Introduction to Risk Management Citibank

Introduction to Risk Management 05/15/96

Introduction to Risk Management

Warning This workbook is the product of, and copyrighted by, Citicorp North America, Inc. It is solely for the internal use of Citicorp North America, Inc., and may not be used for any other purpose. It is unlawful to reproduce the contents of these materials, in whole or in part, by any method, printed, electronic, or otherwise; or to disseminate or sell the same without the prior written consent of Training and Development Centers - Asia Pacific / CEEMEA / Latin America. Please sign your name in the space below.

Table of Contents

Table of Contents INTRODUCTION Introduction: Risk Management Module.............................................................vii Overview..................................................................................................... vii Introduction to Risk Management .........................................................................xi Overview...................................................................................................... xi Objectives ................................................................................................... xi Topics......................................................................................................... xii The Workbook ........................................................................................... xii UNIT 1: Risk Categories Introduction....................................................................................................................... 1-1 Unit Objectives................................................................................................................. 1-1 Major Risk Categories.................................................................................................... 1-2 Credit Risk ....................................................................................................................... 1-3 Lending Risk........................................................................................................1-4 Direct Lending Risk................................................................................ 1-4 Contingent Lending Risk....................................................................... 1-4 Issuer Risk............................................................................................................1-5 Counterparty Risk................................................................................................1-6 Pre-settlement Risk................................................................................ 1-6 Settlement Risk ...................................................................................... 1-7 Clearing Risk .......................................................................................................1-8 Summary — Credit Risk.....................................................................................1-8 Market Risk...................................................................................................................... 1-9 Price Risk.............................................................................................................1-9 Interest Rates .......................................................................................... 1-9 Commodity Prices................................................................................1-10 Volatility in Options ..............................................................................1-11 Liquidity Risk .....................................................................................................1-11

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UNIT 1: Risk Categories (Continued) Funding Liquidity Risk.........................................................................1-12 Trading Liquidity Risk..........................................................................1-12 Market Risk in Credit-related Products ..........................................................1-12 Issuer Risk.............................................................................................1-13 Pre-settlement / Settlement Risk .......................................................1-13 Summary — Market Risk .................................................................................1-13 Other Major Risks..........................................................................................................1-14 Equity Risk .........................................................................................................1-15 Country Risk.......................................................................................................1-15 Political (Sovereign) Risk....................................................................1-16 Convertibility Risk ................................................................................1-16 Transfer Risk.........................................................................................1-16 Fiduciary Risk....................................................................................................1-17 Documentation Risk..........................................................................................1-18 Disclosure Risk .................................................................................................1-18 Legal and Regulatory Risk ...............................................................................1-19 Systems Risk.....................................................................................................1-19 Summary — Other Major Risks .......................................................................1-20 Examples of Product-related Risks.............................................................................1-21 Trade Finance ...................................................................................................1-21 International Securities Services — Custody.................................................1-22 Operational Risk: Settlement.............................................................1-23 Credit Risk: Settlement.......................................................................1-23 Operational Risk: Post-settlement....................................................1-23 Unit Summary ................................................................................................................1-24 Progress Check 1 .........................................................................................................1-25 UNIT 2: Citibank's Risk Management Organization Introduction....................................................................................................................... 2-1 Unit Objectives................................................................................................................. 2-1 Overview of the Risk Management Organization......................................................... 2-1 Management Committee................................................................................................ 2-3

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UNIT 2: Citibank's Risk Management Organization (Continued) Credit Policy Committee (CPC).................................................................................... 2-4 Market Risk Policy Committee (MRPC)....................................................................... 2-6 Summary  Management Committee, CPC, MRPC.....................................2-8 Line Management ........................................................................................................... 2-8 Credit Risk Management ...................................................................................2-9 Senior Credit Officers...........................................................................2-11 Senior Securities Officers....................................................................2-11 Market Risk Management ................................................................................2-12 Summary — Line Management.......................................................................2-12 Business Risk Review (BRR) ......................................................................................2-13 Portfolio Risk Assessment...............................................................................2-14 Process Assessment........................................................................................2-14 Unit Summary ................................................................................................................2-15 Progress Check 2 .........................................................................................................2-17

Unit 3: Managing Credit Risk in Citibank Introduction....................................................................................................................... 3-1 Unit Objectives................................................................................................................. 3-1 Overview of the Credit Process..................................................................................... 3-2 Credit Management Model ................................................................................3-2 Phase I: Portfolio Strategy and Planning .................................................................... 3-4 Concentration Limits...........................................................................................3-5 Credit Policies.....................................................................................................3-6 Business Strategy...............................................................................................3-6 Target Market and Risk Acceptance Criteria ..................................................3-7 Line Management Responsibility......................................................................3-8 Phase II: Credit Origination and Maintenance ............................................................ 3-9 Origination............................................................................................................3-9 Evaluation.............................................................................................................3-9 Approval.............................................................................................................3-10 Monitoring and Maintenance............................................................................3-11

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UNIT 3: Managing Credit Risk in Citibank (Continued) Problem Recognition...........................................................................3-12 Remedial Management ......................................................................3-13 Citibank’s Credit Classification System.........................................................3-15 Distribution to Investors ....................................................................................3-17 Summary — Phases I and II .............................................................................3-18 Phase III: Performance Assessment and Reporting.................................................3-19 Portfolio Monitoring ...........................................................................................3-19 Relationship ..........................................................................................3-19 Customer (Obligor)...............................................................................3-19 Facility....................................................................................................3-20 BRR Portfolio and Process Reviews ..............................................................3-21 I. Business Strategy, Staffing, and Organization...........................3-22 II. Risk Origination and Structuring...................................................3-22 III. Structuring and Distribution ...........................................................3-23 IV. Transaction Monitoring, Maintenance, and Collection ............3-23 V. Portfolio Management ..................................................................3-24 Summary............................................................................................................3-24 Progress Check 3.1 ......................................................................................................3-29 Portfolio Management ..................................................................................................3-39 Objectives of a Portfolio Management System..............................................3-40 Risk Ratings.......................................................................................................3-40 Loss Norms........................................................................................................3-41 Citibank's Risk Ratings ....................................................................................3-42 Customer (Obligor) Risk Ratings ....................................................................3-45 Facility Risk Ratings .........................................................................................3-45 Risk-Adjusted Earnings....................................................................................3-46 Summary............................................................................................................3-47 Progress Check 3.2 ......................................................................................................3-49

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UNIT 4: Managing Market Risk in Citibank Introduction....................................................................................................................... 4-1 Unit Objectives................................................................................................................. 4-1 Overview of the Market Risk Process........................................................................... 4-2 Managing Price Risk ..........................................................................................4-2 Managing Liquidity Risk .....................................................................................4-4 Funding Liquidity Risk........................................................................... 4-5 Trading Liquidity Risk............................................................................ 4-6 Market Risk Management Organization....................................................................... 4-6 MRPC...................................................................................................................4-7 Regional Treasurer .............................................................................................4-7 Country Treasurer................................................................................................4-8 ALCO....................................................................................................................4-8 Risk Management Process............................................................................................ 4-9 Risk Identification..............................................................................................4-10 Risk Measurement ............................................................................................4-10 Evaluation of Risk Management Capacity .....................................................4-11 Limit Setting .......................................................................................................4-11 Ongoing Validation ...........................................................................................4-12 Limit Approval Process ................................................................................................4-12 Price Risk Limits ...............................................................................................4-12 Liquidity Risk Limits..........................................................................................4-13 Summary........................................................................................................................4-13 Progress Check 4 .........................................................................................................4-17

Appendix Glossary ...........................................................................................................................G-1

Index Index....................................................................................................................................I-1

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Introduction

INTRODUCTION TO RISK MANAGEMENT

OVERVIEW

This self-instruction workbook provides an overview of risk management in Citibank and prepares you for the more advanced risk concepts presented in the Credit Risk Management Basics and Market Risk workbooks. When you complete the Introduction to Risk Management, you will be familiar with the risk management vocabulary, the structure of the risk management organization, the basic credit process, and the market risk management concept in use at Citibank. The information in this workbook will be a valuable reference as you study the other workbooks.

OBJECTIVES

When you complete this workbook, you will be able to:

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Identify the major categories of risk associated with a bank activity or product

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Recognize the development, implementation and review process for risk management policies in the bank

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Define the roles and responsibilities of all groups involved in risk management

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Identify the phases of the credit risk management process

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Understand the fundamental issues of market risk management

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Identify other major categories of risk related to bank activities and products

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INTRODUCTION

TOPICS

This workbook is divided into four units: Unit 1:

Risk Categories

Unit 2:

Citibank's Risk Management Organization

Unit 3:

Managing Credit Risk in Citibank

Unit 4:

Managing Market Risk in Citibank

THE WORKBOOK

This workbook is designed to give you complete control over your own learning. The material is divided into workable sections, each containing everything you need to master the content. You can move through the workbook at your own pace and go back to review ideas that you didn’t completely understand the first time. Each unit contains: Objectives –

which point out important elements in the lesson that you are expected to learn.

Text –

which is the "heart" of the workbook. These sections explain the content in detail.

Key Terms –

which also appear in the Glossary. They appear in bold face the first time they appear in the text.

Instructional Mapping –

terms or phrases in the left margin which highlight significant points in the lesson.

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]

Progress Checks –

which do exactly what they say — check your progress. Appropriate questions are presented at the end of each unit, or within the unit in some cases. You will not be graded on these by anyone else; they are to help you evaluate your progress. Each set of questions is followed by an Answer Key. If you have an incorrect answer, we encourage you to review the corresponding text and find out why you made an error.

In addition to these unit elements, the workbook includes: Appendix – Glossary

which contains definitions of all key terms used in the workbook.

Index –

which helps you locate glossary items in the workbook.

Since this is a self-instruction workbook, your progress will not be supervised. We expect you to complete it to the best of your ability and at your own speed. You are ready to begin!

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INTRODUCTION

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Unit 1

UNIT 1: RISK CATEGORIES

INTRODUCTION

Risk management is a necessary element in achieving Citibank's objectives. Risk-taking activities are intended to increase earnings. However, they can result in a loss of revenue, and may even damage the bank's reputation. It is important to understand the risks we take and to manage them systematically. In this unit, you will learn the major categories of risk that affect our business and the common risk vocabulary that allows us to communicate about risk.

UNIT OBJECTIVES

When you complete this unit, you will be able to:

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Identify the major categories of risk in banking

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Identify specific types of risk which fall into each category

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Match some types of banking activities or products with their predominant risk categories

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RISK CATEGORIES

MAJOR RISK CATEGORIES

A knowledge of the major risk categories and an ability to identify, assess, and control the risks that are inherent in transactions are essential prerequisites for developing an effective risk management system. In this unit, we will introduce the major categories of risk, the types of risk in each category, and certain risks that are inherent in some banking activities. The risks are grouped as follows: n

Credit Risk

n

Market Risk

n

Other Major Risks

Figure 1.1 illustrates these risk categories with some of the specific risks that are associated with each category. This list does not include all possible risks associated with the bank's business. Other normal risks found in every business activity include operations and technology, legal, tax, and human resources. These, too, must be identified and managed by the responsible Line Manager.

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RISK CATEGORIES

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Figure 1.1: Major categories and sub-categories of risk

CREDIT RISK

Credit risk is the risk that financial obligations to Citibank will not be paid on time and in full as expected or contracted, resulting in a financial loss for the bank. Credit risk is a customer-related risk because the dimension of the risk depends on the customer's willingness and ability to fulfill all obligations to the bank. There are six types of credit risk:

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Direct lending risk

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Contingent lending risk

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Issuer risk

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Counterparty pre-settlement risk

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Counterparty settlement risk

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Clearing risk

Lending Risk Associated with extensions of credit

Lending risk is associated with extensions of credit and/or creditsensitive products, such as loans and overdrafts, where the bank bears the full risk for the entire life of the transaction. There are two types of lending risk: direct and contingent. Direct Lending Risk

Direct lending risk is the risk that actual customer obligations will not be settled on time. Direct lending risk occurs in products ranging from loans and overdrafts to credit cards and residential mortgages. It exists for the entire life of the transaction. Contingent Lending Risk

Contingent lending risk is the risk that potential customer obligations will become actual obligations and will not be settled on time. Contingent lending risk occurs in such products as letters of credit, and guarantees. It exists for the entire life of the transaction.

