FINANCE MANAGEMENT 2: Banking and Financial Institutions

Norwest Corporation Case Analysis

Submitted by: BONITA, Majorie BORJA, Kristian Dan CABADING, Joncarlo CABUGSA, Sheila May CAHARIAN, Blesilda CALOTES, Nia Marie CASINILLO, Michelle CAVALIDA, Sheenika CEJO, Denise Kenneth

Submitted to: Ms. Lilibeth Celesios FINM 2 E

August 2013

I.

Executive Summary Norwest Corporation has three (3) major components namely Norwest Banks, Norwest Mortgage, and Norwest Financial. These provided the corporation with an enormous diverse base of earning assets. The corporation also celebrated, early 1997, a historic achievement the net income exceeded $1 billion. The direction, on the other hand, of the interest rates is uncertain. Experts assumed that the Fed will soon increase the rate to be ahead with possible inflation pressures. This will greatly affect the corporation because even though they have achieved a more than $1 billion net income, their current interest-sensitivity position makes the corporations earning vulnerable to the changes in the rates.

II.

Statement of the Problem With the current assumptions of some experts that the Fed would soon raise the rates, the corporation is in a vulnerable position. Considering also the corporations current interest-sensitivity position which might led to lowering their earnings. The problem therefore is how the corporation will cut the cost of the possible rise of rates to their earnings and how to properly manage their portfolio so that the effect to them will be minimized.

III.

Areas of Consideration 1. Feds plan of raising rates soon to try to get ahead of possible upcoming inflation pressures The current interest-sensitivity position of the corporation makes this area an important part to consider. The corporation will be greatly affected with the changes or movements in the rates. 2. Accounting perspective and Economic perspective These are two (2) ways or methods of defining the interest-rate risk off the corporation. The corporation draws on aspects of each perspective to provide a complete picture of the interest-rate risk. 3. Questions raised in the last part of the case The questions raised somewhat key solutions in answering the concerns of the corporations. The answers to these questions are presented in Exhibit 1 of this paper.

IV.

Decision Criteria and Alternative Solutions The corporations expenses are increasing as the years pass by. Cutting some of the corporations expenses may help them in their earnings when rates will soon increase. There would be fewer expenses to be deducted to their income which will leave them more. However, cutting expenses may affect the corporations operation. The performance will not be their best anymore.

1. The bank should minimize their expenses.

2. The bank may not declare some dividends to preferred shares or common shares. Investors expect dividends or returns from their investments. Not declaring dividends, as of the moment, can help the corporation in their earnings. Cost of capital in equity demands a higher cost and is also the most expensive which will increase the outflow of cash or asset in the corporation. On the other hand, not declaring dividends, as of the moment, will dismay some of the investors who are expecting declaration of dividends annually. 3. Acquire financial leverage for funds to generate daily operations and also finance charges are tax deductible item which means, more income is left for to the bank. Since there will be an expected increase in rates, the corporation should be prepared. They can acquire leverage which can support the corporations operation. In this way, the corporation continues their operations, reduces earning risk, and cut some of its cost.

4. To have higher retained earnings, higher revenue is necessary in availing more leases and loans and other interest bearing account that may result to an income to the bank. Though it assumed and expected that Fed will increase the rates, the corporation cannot stop its operations. It should still continue. An alternative that can be done probably would to shift the corporations attention to another offer which may earn more. In this way, they can cut some cost it may incur and also, continue earning.

V.

Recommended Solution, Implementation, and Justification The corporation can take either solution 4 or 5. Both cut some of the corporations cost, allow the corporation to continue their operation, and reduce the reduction of earnings. With solution 4 and 5, the corporation can venture their different offers which can supply them with income. They should assure only that the offers which they have not focused as of the moment wont be a complete obsolete. It is because the customers under those offers may be undercompensated or be felt out by the company.

Exhibit 1: Answers to the questions presented in the case 1. The factors that show weaknesses in the prediction and methodology for creating the interest-rate sensitivity gap report are the following: a. The period for appropriately determining the rate sensitivity of assets and liabilities is not clear. b. Cannot readily classify items that have no stated maturity or pay no interest. c. Interest rates on various balance sheet items may not change in the same level. d. The bank management may not be an expert in predicting the movement of interest rate. 2. Interest rate-sensitivity gap information serves as a preparatory tool for Norwest Corporation to estimate the impact of rising interest rates on their earnings if it will be dangerous for the bank or how would the earnings get affected to that. This also gives approximate view of the interest rate risk of the balance sheet being analyzed. Overall, it gives the estimate/approximate view about interest rates on earnings. 3. Norwest uses a simulation model as its primary method in determining accounting risk. In this methodology, the corporation's income is subject to risk of the changes of interest rates from one period to another or for a gap in the years of reporting. In a simulation model, the corporation can predict the trends in the balance sheet for the years to come. In determining economic risk, Norwest uses the market valuation model wherein the market values of assets and liabilities are computed by calculating the present value of all cash flows they generate using a market interest rate chosen by the corporation which reflects the possible characteristics of an asset or liability. The accounting perspective focuses on the risk of the reported net income over a particular time frame and the economic perspective focuses on the risk to the market value of the corporation's balance sheet. 4. The difficulties in the art of earnings simulation model is sometimes it can be less accurate in the sense that its only a view on interest rate risk. It can also face difficulties in foreseeing the future if some information that it will need are not available. It is a preferred method for measuring interest rate risk because it can capture the effects of the future balance sheet trends, different patterns of rate movement, and changing relationships between rates. It can also capture the effects of embedded

option risk by taking into account the effects of interest rate caps and floors, and varying the level of prepayment rates on assets as a function of interest rate. 5. In the market value model, the difficulty is that the chosen interest rate is less than, more than, or extremely far from the real interest rate which does not reflect the true worth of the asset or liability. The market interest rate chosen should be able to bring about the possible characteristics of an asset or liability. 6. Let us assume that the interest rates will materially rise in the year 1997 and that will cause a drop of earnings. These are practical ways that could be done to reduce the size of the earnings reduction: a. The bank should minimize their expenses. b. The bank may not declare some dividends to preferred shares or common shares. c. Acquire financial leverage for funds to generate daily operations and also finance charges are tax deductible item which means, more income is left for to the bank. d. To have higher retained earnings, higher revenue is necessary in availing more leases and loans and other interest bearing account that may result to an income to the bank.