision. However the bank also took into account the rating from external credit agencies such as Moodys. Risk Models must be used with other available data/experience to arrive at a judgement. The current industry scenario along with the changes in the industry must be factored in while arriving at a decision rather than simply entering data/financials in the model and deciding based upon the output of the model.

MCB Report Group 1: Wellfleet Bank Megadeals

Proposal 1
Client: Ashar Industries Requirements and Details: Underwrite upto $850 million of a EUR 8 billion facility for acquisition of Zellmonte SA Would be a partner to the Syndication of the facility that has been awarded to Bentleys, Cramer & Dougherty, MetGen(Bookrunners) who have been joined by ReinBank, Clouseau Brothers, Global Bank(Non-Bookrunners) Knoxville has approached Wellfleet to join as a sub underwriter

Background: Worlds largest steel producer (6% market share by volume) Specializes in low-end commodity steel. Production across developed markets (North America 40% sales (25% auto), Western Europe 33% sales) as well as developing markets (Algeria, Eastern Europe, Kazakhsthan, Sounth Africa and Ukraine) Controlled by Amit Asher and family having several unconsolidated JVs (eg. Telmak Steel) Credit analysis: Challenges Integration risk with the Target company Need to further streamline the complex debt structure of present company Possible real break off in hostile takeover Possible political risk of Zellmonte SA

MCB Report Group 1: Wellfleet Bank Megadeals

Strenghts Worlds largest steel maker Diversified revenue stream High level of raw material integration Good financial performance, high EBITDA margins and FCF generation

Ratings Agency Wellfleet Grade Moody S&P Return to the Bank Explicit In 1st year 52.5bp Additional 20bp-underwriting fee (10bp on agreement, 10bp on close of general syndication) Drop dead fee 10bp (incase acquisition fails) Rating 5A Baa3/ review for downgrade BBB+/watch negative

Future Scope Total Possible earnings in medium term - $1050000 comprising of o Foreign Exchange Wallet $250,000 o Interest Rate Derivatives Wallet $300,000 o Commodities Wallet $250,000-500,000

MCB Report Group 1: Wellfleet Bank Megadeals

Other opportunities include Project finance, future M&As advisory, and structured finance

Broader Picture Integration track record is good Management under control effectively by promoters and family Complex structure, several unconsolidated joint ventures and associates. However company claimed to have no unconsolidated debt. Management track record of turning around underperforming assets to date good Clean audit reports Strong record of leveraging to acquire and then de-leveraging Deal expected to be 25% Debt-75% Equity Wellfleet Reputational Risk Committee clears name Several claims against environmental issues Competitive practices abuse cases against company in EU Industry Issues: o Wellfleets exposure to the steel industry is currently $1.2bn, 5%of risk weighted assets. o Due to high fixed costs in their cost structure, steel companies display sensitivity to product price movement. o Supply and demand match over the last 10years o Future growth: continued expansion in capacity in China and India

MCB Report Group 1: Wellfleet Bank Megadeals

Proposal 2
Client: Gatwick Gold Corporation Requirements: Refinance $ 1 Billion Convertible-Bond Financing Background: GCC was worlds third largest gold producer, accounting for about 7% of global gold production. It operates in 21 mining operations in 10 countries across the globe and conducted extensive exploration. 41% of its production came from the deep-level hard rock operations in South Africa. Credit Analysis: Challenges: Need to refinance $ 1 billion convertible bond due to expire on 27th February 2009. Total Debt to EBITDA was 800% in 2007. Debt protection: EBITDA to interest expense was -3.1% in 2007, showing a diminishing curve since 2003. Strengths: The worlds 3rd largest gold producer with 7% of global gold production. Diversified production base. Low-cost producer( in the lower 50% of global cost curves on average across all their mines)