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RISK CATEGORIES

Example

1-5

Let's look at an example that illustrates contingent lending risk. ABC, Inc., a government-owned oil company, contracts with LMN Builders, Inc. to construct an oil refinery in that country. As part of the contract, ABC demands that LMN obtain a letter of credit from its bank with ABC as beneficiary. The letter of credit states that upon the first written demand from ABC indicating that work has not been performed according to the contract, the bank will pay ABC. Up to this point, the obligation is a contingent risk for the bank – it only has to pay if ABC makes a claim.Once the bank pays ABC, then the obligation becomes a loan to LMN which LMN is expected to repay.Although LMN indemnifies the bank against such payment, the bank has a direct lending risk that LMN will not pay.

Issuer Risk Associated with underwriting and distribution

Issuer risk occurs in underwriting and distribution activities when the bank commits to purchase a security or other debt instrument from an issuer or seller and there is a risk that the instrument cannot be sold within a predetermined holding period to an investor or purchaser. If this happens, the bank as the holder of the instrument is exposed to direct lending risk and unintended price risk. Issuer risk is the risk that the market value of a security or other debt instrument that the bank intends to hold for a short period of time may change when the perceived or actual credit standing of the issuer changes, thereby exposing the bank to a financial loss. Issuer risk is interrelated with price risk. (See page 1-7).

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RISK CATEGORIES

For example, let's look at a situation that could occur in the US. Suppose that BigShop needs financing, and Midtown Bank agrees to underwrite a fixed-rate mortgage. Midtown does not intend to hold the mortgage on its books but, instead, plans to sell the mortgage within 30 days to investors.In this situation, Midtown first has price risk, which is the risk that interest rates will rise before the bank sells the bonds. If interest rates rise,the value of the fixed-rate bonds will drop and Midtown will suffer the loss.Second, Midtown has credit risk, which is the risk that the perceived or actual credit standing of BigShop will deteriorate before the bank sells the bonds. If BigShop's credit standing deteriorates, interest rates will rise only for BigShop. The effect on the value of those bonds and the P & L of Midtown Bank will be the same as if interest rates in general had risen in the marketplace.

Counterparty Risk A counterparty is a customer with whom we have a contract to simultaneously pay each other agreed values at a stated future date. Pre-settlement Risk Risk of customer default before contract value date

Pre-settlement risk is the risk that a counterparty may default on a contractual obligation to the bank before settlement date of the contract. Pre-settlement risk is measured in terms of the current economic cost to replace the defaulted contract with another customer (known as "current mark-to-market") plus the possible increase in the economic replacement cost due to future market volatility (known as the "maximum likely increase in value"). When a counterparty defaults on a contract obligation during the contract before the settlement or maturity date, the bank must find another counterparty at the current market rate. The bank is exposed to possible adverse price fluctuations between the contract price and the market price on the date of default. If the prevailing market rate is less attractive than the contract rate, the bank faces a possible loss.

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As an example, let's assume that Bank XYZ needs to buy US dollars forward 90 days at a rate of 1US$ = Yen 120. Forty-five days into the contract, the seller informs Bank XYZ that she has declared bankruptcy. Bank XYZ must buy the dollars from a new seller at the current market rate of 1US$ = Yen 130. The bank experiences a loss of 10 Yen per US$ on the transaction. Pre-settlement risk belongs to the family of credit risk because the primary consideration is the creditworthiness of the counterparty — the judgment of counterparty creditworthiness is a credit issue. However, the size, or level, of pre-settlement risk is calculated based on the likely expected change in market prices. Therefore, the judgment of credit risk factors is a market risk issue. Settlement Risk Risk of customer default on contract value date

Settlement risk occurs on the maturity date when the bank simultaneously exchanges funds with a counterparty for the same value date and cannot verify that payment has been received until after the bank's side of the transaction has been paid or delivered. In today's international banking environment, the different time zones between countries make it difficult to achieve a simultaneous exchange between counterparties. The risk is that we deliver our side of the transaction but do not receive delivery and, therefore, are exposed to direct lending risk. In this situation, at least 100% of the principal amount is at risk. The risk may be larger than 100% if, in addition, there has been an adverse price fluctuation for us between the contract price and the market price. Suppose Bank XYZ delivers the Yen at maturity of the forward contract. Due to time zone differences between Japan, where the Yen have to be paid, and New York, where the US dollars are to be received, Bank XYZ experiences a settlement risk (at least 100%) for a period of 12 hours longer than normal.

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RISK CATEGORIES

In this case, the risk is more than 100% because the market price for 1US$ has moved from 120 to 130 Yen before the contract is settled. If the counterparty fails to deliver the dollars, Bank XYZ will have to replace the dollars (100% of the principal) at the higher rate. Therefore, the risk is actually more than 100%.

Clearing Risk Clearing risk is the possibility that the bank may not be reimbursed on the same value date for payments that are made on behalf of customers. Clearing risk occurs when the bank acts on a customer's instructions to transfer funds before being reimbursed.

Summary — Credit Risk Credit risk is a customer-focused risk related to a customer's fulfillment of financial obligations to the bank. The size of issuer risk and pre-settlement risk is linked to market risk. Likewise, credit risk incorporates, or is closely linked with many other risks which must be recognized and dimensioned. In contrast to credit risk management, which focuses on the customer, market risk management focuses on market prices and liquidity. In the next section, we will discuss three market factors that give rise to price risk. We will also define the two types of liquidity risk.

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MARKET RISK

The shift in the business emphasis in banking to include both lending transactions and trading transactions has caused an increase in the need to identify and manage market risks. Market risk is a generic term for price risk and liquidity risk. Price risk is the potential earnings exposure arising from changes in market rates. Liquidity risk is the risk that the bank will be unable to meet financial commitments when they are contractually due.

Price Risk Price risk exposure is the sensitivity of earnings to changes in three types of market factors: n

Interest rates

n

Commodity prices (including foreign currencies and equities)

n

Volatilities in options

As in any risk situation, the size of price risk must be related to expected revenues in order to allow risk / return analysis. Interest Rates Sensitivity to changes in the yield curve

The yield curve represents the relationship between interest rates (yield) and time to maturity. Interest rate fluctuations affect the value of all interest rate-sensitive positions. Some positions are more sensitive to the level of interest rates and some are more sensitive to the differential between rates.* n

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Changes in the level of the yield curve for a specific instrument affect interest rate level sensitive positions.

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Changes in the spread between yield curves for two different instruments with the same maturity, or for two different maturities in the same instrument, affect interest rate differential sensitive positions.

*For details on yield curve and interest rate level and interest rate differential-sensitive positions, see the Market Risk Management self-instruction workbook. Commodity Prices Price changes affect value of net positions

Changes in commodity prices can affect the value of net positions in foreign currencies, equities, precious metals and other commodities. A net position is the difference between assets plus any unliquidated purchases on one side and liabilities plus any unliquidated sales on the other side in a given commodity. Assets + unliquidated purchases - Liabilities + unliquidated sales = Net Position

Net FX position

A foreign currency net position is overbought when assets plus unliquidated purchases in a currency exceed liabilities plus unliquidated sales in the same currency; a net position is oversold when liabilities plus unliquidated sales exceed assets plus unliquidated purchases. Net position risk is the risk that there will be adverse fluctuations in currency values when we hold a net overbought or net oversold position. Currency fluctuations are typically influenced by economic and/or political events in the world.

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Volatility in Options Affects the value of an option

Volatility in options is a market-focused risk associated with the magnitude of expected changes in the market price of the "underlying" to which the option relates. Higher expected volatility increases the value of an option and lower expected volatility decreases the value of an option. The model used to calculate an option premium requires five variables: strike price, market price, time to maturity, money market interest rate, and volatility of the price of the underlying. The first four variables are known. The only unknown variable is volatility, which reflects the market's estimate of future movements in the price of the underlying. Since four variables are known and one (volatility) is not known, we can see why volatility in options is an independent market price and, therefore, trading options is trading volatility. Technically, volatility is defined as the standard deviation of expected change in the price of the underlying expressed in percent per annum. In other words, volatility relates to the likely trading range of an option's price given the uncertainty of price movements of the underlying. Future estimated volatility may be derived from options-implied volatility, historical data on price movements, or reasoned management judgment.

Liquidity Risk Liquidity risk is the risk that the bank may be unable to meet its financial commitments to customers or other market participants. Liquidity exposures may arise in both funding and trading activities.

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RISK CATEGORIES

Funding Liquidity Risk Inability to meet obligations when due

Funding liquidity risk is the risk that funds will not be available to meet financial commitments when they are contractually due. For example, Bank A borrows $1 million for 30 days from Bank B and lends it to Bank C for 90 days. After 30 days, Bank A has to repay the borrowed funds to Bank B or borrow again for another 30- or 60-day period. Bank A's risk is that it will be unable to renew the 30-day borrowing to match the remaining 60-day period of the loan to Bank C and, therefore, will not have the available cash flow to repay the funds to Bank B. The monitoring of funding liquidity also tracks the availablity of funds to take advantage of attractive business opportunities. Trading Liquidity Risk

Inability to liquidate a position to meet funding needs

Trading liquidity risk is the risk that the bank will not be able to instantly liquidate price risk positions without changing market prices, attracting the attention of other market participants, or compromising on counterparty quality. The inability to liquidate a position quickly may impair funding liquidity or cause losses in situations where we have a substantial price risk position that cannot be liquidated before the market price changes.

Market Risk in Credit-related Products There are two businesses belonging to the family of credit risk in which the size of the risk is largely determined by changes in market prices. These two businesses are underwriting, which generates issuer risk, and distant value date products (forwards, swaps, and purchased options) which generate pre-settlement and settlement counterparty risk.

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Issuer Risk

Issuer risk in underwriting activities involves market risk in addition to credit risk. There is a risk that market prices will move against us between the time we agree to purchase and actually purchase an equity or debt instrument. There is also a risk that market prices will move against us while we hold an instrument or between the time we agree to sell and the time we actually deliver the instrument. Pre-settlement / Settlement Risk

As we said in the counterparty risk section, pre-settlement / settlement risk occurs when an adverse market rate change occurs after a distant date transaction has been agreed upon. Specifically, we are at risk if the change in the market rate results in a situation where the contract rate is more favorable to us than the prevailing market rate. Since the change in the market rate causes the pre-settlement / settlement risk, the determination of the size of this risk is a market risk issue. In underwriting as well as distant-date trading, the approval of the counterparty and the extent to which the bank wishes to extend credit to such parties is exclusively a question of credit risk.

Summary — Market Risk Market risk is made up of two elements: price risk and liquidity risk. Price risk is the risk associated with changes in market factors that affect the value of all positions. These factors include interest rates, commodity prices, and volatility in options.

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RISK CATEGORIES

Liquidity risk is the risk that Citibank will not be able to meet financial commitments to customers or other market participants when they are due. There are two types of liquidity risk. Funding liquidity risk is the risk that the bank will not have the funds available to fulfill its financial obligations. Trading liquidity risk is the risk that the bank will be unable to liquidate assets or will have to liquidate at a loss for funding purposes. Whenever market risk is assumed, the size of this risk must be dimensioned and related to the expected revenues in order to assure a satisfactory risk / return ratio. Even though issuer risk and pre-settlement / settlement risk were introduced as credit risks, both types of risk have substantial market risk components — the size of these risks depends on changes in market prices. In addition to credit risk and market risk, other major risks associated with the bank's activities must be managed. In the next section, we will discuss some of these risks.

OTHER MAJOR RISKS

Other major risks that must be identified and managed include: n

Equity

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Country (including political risk and transfer risk)

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Fiduciary

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Documentation

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Disclosure

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Legal and regulatory

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Systems

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In the remainder of this unit, we will describe each of these risk categories.

Equity Risk Risk of fluctuation in value of equities

Equity risk occurs when the bank invests in, holds, or receives equity, equity-like securities, or other junior securities in non-affiliated entities. These securities include instruments such as common shares, preferred shares, and related derivative instruments such as warrants, stock options, calls, and stock index futures. For example, Builders, Inc. decides to issue shares of stock and asks Bank XYZ to manage the underwriting of these shares. Many shares are sold to other investors, but Bank XYZ keeps a portion of them and, thus, becomes a shareholder in Builders, Inc. If Builders does well, the value of the shares may increase; but if the company experiences adverse business conditions, the value of the shares may decrease. XYZ, along with the other shareholders, is risking a fluctuation in the value of the stock.

Country Risk Country risk is a broad risk category that includes political risk, convertibility risk (also known as cross-border risk), and transfer risk.

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RISK CATEGORIES

Political (Sovereign) Risk Government actions or independent events

Political risk is the risk that the actions of a sovereign government (such as nationalization or expropriation) or independent events (such as war, riots, or civil commotion) may affect the ability of customers in that country to meet their obligations to Citibank. Nationalization or expropriation risk exists when a government action deprives a borrower of access to significant assets, or prevents the borrower from operating all or part of its business. Convertibility Risk

Prohibition of Convertibility risk exists in any transaction in which the borrower is converting currencies unable, due to laws or regulations, to convert its local currency into the

foreign currency of the payment when the obligation in that currency matures. For example, when Citibank in Brazil advances local currency to a textile firm in Brazil, Citibank has credit risk  the risk that the textile firm (borrower) will not generate sufficient funds to repay the debt. However, when Citibank in London advances pounds to the same textile firm in Brazil, Citibank has an added risk. Even if the Brazilian textile firm generates enough funds in local currency, there is still the risk that the Central Bank of Brazil may prevent the conversion of local currency into pounds to service the debt in London. Transfer Risk Prohibition of funds movement

Transfer risk is the risk that a borrower will be unable (due to legal or payment barriers) to move funds in the foreign currency of a transaction when an obligation in that currency matures.

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Even if the Brazilian textile firm generates enough funds in local currency and can convert them into pounds, there is still the risk that the Central Bank of Brazil may prevent the transfer of converted funds to London to service the claim.

Fiduciary Risk Acting on behalf of a third party

Fiduciary risk occurs when the bank is charged with the responsibility of acting as a trustee for any third party. The risk is reduced by having a trust agreement that clearly defines our duties and responsibilities and specifies when we may be exposed to potential or real conflicts of interest. Whenever Citibank acts primarily for the benefit of a third party, it is acting in a fiduciary capacity. For example, the bank may serve as an investment advisor or portfolio manager of an account. In that capacity, it may be authorized to select the securities or other properties that should be purchased, sold, or retained. Some of the risk factors inherent in fiduciary responsibility include:

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Failure to establish a clear agreement in the documentation, which could result in the bank being charged with inappropriate conduct

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Failure to disclose all relevant information, which could result in a client charging the bank with breach of fiduciary duty

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An actual or potential conflict between the bank's interest and its fiduciary responsibility

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Failure to comply with applicable policies or laws

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Documentation Risk Unenforceable documentary evidence

Documentation risk is the risk that the documentary evidence on which we depend to enforce our rights under contracts or transactions may not be complete, correct, or enforceable. For example, Bank XYZ grants a loan to Builders, Inc. and asks Builders, Inc. to sign a promissory note. Mr. Smith of Builders signs the note, but he is not authorized by the company to do so. The note becomes unenforceable, and the bank may not be able to use the documentation as proof of claim if Builders, Inc. defaults on the loan.

Disclosure Risk Improper information reporting

Disclosure risk occurs when we act as an agent for other investors, either as an underwriter or as an advisor on a transaction. The bank is required to disclose certain information, and the risk is that we: n

Disclose information that we either know or should have known to be incorrect

n

Do not disclose actual or potential conflicts of interest

n

Do not disclose or delay in disclosing material information

n

Disclose information without authorization from the client

n

Fail to investigate and evaluate the borrower and the transaction

For example, suppose Builders, Inc., approaches Midtown Bank for another loan. Midtown Bank wishes to check Builders, Inc.'s references, so it calls Bank XYZ and requests information regarding Builders, Inc.'s account. Bank XYZ confirms that Builders has been a good customer and reveals that they have a healthy deposit account of $1,823,000. Unfortunately, Bank XYZ is not authorized to disclose Builders, Inc.'s deposit account balance, and once again, Bank XYZ is in trouble.

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Legal and Regulatory Risk Regulatory, civil, or criminal sanctions or litigation

Legal and regulatory risk occurs whenever the bank, a related corporate entity (such as a non-bank subsidiary or affiliate), a transaction, or a customer is subject to a change in exposure resulting from regulatory, civil or criminal sanctions, or litigation. Strict compliance with all relevant regulations is one of Citibank's core values and is essential to our reputation and success. When a transaction does not comply with all the applicable laws and regulations, the bank may face civil, criminal, and administrative proceedings and may also be fined. For instance, suppose that Builders, Inc. wishes to borrow $1,000,000 to finance a new construction project. Bank XYZ agrees to do this and draws up a contract for that amount. However, Bank XYZ and Builders, Inc. are located in a country which imposes a legal lending limit of 5%, meaning that Bank XYZ cannot loan more than 5% of its capital to one customer. The current capital of Bank XYZ is $10,000,000, so it is legally allowed to loan Builders, Inc. only $500,000. Exceeding the legal lending limit may subject the bank to a sanction or fine.

Systems Risk Operational aspects of a product

Systems risk refers to those risks arising from the operational aspects of the product, including systems which can be both external and internal to the bank. In many instances, these risks are associated with the use of technology. An example of an external system is a money transfer system. When the bank transfers funds by wire, it may use private international communications systems such as the Society for Worldwide International Financial Telecommunications ( SWIFT). Whenever the bank's operations use these systems, there is a risk that a disruption of services may occur.

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"Internal systems" applies to the operational infrastructure  data processing center, premises and facilities services, and telecommunications network  managed by the bank. If there is a major failure in one institution, the impact may be felt in other institutions. For example, in 1991 there was a fire at a utility substation in New York which caused interruption of services at Citibank, and at all other banks in New York, for three to five days.

Summary — Other Major Risks In this section, we identified some other major risks associated with different types of banking activities. Equity risk is the risk that the value of equities will fluctuate adversely. Political or sovereign risk results from government actions or independent events in a country. Transfer or cross-border risk is the risk that funds either cannot be converted into foreign currency funds or that converted funds cannot be moved past an exchange control border. Fiduciary risk arises from acting for the benefit of a third party. Documentation risk is the risk that documentary evidence of a transaction is incorrect, incomplete, or cannot be enforced. Disclosure risk arises from the bank's obligation to report information when acting as an agent for other investors.

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Legal / regulatory and systems risks are inherent in all banking transactions. The bank is responsible for making sure that all transactions comply with US and other relevant country systems of law, taxation, regulation, and accounting. Legal risk is inherent in documentation preparation, regulation adherence, disclosure procedures, and exposure to litigation. There is also the risk that systems or people within the bank will fail to provide adequate information and processing support for transactions.

EXAMPLES OF PRODUCT-RELATED RISKS

Each bank product has specific risks associated with it. The profitability of a transaction depends on our ability to recognize, analyze, and manage the risks. Let's look at two examples of risks associated with specific transactions. Trade Finance In this example, we will examine some of the risks associated with a trade finance transaction in which an exporter receives advance payment for future shipments. Suppose an exporter in Spain receives an advance of US$5MM today from Citibank, New York, for goods that will be shipped to a US importer nine months from now. The US importer agrees to pay the principal amount in US dollars to Citibank, N.Y., upon receiving the shipments. The exporter agrees to pay the interest. He will convert Spanish pesetas into US dollars through the local Citibank branch, which will remit the interest payments to Citibank, N.Y.

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Shipments to the importer begin in nine months and take place over a period of two months. For each shipment received, the importer has thirty days to remit the corresponding payment to Citibank , N.Y. In the meantime, the exporter pays Citibank, N.Y. 10% p.a. interest on the balance due. This rate is a function of the risks associated with the transaction and the cost of mitigating the risks. The risks for Citibank associated with this transaction are: n

Performance Risk: Risk that the exporter is not able to produce the goods or to pay the interest on the balance due

n

Credit Risk: Risk that the importer is unable to pay all or part of the principal

n

Political (Sovereign) Risk: Risk that the exporter is unable to export due to local government actions such as confiscation, expropriation, or nationalization

n

Transfer (Cross-border) Risk: Risk that the exporter is unable to convert local currency to US$ to pay interest on balance due

International Securities Services — Custody Securities custody is the set of services provided to an investor or securities intermediary after a trade is executed. Custody includes securities transaction settlement, cash management and foreign exchange, reporting, safekeeping, and processing of income collection and corporate actions. Customers purchase securities custody as a transaction processing product and to reduce risk; contractually, Citibank assumes responsibility for customer losses caused by the bank's negligence. Therefore, in addition to normal operational and credit risks, we should consider actions or omissions that could increase customer risks. Let's look at some examples of risks associated with custody.

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Operational Risk: Settlement

Super Securities, a major broker–dealer in New York, buys Argentine stocks through its broker and sends instructions to Citibank Argentina to receive the securities against payment. Citibank in Buenos Aires fails to "pre-match" the transaction (verify or compare the details) with the broker in advance. When the settlement deadline approaches, Citibank discovers that the broker is expecting to receive $100,000 more than Citibank has been instructed to pay. Since it is too late to check with Super Securities, Citibank "fails" the transaction (does not pay). The next day the broker claims penalty interest on the entire transaction amount from Super Securities, which, in turn, claims it from Citibank. Credit Risk: Settlement

An investor customer of State Street Bank and Trust sells Mexican Government bonds through a Mexican broker, and State Street instructs its custodian, Citibank Mexico, to deliver the bonds against payment. Although the broker has a current account with Citibank, it has no approved credit lines in place. At 4:00 p.m., which is the market deadline for settlement of bonds, Citibank finds that the broker does not have sufficient funds in its account. The broker advises that it has checks in transit to cover the shortfall; Citibank delivers the bonds. At the end of the day, the funds fail to arrive to cover the overdraft. Operational Risk: Post-settlement

The Brazilian telecommunications giant, Telebras, announces a rights issue. Citibank Sao Paulo fulfills its obligation of advising all customers, but it misplaces a record of the fax transmission to one of its customers in London. The day the rights issue closes, the London customer calls Citibank, Sao Paulo, claiming it was never advised of the action and demanding compensation of $300,000 to compensate for the loss of a valuable opportunity to exercise its rights under very favorable market conditions.

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These examples illustrate that, in addition to identifying and controlling the bank's risk-taking activities, we must also look at customer risks; if we don't, they may become risks for the bank.

UNIT SUMMARY

The major categories of risk are: credit risk, market risk, and other major risks, including equity, country, fiduciary, documentation, disclosure, legal / regulatory, and systems risk. Legal / regulatory and systems risks affect all transactions. Credit risks are customer-focused  they are related to the customer's willingness and ability to fulfill obligations. Market risks are marketfocused  they relate to fluctuations in market prices, such as interest rates, foreign exchange rates, and volatilities in options. Other risks are related to the specific type of transaction.

You have completed Unit One: Risk Categories. Please complete the following Progress Check before continuing to Unit Two: Citibank's Risk Management Organization. If you answer any Progress Check question incorrectly, you should return to the text and read the corresponding section again.

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þ

PROGRESS CHECK 1

Directions: Select the correct answer for the following questions. There is only one correct answer unless otherwise stated in the question. Check your answers with the Answer Key on the next page. If you answer any of the questions incorrectly, return to the appropriate section of the text and review the material. Question 1: In the spaces below, write the major risk categories. You may select from the following list: Clearing Pre-settlement Lending Disclosure Volatility in Options Transfer

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Commodity Prices Fiduciary Interest Rate Contingent Documentation Legal & Regulatory

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Systems Country Trading Political Funding Liquidity

Direct Issuer Equity Price Settlement Counterparty Convertibility

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RISK CATEGORIES

ANSWER KEY Question 1: In the spaces below, write the major risk categories. You may select from the following list: Clearing Pre-settlement Lending Disclosure Volatility in Options Transfer

Commodity Prices Fiduciary Interest Rate Contingent Documentation Legal & Regulatory

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Systems Country Trading Political Funding Liquidity

Direct Issuer Equity Price Settlement Counterparty Convertibility

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PROGRESS CHECK 1 (Continued)

Question 2: Below are descriptions of some major risk categories. Beside each description, write the risk category it defines.