MCB Report Group 1: Wellfleet Bank Megadeals

Ratings: Agency Wellfleet Grade Moody S&P GCC- Broader Issues Commodity prices/Hedging: The single largest risk for GGC in the long term would be sustained fall in the gold price. The risk trigger is gold price under $ 650/oz. During the recent commodity price turmoil, the gold price has only been below $700 on one day. Low prices would make some of its mines uneconomic and would impact investment capex and exploration. Mining-cost inflation: Mining costs are growing rapidly globally. Electricity: Mines are heavy users of electricity. Electricity costs will increase in line with the energy-price increases. Labour: Labour costs in South Africa are increasing by around 12% PA Equipment: Industry demand for new equipment was very strong from 2004- 2007, with sharp price increase, but the pressure is now starting to ease with Capex cutbacks across the industry. Cost inflation in GGCs operations over the past 21 months has been appox. 21% in $ terms. The rate is likely to slow down with the depreciation of the ZAR, fall in disel prices, and fall in demand for mining equipment. Productivity investment will begin to pay dividends. Political Risk: Rating 5B NA NA

MCB Report Group 1: Wellfleet Bank Megadeals

Around 72% of current production is in Sub-Saharain Africa. Gold is a key export and cash generator for all 6 African Countries.

Diversification of mines (21mines across 10 countries) mitigates risk.

Black Economic Empowerment: BEE is a program launched by the South African Government to redress the inequalities of the apartheid by giving, historically disadvantaged South Africans economic opportunities previously not available to them. In terms of mining, companies are required to convert their existing licences into a new generation of mining licences. Companies that dont comply with BEE legislation, which most importantly includes the provision of transfer of ownership of equity or assets to BEE. Shareholder Distribution: Company presently distributes 20% of earnings as dividends.

Management Team: Good all-round mining experience supported by well-connected African-oriented board. Acquisitions are for shares and not for cash.

Industry Issues: Financial profile of the gold industry is characterized by: heavy investment in FA; 2+ year development period, very high fixed costs. Due to high fixed costs in their cost structure, gold mining companies display extreme sensitivity to product price movements.

MCB Report Group 1: Wellfleet Bank Megadeals

Economic and Financial Analysis

Kindly refer to the Excel sheet for detailed calculations and comments.

Some Highlights Particulars

Expected Loss Total Revenue Risk Adjusted Revenue Economic Revenue Economic Profit

Proposal 1
10,63,282.00 78,62,500.00 67,99,218.00 45,99,218.00 22,73,505.00

Proposal 2
20,37,750.00 77,50,000.00 57,12,250.00 19,12,250.00 6,92,250.00

Proposal 1
CAGR over the last 3 financial years of Revenue has been at 74.84% while that of EBIT has been at a phenomenal 180.52% There has been a steady and healthy growth in Net Income of over 17.68% over the last 3 years The company has bounced back from the slump period in 2002-03 indicating the ability of the management to turnaround underperforming assets In the recent years, the company has increased its long term borrowings for investment activities raising its D/E ratio to 0.82 in 2005 from the previous 0.34 Company has a history of overleveraging to acquire assets and then deleveraging (seen during 2002-03 and again in 2004-05) Debt servicability ratios are healthy at 13-17 times the EBIT and EBITDA.

Proposal 2 While Revenue has grown at a CAGR of 12.48% over the last 3 years, the
profitability has taken an enormous hit with EBIT having a negative growth
MCB Report Group 1: Wellfleet Bank Megadeals

 There is a negative net income (loss) in the last 3 financial years The company has shown decrease in EBITDA margin from 27.6% to 7.20% in the
past year having a negative ROI in the present year.

The EBIT to interest expense is negative indicating the inability of the firm to service the present debts it has undertaken.

Closing Statements
From the Economic and Financial Analysis of the two proposals it can be seen clearly that Proposal 1 (Ashar Industries) seems to be in strong financial position, growing at at a rate higher than industry standards and is in the hands of experienced management that has a history of turning around unproductive assets. It has experience in several acquisitions and mergers, however the financial structure is complex and the current debt taken is at very high levels. The company though has a history of heavy leveraging for acquisition of assets and then deleveraging heavily as seen in the past. Proposal 2 on the other end, of GGC is in the red. Having negative growth over the past 3 years, the statements show of loss and the company is unable to service its present debt. Much harm has been caused to the company by the decision to hegde its gold prices for the future two years in 2005. However the future outlook of must be considered with respect to the industry it operates in. A broader view must be taken with respect to the two companies, and one must ascertain the exact use of funds in case the acquision by Ashar Industries does not turn successful before approving the facility. However, we suggest the Bank stay away from GGC until it turns profitable.