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a)

Any transaction which involves moving money through an exchange control barrier has this risk.

b)

A bank must be sure to comply with all laws and regulations to guard against this risk.

c)

Banks must study the market carefully to reduce this investment risk.

d)

All operating functions, such as data processing, telecommunications, etc. should be supervised to be sure they are running smoothly and accurately.

e)

Because market factors change, a bank must consider how market fluctuations will affect a position.

f)

When a bank makes a loan, it must make sure that the customer will be able to fulfill all obligations.

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ANSWER KEY Question 2: Below are descriptions of some major risks. Beside each description, write the risk category it defines. a)

Transfer

Any transaction which involves moving money through an exchange control barrier has this risk.

b)

Legal

A bank must be sure to comply with all laws and regulations to guard against this risk.

c)

Equity

Banks must study the market carefully to reduce this investment risk.

d)

Systems

All operating functions, such as data processing, telecommunications, etc. should be supervised to be sure they are running smoothly and accurately.

e)

Price

Because market factors change, a bank must consider how market fluctuations will affect a position.

f)

Credit

When a bank makes a loan, it must make sure that the customer will be able to fulfill all obligations.

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PROGRESS CHECK 1 (Continued)

Question 3: The type of transaction largely determines the predominant risk associated with it. Several types of transactions are described below. Beside each description, write the letter of the predominant risk incurred in that transaction. a)

Issuer Risk

b) Pre-settlement Risk c) Liquidity Risk d) Fiduciary Risk e) Documentation Risk

The bank buys dollars forward 90 days against local currency from an exporter. After 30 days, the exporter goes bankrupt. The treasurer decides to borrow money short-term, while lending long-term. He expects the rates to go down. One week later the monetary authority imposes severe restrictions on the money supply, making it difficult for the treasurer to renew short-term borrowing. While reviewing a loan contract and promissory note, the account manager realizes that the note has been amended. According to local law, this means the note is now unenforceable. The bank accepts a mandate to manage a customer's pension fund portfolio. The bank buys some marketable securities, but soon the originator of the securities starts to have financial problems.

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ANSWER KEY Question 3: The type of transaction largely determines the predominant risk associated with it. Several types of transactions are described below. Beside each description, write the letter of the predominant risk incurred in that transaction. a)

Issuer Risk

b) Pre-settlement Risk c) Liquidity Risk d) Fiduciary Risk e) Documentation Risk

b

The bank buys dollars forward 90 days against local currency from an exporter. After 30 days, the exporter goes bankrupt.

c

The treasurer decides to borrow money short-term, while lending long-term. He expects the rates to go down. One week later the monetary authority imposes severe restrictions on the money supply, making it difficult for the treasurer to renew short-term borrowing.

e

While reviewing a loan contract and promissory note, the account manager realizes that the note has been amended. According to local law, this means the note is now unenforceable.

d

The bank accepts a mandate to manage a customer's pension fund portfolio.

a

The bank buys some marketable securities, but soon the originator of the securities starts to have financial problems.

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Unit 2

UNIT 2: CITIBANK'S RISK MANAGEMENT ORGANIZATION

INTRODUCTION

After the risks of a transaction have been identified, we estimate the probability that each risk will materialize, evaluate its potential impact on our business, and develop a plan to minimize it. In this unit, you will learn about the different groups that participate in the risk management process. You will also see how the policies, rules, and procedures for the risk management process are implemented, enforced, and reviewed in Citibank.

UNIT OBJECTIVES

When you complete this unit, you will be able to: n

Identify the organizational groups involved in risk management

n

Recognize the roles of each group in the risk management process

n

Describe the general responsibilities of each group

OVERVIEW OF THE RISK MANAGEMENT ORGANIZATION Decentralized process

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Risk management in Citibank is a decentralized process guided by centrally established policies and rules. Senior staff committees define our credit and market risk culture and establish overall policies and rules. Line Management manages and controls risk.

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Five organizational groups

CITIBANK'S RISK MANAGEMENT ORGANIZATION

There are five major organizational groups that participate in Citibank's risk management process. These groups are responsible for defining, implementing, and/or reviewing risk management policies, rules, and procedures within Citibank: n

Management Committee

n

Credit Policy Committee (CPC)

n

Market Risk Policy Committee (MRPC)

n

Line Management

n

Business Risk Review (BRR)

The Management Committee establishes the risk tolerance level for the bank and sets the goals and objectives for risk management activities. The Credit Policy Committee (CPC) and Market Risk Policy Committee (MRPC) establish policies and rules that communicate the strategy for achieving the goals and objectives set forth by Senior Management. Line Management is responsible for developing procedures to implement the policies and rules established by the CPC and MRPC. Finally, the Business Risk Review (BRR) group reviews the policies and rules set by the CPC and MRPC and also reviews the practices against the standards of Line Management to ensure that portfolios are structured and managed to achieve Management Committee's goals.

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MANAGEMENT COMMITTEE + Risk tolerance level + Goals for risk management activities

MARKET RISK POLICY COMMITTEE

CREDIT POLICY COMMITTEE

+ Policies and rules

+ Policies and rules

LINE MANAGEMENT + Procedures + Implementation

BUSINESS RISK REVIEW + Reviews + Recommends

corrective action

Figure 2.1: Risk management organization

In the sections that follow, we will discuss the roles and general responsibilities of each group.

MANAGEMENT COMMITTEE Sets risk tolerance levels and goals / objectives

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As the highest decision-making body within Senior Management, the Management Committee allocates key corporate resources. Its leadership drives our corporate and credit cultures. The Management Committee's role in the risk process is to: n

Establish the bank's overall risk capacity

n

Set strategic targets and aggregate limits at the corporate level

n

Review individual credit and market decisions that pose potentially material risks to the bank's franchises, business strategy, risk concentrations, or reputation

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CITIBANK'S RISK MANAGEMENT ORGANIZATION

CREDIT POLICY COMMITTEE (CPC) Establishes policies for credit risk and equity risk

The CPC is a senior-level staff group that establishes policies for credit risk and equity risk. These include approval hierarchies, rules and standards covering credit products, and limits for portfolio concentrations. CPC issues the Citibank Core Credit Policies (CCCP) manual that

includes an overview of Citibank's credit philosophy, a summary of the credit policy development process, the organization and phases of the credit process, approval rules, and specific credit policies. The CPC updates the core credit policies and rules and then communicates the changes by issuing replacement pages for the CCCP document. In addition, Line Management consults with the chairman or a member of CPC in accordance with CCCP. The committee's responsibilities include: n

Maintaining a sound, effective credit risk structure

n

Participating in portfolio planning and credit loss forecasting

n

Establishing, reviewing, and updating credit polices and standards that conform to applicable law, regulations, and corporate policies

n

Reviewing and approving exceptions to core credit policies that represent unusual risk

n

Keeping aggregate credit risk within the Bank's risk-taking capacity

n

Granting approval authority to skilled, highly qualified individuals

n

Reviewing the adequacy of credit training across the bank*

*[Core Credit Policies — September, 1992] Reporting responsibilities

The Chairman of the CPC reports to the Chairman of Citicorp / Citibank and provides reports on credit to the Management Committee and the Board of Directors. The reports include:

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Monitoring and advisory role

n

Policy exceptions reviewed by CPC that have implications for significant policy considerations

n

Portfolio reviews including quality assessment, risk profiles, tenors, concentrations, and any excesses over limits

n

Problem credits consistent with Board and regulatory requirements

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The CPC also acts as one check and balance for the credit process. The committee monitors ongoing risk management activities and acts in an advisory capacity when needed. It is CPC's responsibility to ensure that the bank's business is conducted within the risk-taking parameters established by the Management Committee. CPC monitors the quality or performance of the credit portfolio and looks for unusual trends or concentrations related to such factors as geography, business segment, industry exposure, currency mix, tenor, risk categories, and risk levels. To facilitate the implementation of its policies and rules, CPC also interacts in an advisory capacity with Line Management. In this role, CPC:

Staffing and training responsibilities

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n

Assists Line and Senior Management in maintaining a balanced portfolio within the parameters of the bank's tolerance for risk

n

Participates with Line groups in business planning and reviews target market concentrations, unusual marketing strategies, and other questionable risk characteristics

n

Oversees, with Business Risk Review, the implementation by Line Management of recommended improvements in the credit process that result from reviews

The CPC's role in staffing and development is to maintain the integrity of the institutional credit approval system and the integrity and quality of credit officers. In this capacity, the CPC:

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CITIBANK'S RISK MANAGEMENT ORGANIZATION

n

Approves and reviews Senior Credit Officer and Senior Securities Officer appointments

n

Ensures that approval authority is granted to skilled, highly qualified individuals

MARKET RISK POLICY COMMITTEE (MRPC)

The Market Risk Policy Committee (MRPC) sets policies and standards for market-focused risk identification, analysis, and management. The MRPC is also responsible for overseeing the bank's market risk management activities. The Chairman of MRPC reports to the Management Committee and Board of Directors. General responsibilities

The MRPC's responsibilities include, but are not limited to: n

Setting corporate policies and guidelines for market risk measurement, management, and reporting

n

Confirming that market risk management processes (including people, systems, operations, limits, and controls) satisfy corporate policies and are consistent with current technology

n

Promoting a risk management environment that encourages and requires the highest standards of ethical behavior by Risk Managers and transactors

n

Reviewing and approving market risk limits, which implies active involvement in the respective line business’ annual budget and planning process

n

Reviewing and approving any exceptions to policies codified in this manual

n

Assisting (when necessary) in the development of new product programs or market risk management programs

n

Monitoring the timely and accurate reporting of exposures by businesses

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n

Assisting in the development and implementation of ALCO policies within respective countries

n

Evaluating the magnitude, direction, and distribution of market risks across the Corporation from a portfolio perspective

n

Ensuring that the businesses provide for the ongoing validation of the adequacy and soundness of policies, assumptions, practices, and procedures. A Technical Advisory Sub-Committee (TASC) supports MRPC, acting as an institutional focal point on the financial mathematics, valuation techniques, and computer models

n

Appointing Regional Treasurers and Country Treasurers

n

Approving specified Exchange and Clearing House memberships

n

Encouraging the professional development and training of staff engaged in market risk taking and market risk management activities

[Market Risk Policy Committee – Market Risk Standards, February, 1993]

Summary — Management Committee, CPC, MRPC The risk management organization consists of the committees that establish policies, rules, and standards for the bank's risk management activities. The Management Committee establishes the risk culture and sets strategic risk targets for the bank. The Credit Policy Committee defines the policies for credit risk, rules used in credit extension, and the general parameters within which Line Management originates, approves, and manages credit risk. The Market Risk Policy Committee establishes policies and standards for identifying, managing, and reporting price and liquidity risk.

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CITIBANK'S RISK MANAGEMENT ORGANIZATION

In the next section, we will discuss the role of Line Management in the risk process. Line Management is the group that is responsible for developing and implementing procedures that comply with the policies and rules established by the committees.

LINE MANAGEMENT

Line Management is the group in the risk management organization that develops and executes business plans and initiates and approves all risk positions. Line Managers are directly responsible and accountable for: n

Initiating and managing risk

n

Setting and achieving business goals

Credit Risk Management Credit risk management responsibilities

Line Management is the core of Citibank's decentralized credit risk management system. The bank depends on Line Management to: n

Develop a business strategy, including target markets and risk acceptance criteria, in accordance with established policy and portfolio parameters (Risk Acceptance Criteria [RAC or RAAC] is a set of characteristics used to define the type of risk the bank is willing to assume for each targeted industry and to identify potential customers within an industry.)

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n

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Originate and maintain Credit Programs and Credit Transactions in line with those parameters (Credit Programs focus on the extension of credit to sets of customers with similar characteristics and/or product needs. Credit Transactions focus on the extension of credit to an individual customer or customer relationship.)

Portfolio management responsibilities

n

Consult with CPC, when required, according to CCCP

n

Report to the CPC as needed

n

Identify an officer, known as "responsible officer," who has primary responsibility for each credit program or credit transaction

n

Comply with all legal and regulatory requirements

n

Ensure the timely creation of appropriate loss reserves

n

Initiate identification and classification of problem credits and portfolios and implement remedial management efforts

n

Implement recommendations for improvements from Management Committee, CPC, MRPC, or Business Risk Review

A portfolio is an aggregate of transactions. A business must be aware of and manage trends and concentrations within its portfolio. For example, a portfolio may show a tendency to emphasize one or two products or to concentrate activities in a specific industry, geographic area, or currency. These concentrations may or may not be desirable and should be monitored carefully. To manage a portfolio, Line Management is responsible for:

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n

Understanding the risk / return dynamics of each type of credit risk in the portfolio

n

Understanding the impact of changing business and economic cycles on a portfolio

n

Obtaining sufficient data profiling for the portfolio

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Staffing and development responsibilities

CITIBANK'S RISK MANAGEMENT ORGANIZATION

n

Performing standard, periodic portfolio reviews to monitor portfolio and process quality

n

Correcting portfolio deficiencies as needed

Like CPC and MRPC, Line Management also has a role in staffing and development. Specifically, Line Management must: n

Determine the skill level necessary to undertake and manage credit risk proposed in the business plan

n

Establish appropriate risk management policies and procedures

n

Ensure highly qualified personnel through selection and training

n

Nominate Senior Credit Officers, Senior Securities Officers, and other credit authority delegations

Line Managers and staff personnel with extensive training, experience, and market expertise may be designated as Senior Credit Officers and/or Senior Securities Officers. Senior Credit Officers Customer experts

The highest professional designation in the credit process at Citibank is that of a Senior Credit Officer (SCO). SCOs are customer experts who are responsible for preserving the integrity of credit policies and exercising balanced, independent credit judgment. They are appointed on the basis of their experience, abilities, and personal characteristics. Senior credit officers who have been granted Line Manager SCO limits may provide final credit approval for amounts up to those limits. There are four levels of Line Manager SCOs.

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Senior Securities Officers Expert in underwriting and distribution activities

Senior Securities Officers (SSO) are specialists who apply their experience and expertise to risk and process decisions for underwriting and distribution activities. These capabilities have evolved to their current level of sophistication in a relatively short period of time and continue to evolve in a rapidly changing market environment. SSOs are appointed to preserve the integrity and manage the risk of

Citibank's market practices in the underwriting and distribution to investors of corporate, money market, and government instruments. Their major responsibilities are to: n

Exercise independent judgment regarding the marketability of paper

n

Approve specific counterparty risks

n

Approve portfolio investment in equities / securities

Market Risk Management Market risk is most effectively managed by professionals who have close, ongoing contact with customers, products, and markets. The market risk management process is consistent with Citibank's policy of decentralized line management with responsibilities for: n

Identifying price and liquidity risks associated with business activities

n

Developing plans for measuring and managing those risks in formal product programs (Product programs identify and quantify price and liquidity risks and describe the procedures and operating systems for controlling these risks.)

n

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Analyzing risk / return ratios

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CITIBANK'S RISK MANAGEMENT ORGANIZATION

n

Avoiding undue concentrations

n

Reporting to MRPC

This system of line management responsibility, together with centralized reporting and controls, ensures that Citibank's policies, processes and systems adapt to the changing nature of market risks in an efficient and timely manner.

Summary — Line Management Line Management develops and implements procedures to implement Management Committee, CPC, and MRPC policies and guidelines. Line Management is responsible for designing appropriate risk assessment tools, managing portfolios, and providing competent Senior Credit and Security Officers that are qualified to monitor risk management procedures and make decisions based on experience and sound judgment. In the next section you will see how Business Risk Review provides an independent evaluation of risk positions and risk management policies and procedures.

BUSINESS RISK REVIEW (BRR)

The final group of Citibank's risk management organization is Business Risk Review. This group reports administratively to the Chairman of the Credit Policy Committee and reports functionally to the Audit and Examining Committee of the Board of Directors. BBR personnel are Line officers with a minimum of ten years of credit experience. Senior officers may be invited to participate as guest reviewers on the BRR team. As part of their risk management training, SCOs must participate in a review at least once every three years.

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Independent evaluation of business risk management

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Business Risk Review assesses portfolio risk and the risk management process from a business unit perspective. It provides an independent evaluation of Citibank's business risk exposures and the adequacy of policies, practices, procedures, and reporting mechanisms used to manage these risk positions. Specifically, BRR is responsible for assessing the: n

Stated book value and the unit's capacity to absorb loss

n

Compliance of all risk management practices, systems of internal control, and procedures with established policy and standards

These assessments may lead to recommendations for improvements in policies, practices, and procedures to be carried out by Line Management, the CPC, the MRPC, and the Management Committee.

Portfolio Risk Assessment The BRR determines the value and collectability of both direct and contingent individual assets and also estimates the potential loss in risk portfolios. To estimate loss, the BRR evaluates the: n

Adequacy of the loss forecasts established by line management for identified problems

n

Capacity of the business to absorb unforeseen future losses

The five objectives for portfolio risk assessment are to: 1. Discover whether troubled positions in a portfolio have been properly identified by the line 2. Determine if adequate reserves / write-offs have been taken for all troubled positions ( BRR has the final say on individual classifications)

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3. Quantify the risk level of the portfolio and compare it with line projections 4. Determine if Line Management has segmented the portfolio where different risk levels or patterns can be identified 5. Assess whether Line Managers have adequately stress-tested the portfolio based on their forecast of possible adverse changes in the market

Process Assessment The BRR reviews the performance of each business unit against its risk management standards and against institutional standards. It also evaluates the risk management procedures developed by Line Management. Finally, it reviews the implementation of recommended improvements to the risk management process, related MIS systems, and to portfolio management. Process assessments are conducted to assess the effectiveness of controls and to evaluate how risk exposures are created, managed, and eventually liquidated. This approach is based on the concepts that (1) any risk management process must be connected to an underlying business flow and (2) in each risk management process there are identifiable key risk factors.

UNIT SUMMARY

In this unit, we have identified the organizational groups involved in risk management within Citibank. Management Committee sets the tone for risk management activities and the risk tolerance level for the bank. Credit Policy Committee and Market Risk Policy Committee formulate the policies and rules which guide the risk management process.

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Line Management develops procedures to implement the policies, rules, and standards from CPC and MRPC, and makes risk initiation and management decisions in the field. Senior Credit Officers are ultimately responsible for credit risk and process decisions. Senior Securities Officers are responsible for risk and process decisions relative to underwriting and distribution activities. The Business Risk Review completes the risk management organization. It is responsible for reviewing the actions of Line Management, ensuring that they are consistent and in line with corporate policies and rules. The BRR may also recommend changes in policy to the CPC and MRPC.

You have completed Unit Two: Citibank's Risk Management Organization. Please complete the following Progress Check before continuing to Unit Three: Managing Credit Risk in Citibank. If you answer any Progress Check question incorrectly, you should return to the text and read that section again.

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PROGRESS CHECK 2

Directions: Select the correct answer for the following questions. There is only one correct answer unless otherwise stated in the question. Check your answers with the Answer Key on the next page. If you answer any of the questions incorrectly, return to the appropriate section of the text and review the material. Question 1: These five organizational groups participate in Citibank's risk management process: ____ a) Board of Directors, Corporate Division, Senior Credit Officers, Senior Securities Officers, and Line Management. ____ b) Risk Managers, Regional Treasurer, Business Risk Review, Line Management, and Management Committee. ____ c) Management Committee, Credit Policy Committee, Market Risk Policy Committee, Line Management, Business Risk Review. ____ d) Market Risk Policy Committee, Corporate Division, Senior Credit Officers, Business Risk Review, and Senior Securities Officers. Question 2: Complete the statements below by providing the correct answer from the list: Business Risk Review Board of Directors Corporate Division Market Risk Policy Committee

Senior Credit Officers Senior Securities Officers Line Management Credit Policy Committee

Risk Manager Management Committee Regional Treasurer Country Credit Officer

________________________________ establish(es) the risk tolerance level for the bank and sets the tone for risk management activities. The____________________________ and the _____________________establish policies and rules for risk management. ___________________________________ is/are responsible for developing procedures to implement policies and rules. _____________________ review(s) and evaluate(s) policies, rules, and procedures to ensure that portfolios are structured to achieve the corporation's goals.

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ANSWER KEY

Question 1: These five organizational groups participate in Citibank's risk management process: c) Management Committee, Credit Policy Committee, Market Risk Policy Committee, Line Management, Business Risk Review.

Question 2: Complete the statements below by providing the correct answer from the list: Business Risk Review Board of Directors Corporate Division Market Risk Policy Committee

Senior Credit Officers Senior Securities Officers Line Management Credit Policy Committee

Risk Manager Management Committee Regional Treasurer Country Credit Officer

Management Committee establishes the risk tolerance level for the bank and sets the tone for risk management activities. The Credit Policy Committee and the Market Risk Policy Committee establish policies and rules for risk management. Line Management is responsible for developing procedures to implement policies and rules. Business Risk Review reviews and evaluates policies, rules, and procedures to ensure that portfolios are structured to achieve the corporation's goals.

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PROGRESS CHECK 2 (Continued)

Question 3: Senior Credit Officers are appointed in order to: ____ a) preserve the integrity of the bank's credit policies and to exercise balanced independent judgment. ____ b) conduct periodic portfolio reviews. ____ c) exercise independent judgment as to marketability of paper. ____ d) audit the bank's liquidity management.

Question 4: Select one responsibility of Senior Securities Officers. ____ a) The securitization of assets ____ b) Market risk associated with underwriting ____ c) Approving the inclusion of new names in the target market ____ d) Periodic portfolio reviews

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ANSWER KEY

Question 3: Senior Credit Officers are appointed in order to: a) preserve the integrity of the bank's credit policies and to exercise balanced independent judgment.

Question 4: Select one responsibility of Senior Securities Officers. b) Market risk associated with underwriting

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PROGRESS CHECK 2 (Continued)

Question 5: Listed below are some risk management duties. Next to each duty write the letter of the group that is primarily responsible for carrying it out. a)

Management Committee

b) Credit Policy Committee ( CPC) c) Market Risk Policy Committee ( MRPC) d) Line Management e) Business Risk Review ( BRR) _____Report to the Board on large classified credits _____Understand the impact of changing industry and economic cycles on the portfolio _____Manage the portfolio _____Coach, train, and develop Credit Officers _____Appoint Senior Credit Officers _____Approve market risk limits _____Set the tone for Citibank's risk management activities _____Ensure timely creation of appropriate reserves _____Establish specific limits for certain higher risk portfolio concentrations _____Appoint Regional Treasurers _____Decide how much risk the bank is willing to assume _____Provide an independent evaluation of business risk exposures _____Nominate SCOs and SSOs and provide other credit authority delegations

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ANSWER KEY Question 5: Listed below are some risk management duties. Next to each duty write the letter of the group that is mainly responsible for carrying it out. a) Management Committee b) Credit Policy Committee (CPC) c) Market Risk Policy Committee (MRPC) d) Line Management e) Business Risk Review (BRR) b

Report to the Board on large classified credits

d

Understand the impact of changing industry and economic cycles on the portfolio

d

Manage the portfolio

d

Coach, train, and develop Credit Officers

b

Appoint Senior Credit Officers

c

Approve market risk limits

a

Set the tone for Citibank's risk management activities

d

Ensure timely creation of appropriate reserves

b

Establish specific limits for certain higher risk portfolio concentrations

c

Appoint Regional Treasurers

a

Decide how much risk the bank is willing to assume

e

Provide an independent evaluation of business risk exposures

d

Nominate SCOs and SSOs and provide other credit authority delegations

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Unit 3

UNIT 3: MANAGING CREDIT RISK IN CITIBANK

INTRODUCTION

In Unit One, we defined the major categories of risk that are inherent in banking activities. We discussed Citibank's risk management organization in Unit Two and identified Line Management as the group that is responsible and accountable for creating and managing risk. The risks described in Unit One cannot be effectively managed in isolation; actions to reduce one type of risk can often increase another. As a Citibanker, it is important for you to understand the credit risk management process and how your own responsibilities might contribute to the bank's portfolio and risk management goals. In this unit, we will focus on the credit process and those elements that address portfolio management.