MCB Report Group 1: Wellfleet Bank Megadeals

Party
Wellfleet Rating- 5A Loss Given Default (LGD) Draw amount Expected Loss (EL)

Ashar Industries
Probability of Default (PD) 0.22% 56.86% 85,00,00,000.00 (Eight hundred fifty million US $) 10,63,282.00 Draw Amount *PD*LGD

Interest Income (bp) Fee Income Underwriting fee (bp) Participation fee (bp)

52.5 20 20

44,62,500.00 Total Interest Income 17,00,000.00 17,00,000.00 34,00,000.00 Total Fee Income 78,62,500.00 67,99,218.00 22,00,000.00 45,99,218.00 8,25,713.00 15,00,000.00 22,73,505.00 Economic Revenue - Tax - Transaction Cost RAR - Net Capital Charge Total Interest Income + Fee Income Total Revenue (TR) - Total Expected Loss (EL)

Total Revenue Risk Adjusted Revenue (RAR) Net Capital Charge Economic Revenue Transaction Cost Tax Economic Profit

Party
Wellfleet Rating- 5B Loss Given Default (LGD) Draw amount Expected Loss (EL)

Gatwik Gold Corporation

Probability of Default (PD) 0.39% 52.25% 1,00,00,00,000.00 (One billion US $) 20,37,750.00 Draw Amount *PD*LGD

Interest Income (bp) Fee Income Underwriting fee (bp) Participation fee (bp)

47.5 30 0

47,50,000.00 Total Interest Income 30,00,000.00 0.00 30,00,000.00 Total Fee Income 77,50,000.00 57,12,250.00 38,00,000.00 19,12,250.00 3,00,000.00 9,20,000.00 6,92,250.00 Economic Revenue - Tax - Transaction Cost RAR - Net Capital Charge Total Interest Income + Fee Income Total Revenue (TR) - Total Expected Loss (EL)

Total Revenue Risk Adjusted Revenue (RAR) Net Capital Charge Economic Revenue Transaction Cost Tax Economic Profit

Ashar Financials
2002 Income Statement 2003 2004 2005

2002-03 95.68% 87.01% 330.38% 536.74% -5733.33% -3.85% 2312.24%

2003-04 132.02% 67.07% 242.76% 358.29% 338.07% 32.50% 297.72%

2004-05 17.73% 49.91% -4.32% -24.35% -23.32% 27.92% -28.42%

CAGR 3 years CAGR 2 years 74.84% 67.31% 141.67% 180.52% 480.84% 17.68% 309.51% 65.27% 58.26% 81.09% 86.19% 83.28% 30.19% 68.73%

Revenue D&A EBITDA EBIT PBT Interest Expense Net Income Minorities
Cash Flow

4889 177 395 215 -24 -208 49 0

9567 331 1700 1369 1400 -200 1182 35

22197 553 5827 6274 6133 -265 4701 615

26132 829 5575 4746 4703 -339 3365 520

7000 6000 5000 4000

Funds from Operations(FFO) Change in WC cash From operations(CFO) Gross CAPEX Other Investments/acquisitions Cash from investing activities Cash Dividend
Balance Sheet

150 18 168 -108 28 -80 0

1413 -93 1320 -421 -275 -696 -164

5784 -1171 461 -898 95 -803 -736

4511 -537 3974 -1181 -6431 -7612 -2092

Cash & Eq. Marketable Securities Fixed Assets Total Assets Short term debt Long term debt Gross debt Net debt/(Cash) Common Equity Minority Interest Shareholder's equity
Profitability

77 0 3035 5512 262 2022 2284 2207 128 0 128

760 0 4654 10137 760 2287 3067 2307 2561 261 2822

2495 1 7562 19153 341 1639 1980 -516 5846 1743 7589

2035 14 15539 31190 252 8056 8308 6259 10150 1834 11984

3000 2000 EBITDA 1000 0 1 -1000 2 3 4 EBIT PBT Interest Expense Net Income

EBITDA margin EBIT margin Net margin ROE Return on Capital Employed
Capital Structure