UNIT OBJECTIVES

When you complete this unit, you will be able to: n

Identify the three phases of the credit process as defined by Core Credit Policies

n

Define the activities associated with each phase

n

Recognize the key risks of the Business Risk Review audit process

n

Identify the four objectives of portfolio management

n

Recognize the risk ratings assigned to facilities and customers

Recognize the return-on-risk objective for credit extensions

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OVERVIEW OF THE CREDIT PROCESS

The diversity of customers, products, and business strategies at Citibank requires that we have a well-defined, integrated credit structure. This "credit architecture" includes clearly stated policies and procedures for managing credit, the necessary tools and information flows to make decisions, and people who share core values, a common vocabulary, and a conceptual understanding of their roles in the credit process. When these elements are thoughtfully integrated, they create an efficient and effective credit culture.

Credit Management Model Individual and commercial customer constituencies

Three phases of the credit process

Citibank's organization and credit activities are built around two basic customer constituencies: individuals and commercial enterprises. We will focus on the commercial credit model, which is geared toward lower transaction volume, larger transaction size, and customized products that require a judgmental process for originating, approving, and maintaining transactions. The goals of an efficient and effective credit process are to: n

Ensure that the bank achieves targeted risk-adjusted financial results with a high degree of reliability

n

Minimize losses consistent with targeted returns and our tolerance for risk and risk appetite

To manage the credit process with predictable results, we must understand the dynamic and interactive nature of each phase of the credit process. The three phases, as defined in Citibank Core Credit Policies, are: I. Portfolio Strategy and Planning Define desired financial results and the strategies required to achieve them.

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II. Credit Origination and Maintenance Create and maintain transactions and portfolios with characteristics that are consistent with our strategies. III. Performance Assessment and Reporting Monitor our performance for continual improvement. Responsibilities

Each group that participates in the credit process has well-defined responsibilities. Management Committee • Establishes performance objectives and portfolio composition criteria for the bank • Sets concentration limits with Credit Policy Committee Credit Policy Committee • Sets concentration limits with Management Committee • Develops credit policies • Monitors and assesses portfolio and portfolio management process Line Management • Establishes a business strategy • Defines target market and risk acceptance criteria • Solicits customers and evaluates risk • Approves risk exposures • Handles disbursement and documentation of credits • Monitors and maintains credit transactions

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• Distributes to investors • Monitors performance of credits, problem indentification, and remedial management • Monitors and assesses portfolio and portfolio management process • Provides effective organizational structure • Promotes performance quality In the next sections, we will look at each phase of the credit process.

PHASE I: PORTFOLIO STRATEGY AND PLANNING Objectives

Portfolio strategy and planning activities are an integral part of the annual planning process for each business. The objectives of this phase of the credit process are to define: n

Desired risk-adjusted financial results for each business and for the bank as a whole

n

Credit standards required to achieve them

In Phase I, the Management Committee sets performance objectives and establishes criteria for developing portfolios to achieve the objectives. The Credit Policy Committee and the Management Committee approve portfolio concentration limits. Credit Policy Committee develops policies for the extension of credit and Line Management develops an overall business strategy, defines target markets, and establishes risk acceptance criteria.

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Concentration Limits The Credit Policy Committee and the Management Committee approve portfolio concentration limits based on the bank's overall risk capacity, capital considerations, and evaluation of internal and external environments. By setting and adhering to limits, businesses in Citibank avoid concentrations that can result from seemingly unrelated activities and ensure that none of the asset categories or risk dimensions can harm the overall performance of the bank. Limits for different risk dimensions

Group Executive Vice-presidents, with approval of the Credit Policy Committee, set specific concentration limits to control Citibank's exposure to different portfolio risk dimensions. Concentration limits must be set for at least the following risk factors: n

Customer

n

Industry

In addition, limits may be set for other factors, such as: n

Geography

n

Equities and subordinate debt

n

Product

n

Highly leveraged transactions

n

Risk rating

The Management Committee and the Chairman of the Credit Policy Committee may set aggregate concentration limits at the corporate level and adjust line business limits accordingly. Line Managers must monitor and report outstandings by each factor and ensure that portfolios under their responsibility are kept within the approved limits.

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Credit Policies Balance earnings objective with customer needs

Our goal is to achieve our risk-adjusted earnings objective and satisfy our customers' needs while maintaining a sound credit portfolio. Credit policies help us to achieve this balance. Credit policies include: Policies

that define appropriate behavior.

Standards or performance criteria

by which behavior can be measured for compliance with policies and objectives.

Procedures

that define specific activities to ensure that standards are met.

Credit policies are constant. They define credit management issues from a strategic perspective. Credit procedures have a tactical perspective and change as frequently as our business changes. We must re-examine procedures frequently to ensure that they conform to policies.

Business Strategy Plan for meeting targeted earnings objective

Citibank's objective is to build strong customer relationships and diversified product portfolios. We target industry sectors in which we can achieve a strong market position and adequate returns on capital. Each business charts a course for achieving a targeted risk-adjusted earnings objective and designs products to translate a risk-conscious business strategy into terms and conditions that control risk.

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Strategic business planning begins with an assessment of external and internal factors. Important external environmental factors include: n

Global, national, and local economic trends

n

Current social, political, legislative, and demographic forces of change

n

Legal and regulatory context

n

Perception of Citibank's business by financial markets and rating / regulatory agencies

The business planning process must also consider internal factors, such as: n

Staff availability and skill relative to business risks and opportunities

n

Quality and composition of our portfolio

n

The bank's capital position relative to the business risks

n

Adequacy of the managerial, technological, and operational infrastructure

Target Market and Risk Acceptance Criteria Target market analysis: customer profile

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A target market definition identifies the acceptable profile of customers and the products we will offer them. A target market analysis includes: n

Identifying potential markets (geographic, industry, product, etc.) based on a review of all participants in each market

n

Defining opportunities within those markets

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Risk acceptance criteria: screening tools

MANAGING CREDIT RISK IN CITIBANK

n

Continuously monitoring the business climate, evaluating the bank's position in each market, and adjusting the target market criteria accordingly

n

Describing quantitative and qualitative factors of target clients in each market

Risk acceptance criteria are the terms and conditions for selecting customers within the target market. Once a business has developed a business strategy and identified a target market, it must establish screening tools to ensure that individual exposures and the overall portfolio are consistent with business objectives. A business identifies specific accounts that fit its risk acceptance criteria. The criteria may include such indicators as: n

Level of sales

n

Management quality

n

Growth potential

n

Relationship with government

n

Position within the industry sector

n

Financial parameters

n

Suitable credit terms

n

Earnings potential for the bank

Line Management Responsibility Line Management establishes and approves a business strategy, based on a clearly defined target market, comprehensive risk acceptance criteria, minimum profitability standards, and appropriate concentration limits that match the characteristics of the portfolio to the risk capacity of the bank. Line Managers are also responsible for planning for the resources needed to manage existing business and risks.

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PHASE II: CREDIT ORIGINATION AND MAINTENANCE

In the "credit origination and maintenance" phase, Line Management solicits, evaluates, approves, and manages credit exposures according to the strategies and portfolio parameters established in Phase I. Underwriting for distribution to investors takes place in the second phase of the credit process.

Origination Generating a transaction

Origination refers to the process of soliciting a customer, responding to customer requests, evaluating risk, and setting up a transaction. Transactions are generated within the guidelines of well-defined target market criteria, product configurations, and risk acceptance criteria (RAC). They are evaluated relative to our RAC and other requirements and policies, and approval requirements are determined by a credit's risk rating. (Risk ratings are discussed later in the Portfolio Management section of this unit.)

Evaluation Qualifying potential customers

An analysis of a company is initiated to determine if the company qualifies as a potential customer. Information sources include management within the company and third parties such as other banks, the market, and credit agency reports. Evaluation of a borrower's creditworthiness focuses on the five Cs of credit: character, capacity, cash flow, collateral, and capital. A background check of a customer is conducted to assess:

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Character

n

Operations

n

Management

n

Strategy

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n

Industry as a whole

n

Competitors of the company

n

Prevailing business conditions

The bank checks the capacity of the customer to generate enough cash flow to fulfill its obligations to the bank as well as its other financial obligations. Financial evaluation includes an analysis of the: n

Value of the customer's cash flow

n

Capital

n

Collateral

An analysis of a client's financial statement (audited, if possible), client visits / interviews, a loan structure summary, and a completed report or check list are important elements of the evaluation process.

Approval Credit approval is granted on an individual transaction basis or for a defined set of customers. Both objective criteria and good judgment are required to make sound decisions for accepting or rejecting business. Three-initial credit approval system

Citibank uses a three-initial credit approval system and names a responsible officer for each transaction. A transaction may also require the approval of other parties, such as business or industry specialists or legal counsel. The approving parties are responsible for verifying that: n

The information in the credit analysis addresses both risks and opportunities

n

The structure of the transaction is based on identified risks and protects the bank against them and other creditors

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n

A process is in place for remedial management action, if needed

n

Loan structures are consistent with financing purpose and the borrower's cash flow patterns

n

Target market criteria are met

Risk Summary Reports ( RSRs) summarizing our facilities must be prepared for large transactions or clients with large aggregate exposures in order to inform our Board of Directors.

Monitoring and Maintenance There are two possible conclusions for any credit transaction: 1. Orderly reduction and the eventual end of the risk exposure 2. A workout phase, which consists of intensive collection efforts until there is finally a full or partial repayment Normal risk management

Once a credit transaction has been approved, processes must be in place for monitoring the risk exposure and maintaining it at an acceptable level. Normal risk management includes: n

Controlling documentation and disbursement

n

Monitoring timely repayment

n

Controlling and valuing collateral

n

Reviewing the status of an exposure

By carefully monitoring individual credit transactions, we can recognize troubled exposure as soon as symptoms appear. The earlier a problem is detected, the more options a manager has for implementing remedial management techniques to maximize repayments and minimize losses.

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Problem Recognition Keys to managing troubled exposures

Anticipation, early detection, and timely reporting of potential problems are the keys to identifying and managing troubled exposures successfully. The objective is to recognize problems / weaknesses while adequate alternatives for action exist. Individual responsibilities for monitoring the risk exposure must be clearly defined. To anticipate problems, we ask "What if . . .?" questions when reviewing portfolios, writing call memos, and conducting credit reviews. In most problem accounts, classified credit reviews are generated on a regular basis. These reports contain key performance indicators, including:

Classified credit process

n

Past due obligations

n

Incomplete customer legal documentation, if any

n

Loan recovery strategy

n

Liability MIS, which would include information about the total amount of transactions by customer, industry sector, currency, tenor, etc.

The commercial credit model uses a judgmental process for classifying credits. There are five classification categories: one category for sound credit exposures and four categories of adverse classification indicating increasing degrees of potential risk of loss. The purpose of the classified credit process is to establish a consistent approach to problem recognition, labeling, remediation, and the setting of reserves for credit exposures that are managed on a judgmental basis. The process is designed to: n

Highlight problem credits for attention and action

n

Categorize problems by severity of actual and potential risk of loss

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n

Report problem credits to senior management for review and approval at intervals that are set according to the severity of the classification

n

Provide a common language and methodology across divisions and countries for identifying and managing problem credits

To properly classify a problem credit, a manager must be able to: n

Differentiate between symptoms and their causes

n

Assess the borrower's ability to correct the problem within a reasonable amount of time

n

Consider the options available to the bank to improve its position as a creditor

Remedial Management Objective is to minimize loss

The objective of remedial management is to minimize losses that could result from problem credits. Early intervention may prevent a potential loss from becoming an actual loss. Remedial management begins with a problem-solving strategy that defines alternative courses of action and specific deadlines. These plans must be documented in Classified Credit Reviews ( CCRs). A classified credit may continue to be handled by the unit that managed the credit while it was classified as current, or it may be transferred to a "workout unit." The responsible officer will assess the extent of the problem, implement tracking strategies, analyze and create restructurings, reevaluate strategies as situations change, and redocument new/existing structure as necessary.

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An important part of remedial management is to assess the effectiveness of remedial action for classified credits and for credit process problems. The assessment is fed back through the strategic planning process to improve the business strategy and the risk origination process. Citibank's Credit Classification System (pages 3-15 and 3-16) shows the classifications that may be assigned to a credit, the definition of each classification, and some of the characteristics used to determine the classification.

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CITIBANK’S CREDIT CLASSIFICATION SYSTEM Category Classification I

Current

IA (Other Assets Especially Mentioned)

Definition

Characteristics

No evident weakness

Obligations, or portions of obligations, for which interest and principal payments are fully up to date, and orderly repayment and/or timely settlement in the future is without doubt.

Credits show evidence of weakness in borrower’s financial condition or credit worthiness;

+ Environmental / operational indicators:

Credits may be subject to unrealistic repayment program; lacking adequate collateral, credit information, or documentation.

− clear evidence of adverse changes − absence of controls (frequent accidents; messy inventory) − labor problems − lack of management depth / key management departures − cash draining subsidiaries − over-reliance on single product / supplier / customer − products subject to intense competition or technological obsolescence − over-reliance on imports / exports, or certain types of currencies with strong devaluation risks − adverse regulatory, political, economic environment

+ Financial performance indicators:

− − − −

adverse trend in sales and earnings profit margin erosion interim losses fixed-price contracts in highly inflationary environment

+ Balance sheet deterioration indicators:

− leverage relative to the company’s past; its plan, and industry norms − receivables or inventory excesses − trade payable slowness

+ Transactional indicators:

− no seasonal clean-up; lingering overdraft excesses − term loan covenant violations (indicated by waivers, amendments) − long-term needs financed with short-term facilities − unrealistic repayment schedule − diversion of loan proceeds to other than stated use − absence of adequate collateral where needed

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CITIBANK’S CREDIT CLASSIFICATION SYSTEM Category Classification

Definition

Characteristics

IA (Other Assets Especially Mentioned) (Continued)

II (Substandard)

+ Other indicators:

− failed syndication or sell-down, reflecting market assessment − weak operational or financial controls and internal MIS − inadequate or outdated financial data − qualified auditor’s opinion − significant litigation − material adverse change vis-a-vis the rationale for original risk decision

Normal repayment of principal and interest may be or has been jeopardized; No loss is yet foreseen, but protracted workout period is possible.

III (Doubtful)

Full payment appears questionable on basis of current information; Certain degree of loss, as yet undetermined, is possible.

IV (Loss)

Credit is regarded as uncollectable.

+ Indicators are the same as for IA, but in a more

aggravated situation; + Other indicators:

− credit line frozen due to political pressure, legal action, etc. − bank locked in due to lack of alternative funding sources − ineffective creditor coordination − assets may be pledged to third parties − debt restructuring required − bankruptcy, foreclosure, forced liquidation

+ Key indicator here is the prospect of loss.

Characteristics are more adverse than IA and II. + Other indicators:

− auditor’s disclaimer of opinion or a qualification as to continued viability of company − uncertain collateral coverage − negative net worth and working capital − trade credit frozen − full recovery dependent on unlikely events − ineffectiveness of borrowers’ or creditors’ remedial efforts − consistent failure to meet commitments − principal or interest past due 90 days

The amount of loss can be determined by: + quantifying the shortfall between collateral and amount

owed. + build-up of claims and litigation that will limit the

amount the bank could recover.

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Distribution to Investors Loans are remarketed to third parties (mainly to other banks) for a number of reasons. It allows the bank to generate revenues from the distribution process. It also provides clients with access to different funding sources and with the potential for acquiring more funds than we may be prepared to provide ourselves. Additionally, this enables us to more effectively monitor and control the composition of the bank's portfolio. Remarketing transactions to third parties

Origination and underwriting for distribution to investors also take place in the second phase of the credit process. The same standards apply when assets are originated for sale to third parties as when they are originated for our own books, but they are applied from the point of view of remarketing a transaction to another investor. A market analysis is done to understand current market conditions, the market demand for a particular asset, and the types of investors who would buy the asset. If portfolios and balance sheets are managed effectively, assets are placed in the market on a timely basis and sold at favorable prices. By conducting an intensive evaluation of possible purchasers, the bank is positioned to take advantage of opportunities when the time is right.

Agent for transaction

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After placing an asset with third party investors, the bank may act as an agent by performing contractually defined tasks to facilitate the transfer of information and/or money between the issuers and the investors. To maintain portfolio quality and reputation, syndicated loans must be managed with the same attention and care as held assets.

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Summary — Phases I and Phase II Phases I and II may best be summarized as the planning and implementation phases of the credit process. In the "portfolio planning and strategy" phase, the Management Committee and Credit Policy Committee establish performance objectives, portfolio criteria, concentration limits, and credit policies. Line Management sets business strategies and defines target markets and criteria for risk exposures. In the "credit origination and maintenance phase," Line Management is responsible for managing prospects and customers, evaluating the risk associated with each customer and facility, initiating / approving credit programs / transactions, and documenting / disbursing credit. Transaction monitoring and maintenance in both normal and remedial modes and timely distribution to investors are essential for achieving the objectives of the credit process: to minimize losses and achieve targeted financial results. Phase Three is dedicated to assessing the portfolio and the credit process. We ask the questions: n

"How well did we do?"

n

"What can we do to improve?"

The information is fed back to the Management Committee, Credit Policy Committee, and Line Management — and the process begins again. Let's look at the activities that occur in Phase III.

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PHASE III: PERFORMANCE ASSESSMENT AND REPORTING

Portfolio Monitoring Assess portfolio and adjust process

Senior Managers and Line Managers continually monitor the portfolio to improve portfolio performance. They track portfolio and process trends and make appropriate and timely adjustments to business strategies, portfolio parameters, credit policies, and credit origination and maintenance practices. During this phase of the credit process, we use internal information and external benchmarks to help evaluate portfolio performance. The information derived from the evaluation is a critical corporate resource that provides a link between all three phases of the credit process. The following dimensions must be recorded, monitored, and reported for each credit risk: Relationship n

Name of parent company

n

Parent company standard customer code

Customer (Obligor)

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Name of subsidiary

n

Subsidiary standard customer code

n

Business segment

n

Seasoning (age of credit relationship)

n

Industry (Standard Industrial Code — SIC )

n

Customer risk rating

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Facility n

Amount of facility and outstandings

n

Extending and approving units

n

Product type

n

Direct, contingent, pre-settlement

n

Committed / uncommitted

n

Tenor

n

Collateral type

n

Liquidity

n

Adverse classification

n

Prior write-offs and write-downs

n

Performing (accrual) status

n

Facility risk rating

This information must be aggregated for all credits in the group, division, or country as needed to prepare summary profile data or reports on the unit's total portfolio. This data is used to monitor the portfolio against concentration limits and other established portfolio objectives.

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BRR Portfolio and Process Reviews Independent review by BRR

Five components of BRR business flow

The credit performance of Line Management is subject to independent review by Business Risk Review ( BRR). BRR examines the portfolio management system of each business to analyze portfolio risk positions. It assesses the value and collectability of direct and contingent assets and evaluates the potential for loss. This information is used to answer the following two questions: n

Are line loss forecasts enough to cover any identified problems?

n

How much of a loss can the business absorb if unforeseen problems occur?

For BRR credit review purposes, the credit risk management process is organized as a business flow consisting of five components: I.

Business Strategy, Staffing and Organization

II. Risk Origination and Structuring III. Structuring and Distribution IV. Transaction Monitoring, Maintenance, and Collection V. Portfolio Management The line organization is required to establish specific management processes for properly executing certain activities in each of these business flows. BRR focuses on each activity as a key risk factor, reviewing the quality and adequacy of the risk management process. Let's look at this checklist and the review objective for each factor.

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I. Business Strategy, Staffing, and Organization Risk Factors

Review Objectives

Ρ

Target Market

Ensure that the rationale and process for a target market strategy and adherence is appropriate for a given environment.

Ρ

Risk Acceptance Criteria (RAC)

Ensure that the selection of specific RACs is consistent with business strategies and target markets and appropriate for a given environment.

Ρ

Staffing and Organization

Evaluate (1) staffing adequacy and continuity, (2) organization and placement, and (3) coaching and training.

II. Risk Origination and Structuring Risk Factors

Review Objectives

Ρ

Evaluation

Evaluate the quality of risk origination, the adequacy of the recommendation process for risk extensions, and the appropriateness of the transaction structure.

Ρ

Compliance

Evaluate the business' process for ensuring conformance to legal, tax, accounting, regulatory, ethical, and disclosure requirements.

Ρ

Valuation

Assess the business' valuations of a customer's cash flow and financial performance, collateral, support, and guarantees.

Ρ

Approval

Evaluate the approval process for risk initiations, particularly with respect to accountability.

Ρ

Documentation

Evaluate the adequacy of documentation and the process by which the adequacy of documentation is ensured.

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III. Structuring and Distribution Risk Factors

Review Objectives

Ρ

Underwriting Analysis

Determine that exposures booked for sale are originated under the same standards that apply for held assets. Verify that distribution departments effectively assess market conditions and advise originators accordingly.

Ρ

Sales and Trading

Determine that sales occur as expected and that the business effectively coordinates with relevant departments.

Ρ

Agency

Ensure that syndicated loans are managed with the same attention as held assets and that agent responsibilities are discharged.

IV. Transaction Monitoring, Maintenance, and Collection Risk Factors

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Ρ

Risk Administration

Verify that the business' procedures and MIS reports are adequate to manage credit risks.

Ρ

Problem Recognition

Assess the business' effectiveness in recognizing problem portfolio trends in a timely manner. Evaluate Line Managers' ability to recognize individual credit problems, appropriately reclassify credits or adjust risk ratings, and contain or resolve issues.

Ρ

Remedial Management

Determine the effectiveness of remedial action for classified credits and for credit process problems.

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V. Portfolio Management Risk Factors

Review Objectives

Ρ

Data Integrity

Determine that the business has accurately identified the risk dimensions of its portfolio through proper risk ratings and classifications. Evaluate the process for timely updates of portfolio information.

Ρ

Portfolio Policy and Strategy

Assess adequacy of the tools used to monitor portfolios.

Business Risk Review documents its findings in action-oriented reports to Line Management, Senior Management, and the Board of Directors. These reports supply the information that is needed for updating and improving the credit process at Citibank. BRR provides one integrated rating to the Line Management that indicates its level of concern regarding the current performance of the entire portfolio or any relevant subsegments and concerns about the portfolio's future performance.

Summary Figure 3.1 on the next page is a model of the three phases of the credit process as presented in Citibank Core Credit Policies. The model presents the functions that occur in each phase and the risk organization group that is responsible for each function.

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The comparison table in Figure 3.2 shows the relationship between the three-phased credit process and the five components of the business flow used by BRR in its review process. You can see that Phase I of the credit process involves managing the key risk factors identified as part of BRR's "Business Strategy, Staffing, and Organization" business flow. Phase II of the credit process relates to the second, third, and fourth business flows. Finally, Phase III relates to the key risk factors of BRR's "Portfolio Management" business flow. The goal of an effective and efficient credit process is to ensure that we achieve targeted financial results. To manage the credit process for predictable results, we must understand the dynamics and interactive nature of these phases. We must define desired financial results and the strategies to achieve them, create transactions and portfolios consistent with our strategies, and then monitor our performance to provide information for continual improvement.

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Set concentration limits and develop credit policies. I.

Portfolio Strategy and Planning

Set performance objectives and portfolio composition criteria.

Credit Policy Committee

Management Committee

Set business strategy. Define target market and risk acceptance criteria (RAC). Line Management

Solicit customer and evaluate risk. Line Management

Approve using: + Credit Program

II. Credit Origination and Maintenance

+ Credit Transaction Line Management

Monitor and maintain credit.

Normal management

Distribute to investors.

Remidial management

Line Management

Line Management

III. Performance Assessment and Reporting

Monitor and assess portfolio and process.

Conduct independent reviews of portfolio and process.

Line Management and CPC

Business Risk Review (BRR)

Feedback on strategy, policies, and process

Figure 3.1: The three phases of the credit process

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CORE CREDIT POLICY

BUSINESS RISK REVIEW

Three Phases of the Credit Process

Five Business Flow Components

Portfolio Strategy and Planning

I.

Business Strategy, Staffing, and Organization + Target Market + Risk Acceptance Criteria + Staffing and Organization

II.

Credit Origination and Maintenance

II.