8.10% 4.50% 1% 21% -0.80%

17.80% 14.30% 12.40% 87.90% 3.40%

30.80% 28.30% 21.20% 111.80% 7.20%

19.80% 16.90% 12.00% 42.10% 2.80%

Total debt to common equity Net debt to common equity Total debt to EBITDA Net debt to EBITDA Hostoric market cap
Debt Protection

17.84 17.24 5.78 5.59 267.00

1.20 0.90 1.80 1.36 5679.00

0.34 -0.09 0.29 -0.08 23708.00

0.82 0.62 1.49 1.12 16879.00

EBIT to interest expense EBITDA to interest expense EBITDA - CAPEX to interest expense

1.00 1.90 1.40

6.80 8.50 6.40

23.70 25.80 22.40

14.00 16.40 13.00

GGC Financials
2003 Income Statement 2004 2005 2006 2007

2003-04

2004-05

2005-06

2006-07

CAGR 4 years CAGR 3 years CAGR 2 years

Revenue D&A EBITDA EBIT PBT Interest Expense Net Income Minorities
Cash Flow

2109 280 878 618 676 48 515 18

2297 409 642 233 116 80 113 19

2632 505 682 177 -175 99 -198 23

2975 602 820 219 127 117 -87 30

3269 590 235 -354 -428 113 -605 31

8.91% 14.58% 13.03% 9.88% 11.58% 12.48% 11.45% 46.07% 23.47% 19.21% -1.99% 20.48% 12.99% 8.09% -26.88% 6.23% 20.23% -71.34% -28.07% -28.47% -41.30% -62.30% -24.03% 23.73% -261.64% #NUM! -214.96% #NUM! -82.84% -250.86% -172.57% -437.01% #NUM! -254.52% -256.39% 66.67% 23.75% 18.18% -3.42% 23.87% 12.20% 6.84% -78.06% -275.22% -56.06% 595.40% #NUM! -274.94% -274.80% 5.56% 21.05% 30.43% 3.33% 14.56% 17.73% 16.10%

Funds from Operations(FFO) Change in WC cash From operations(CFO) Gross CAPEX Other Investments/acquisitions Cash from investing activities Cash Dividend
Balance Sheet

525 -64 461 -363 55 -308 -328

579 -121 458 -585 -231 -816 -205

667 -112 555 -723 -63 -785 -165

1224 -129 1095 -818 57 -761 -135

1027 -176 851 -1021 -38 -1059 -149

1000 800 600 400

Cash & Eq. Marketable Securities Fixed Assets Total Assets Short term debt Long term debt Gross debt Net debt/(Cash) Common Equity Minority Interest Shareholder's equity
Profitability

503 0 2753 4838 350 804 1154 651 1621 53 1674

288 26 5870 8176 318 1282 1600 1286 3142 58 3199

210 8 5911 8303 188 1708 1896 1678 2617 59 2676

496 0 6065 8961 59 1426 1485 989 2990 62 3053

493 0 6672 9747 337 1522 1858 1365 2362 63 2424

200 0 1 -200 -400 -600 -800 2 3 4 5 EBITDA EBIT PBT Interest Expense Net Income

EBITDA margin EBIT margin Net margin ROE

Capital Structure

41.60% 29.30% 24.40% 33.50%

27.90% 10.10% 4.90% 5.10%

25.90% 6.70% -7.50% -7.30%

27.60% 7.30% -2.90% -3.10%

7.20% -10.80% -18.50% -23.00%

Total debt to common equity Net debt to common equity Total debt to EBITDA Net debt to EBITDA Hostoric market cap
Debt Protection

0.71 0.40 1.31 0.74 10467

0.51 0.41 2.49 2.00 9311

0.72 0.64 2.78 2.46 13103

0.50 0.33 1.81 1.21 13045

0.79 0.58 7.89 5.80 11848

EBIT to interest expense EBITDA to interest expense EBITDA - CAPEX to interest expense

12.90 18.30 10.70

2.90 8.10 0.70

1.80 6.90 -0.40

1.90 7.00 0.00

-3.10 2.10 -7.00