Risk Origination and Structuring + + + + +

Evaluation Compliance Valuation Approval Documentation

III. Structuring and Distribution + Underwriting Analysis + Sales and Trading + Agency

IV. Transaction Monitoring, Maintenance, and Collection + Risk Administration + Problem Recognition + Remedial Management

III. Performance Assessment and Reporting

V. Portfolio Management + Data Integrity + Portfolio Policy and Strategy

Figure 3.2: Relationship between Credit Process and BRR Business Flow

You have completed the section on the Credit Process. Please proceed to Progress Check 3.1 and answer the questions to check your understanding of the material. Then, continue with the next section, "Portfolio Management."

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PROGRESS CHECK 3.1

Directions: Select the correct answer for the following questions. There is only one correct answer unless otherwise stated in the question. Check your answers with the Answer Key on the next page. If you answer any of the questions incorrectly, return to the appropriate section of the text and review the material. Question 1: The three phases of the credit process may be summarized as: ____ a) origination, management, and distribution. ____ b) planning, problem recognition, remedial management. ____ c) planning, implementation, and assessment. ____ d) origination, collection or remedial management, and evaluation. Question 2: Select two objectives of Phase I of the credit process. ____ a) Originate transactions with newly targeted customers. ____ b) Monitor credits and isolate potential problems for remedial action. ____ c) Define desired risk-adjusted financial results for each business and for the bank as a whole. ____ d) Approve risk exposures for distribution to investors. ____ e) Define credit standards to achieve desired financial results. Question 3: Concentration limits must be set for at least the following portfolio risk dimensions: ____ a) Industry, geography, management, earnings, and risk factors ____ b) Customer, industry, geography, product, and risk ratings ____ c) Customer, business sector, earnings, and product programs ____ d) Target market, business sector, earnings, and risk ratings

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ANSWER KEY

Question 1: The three phases of the credit process may be summarized as: c) planni ng, implementation, and assessment.

Question 2: Select two objectives of Phase I of the credit process. c) Define desired risk-adjusted financial results for each business and for the bank as a whole. e) Define credit standards to achieve desired financial results.

Question 3: Concentration limits must be set for at least the following portfolio risk dimensions: b) Customer, industry, geography, product, and risk ratings

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PROGRESS CHECK 3.1 (Continued)

Question 4:

Select three components of credit policies.

____ a) Policies ____ b) Standards ____ c) Limits ____ d) Customer profiles ____ e) Procedures Question 5: The "credit origination and maintenance" phase includes many activities. Identify the category that applies to each of the following activities by writing the letter of the category next to the activity. Categories:

O = Origination E = Evaluation

M = Monitoring and maintenance D = Distribution

A = Approval

Activities:

____ Assessment of key internal and external factors that may affect the customer's business ____ Assessing the value of a customer's collateral ____ Soliciting a customer ____ Timely intervention to minimize losses ____ Remarketing a transaction to a third party ____ Preparing the loan contract ____ Applying the three-initial system ____ Early detection of problem credits ____ Disposing of assets at favorable prices ____ Analyzing the customer's management team ____ Appointing a responsible officer ____ Assessing the company's future cash flows ____ Understanding the customer's business strategy ____ Classifying problem credits

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ANSWER KEY Question 4: Select three components of credit policies. a) Policies b) Standards e) Procedures

Question 5: The "credit origination and maintenance" phase includes many activities. Identify the category that applies to each of the following activities by writing the letter of the category next to the activity. Categories:

O = Origination E = Evaluation

M = Monitoring and maintenance D = Distribution

A = Approval

Activities:

E

Assessment of key internal and external factors that may affect the customer's business

E

Assessing the value of a customer's collateral

O

Soliciting a customer

M Timely intervention to minimize losses D

Remarketing a transaction to a third party

O

Preparing the loan contract

A

Applying the three-initial system

M Early detection of problem credits D

Disposing of assets at favorable prices

E

Analyzing the customer's management team

A

Appointing a responsible officer

E

Assessing the company's future cash flows

E

Understanding the customer's business strategy

M Classifying problem credits

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PROGRESS CHECK 3.1 (Continued)

Question 6: Mark the following statements true (T) or false (F). ____ a) Different standards apply when assets are originated for sale to third parties than when they are held assets. ____ b) Most of the distribution group's customers are investors. ____ c) By conducting a target market analysis of potential purchasers, the bank is positioned for timely pursuit of underwriting opportunities. ____ d) Syndicated loans must be managed with the same careful attention as held assets.

Question 7: Select the key performance indicators that are periodically reported for problem accounts: ____ Credit file maintenance process ____ Past due obligations ____ Problem credit classification ____ Loan recovery strategy ____ Customer cash flow ____ Incomplete customer legal documentation ____ Total amount of transactions by customer, sector, currency, and tenor

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ANSWER KEY

Question 6: Mark the following statements true (T) or false (F). F

a) Different standards apply when assets are originated for sale to third parties than when they are held assets.

T

b) Most of the distribution group's customers are investors.

T

c) By conducting a target market analysis of potential purchasers, the bank is positioned for timely pursuit of underwriting opportunities.

T

d) Syndicated loans must be managed with the same careful attention as held assets.

Question 7: Select the key performance indicators that are periodically reported for problem accounts: Past due obligations Loan recovery strategy Incomplete customer legal documentation Total amount of transactions by customer, sector, currency, and tenor

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PROGRESS CHECK 3.1 (Continued)

Question 8: To handle problem accounts, management may assign a special task force, which is called: ____ a) a "workout unit." ____ b) a "credit remediation group." ____ c) "Task Force One." ____ d) a "negotiation team."

Question 9: Identify three applications of the credit classification system. ____ a) Rank the portfolio from most risky to less risky assets. ____ b) Categorize credits by seve rity of actual and potential loss. ____ c) Classify loans by industry sector. ____ d) Support the timely update of the target market analysis. ____ e) Highlight problem credits for attention and action. ____ f) Apply a common language and method to problem loan identification and management.

Question 10: Select three objectives of the BRR evaluation process. ____ a) Assess the value and collectability of direct and contingent assets. ____ b) Assess target market selections. ____ c) Evaluate management performance. ____ d) Analyze portfolio risk positions. ____ e) Evaluate potential for loss. ____ f) Analyze business unit balance sheets.

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ANSWER KEY

Question 8: To handle problem accounts, management may assign a special task force, which is called: a) a "workout unit."

Question 9: Identify three applications of the problem classification system. b) Categorize credits by severity of actual and potential loss. e) Highlight problem credits for attention and action. f) Apply a common language and method to problem loan identification and management.

Question 10: Select three objectives of the BRR evaluation process. a) Assess the value and collectability of direct and contingent assets. d) Analyze portfolio risk positions. e) Evaluate potential for loss.

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PROGRESS CHECK 3.1 (Continued)

Question 11: Match each of the five components of BRR's business flow with its corresponding key risk factors: I.

Business Strategy, Staffing, and Organization

II.

Risk Origination and Structuring

III.

Structuring and Distribution

IV.

Transaction Monitoring, Maintenance, and Collection

V.

Portfolio Management

Evaluation Compliance Valuation Approval Documentation Portfolio Strategy Data Integrity Risk Administration Problem Recognition Remedial Management Underwriting Analysis Sales and Trading Agency Target Market Risk Acceptance Criteria Organization and Staffing

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ANSWER KEY

Question 11: Match each of the five components of BRR's business flow with its corresponding key risk factors: I.

Business Strategy, Staffing, and Organization

II.

Risk Origination and Structuring

III.

Structuring and Distribution

IV.

Transaction Monitoring, Maintenance, and Collection

V.

Portfolio Management

II

Evaluation Compliance Valuation Approval Documentation

V Portfolio Strategy Data Integrity IV

Risk Administration Problem Recognition Remedial Management

III

Underwriting Analysis Sales and Trading Agency

I

Target Market Risk Acceptance Criteria Organization and Staffing

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PORTFOLIO MANAGEMENT Limit risk; build in flexibility and liquidity

The composition of the bank's portfolio is managed by limiting concentrations of risk and building in flexibility and liquidity. A portfolio management system allows the Management Committee to identify and control the size and mix of the bank's portfolio while decentralizing to Line Management, in conjunction with the Credit Policy Committee, responsibility for credit origination and maintenance. Line Management in each group is responsible for developing, implementing, and maintaining a comprehensive portfolio management system that reflects the diversity of the business within Citibank. Each group develops its own detailed policies based on the broad policies in Citibank Core Credit Policies. Although the installation, management, periodic review, and approval of portfolio management elements are the responsibility of the Management Committee, some elements require the support and involvement of the Credit Policy Committee to ensure consistency and comparability across the bank. These elements include:

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Debt-rating models or other processes used to assign risk ratings

n

Credit loss forecasting methodology

n

Portfolio profile guidelines and concentration limits

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Objectives of a Portfolio Management System An effective portfolio management system is more important in today's banking environment than ever before due to rapid changes in Citibank's client base and the need to identify, monitor, and control the mix of investment / non-investment grade paper. There are four main objectives of portfolio management. 1) Achieve risk-adjusted returns on capital consistent with corporate objectives and risk tolerance. 2) Provide a framework for origination activities within the concentration limits set by Senior Management. 3) Evaluate the acceptability of potential losses based on current risk profiles and projected alternative scenarios. 4) Understand and communicate the risk profile and other dimensions of a portfolio.

Risk Ratings Common language for comparing credit exposures

In addition to the Credit Classification System, which you saw in the last section, a risk rating scale is another important tool for managing the bank's portfolio. Risk ratings are intended to provide a common language that enables us to describe and compare all Citibank credit exposures, regardless of the nature, type, or location of the credit facility. Risk ratings are assigned to customers and facilities on a scale of 1 to 10. The best rating is a 1, which generally corresponds to a "AAA" investment grade on the Standard & Poor rating scale. A customer or facility with this rating is regarded as close to risk-free. A risk rating of 10 generally corresponds to Standard & Poor's "D" rating and indicates that a customer or facility is "doubtful" or a "loss." Ratings of 1 to 4 are regarded as investment-grade ratings, while 5 to 10 are noninvestment grade. Citibank risk ratings are defined in terms of "loss norms."

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Loss Norms Probability of default multiplied by potential loss

The assignment of a risk rating is a statement that a customer and facility display similar characteristics to other customers and facilities which have, on average over a period of time, produced a present value loss equal to a certain loss norm or within a range of loss norms. The loss norm is not a prediction that there will be an actual loss. It represents the probability of default within the next 12 months, expressed as a percentage, multiplied by the economic loss in the event of default ( LIED), also expressed as a percentage. The resulting loss norm is expressed in basis points and represents the present value of the total cost of credit from the date of default through the life of the problem workout, a period which can be several years. On pages 3-42 through 3-44, you can see a comparison of Standard & Poor's ( S&P ) debt ratings and Citibank's risk ratings. Each Citibank risk rating is listed with the corresponding S&P rating, a definition of the rating, and some characteristics of companies that may be assigned each rating. Keep in mind that loss norms are the only formal definition of Citibank's ratings; the S&P ratings are shown only as a comparison to help with an understanding. Our business environment is constantly changing and, therefore, these profiles are continually being updated based on experience. More important, the quality of our clients is always changing, so their risk ratings must be re-evaluated and updated accordingly.

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CITIBANK’S RISK RATINGS Citibank’s Corresponding Risk Standard & Rating Poor Rating 1

AAA

Definition Largely risk free

Characteristics + Normally includes transactions with full cash

collateral; wholly owned subsidiaries or branches with S&P AAA rating, or 100% guaranteed by AAA-rated banks. + Superior credit risk, with unquestionable

repayment record. 2

AA

Exceptional credit / minimal risk

+ Excellent current and historical cash flows, very

strong balance sheet, dominant position in stable industry. + Includes branches or wholly owned subsidiaries of

companies rated AA by S&P, or guaranteed by AAA-1 rated bank. + May include facilities with excellent collateral

such as investment grade securities or rated bank CDs. 3

A

Good credit quality / low risk Excellent credit quality / very low risk

+ Includes branches or wholly owned subsidiaries of

companies with A rating by S&P, or guaranteed by AAA-2 rated banks. + Company well positioned in industry, probably

dominant. + Very healthy debt capacity and coverage ratios;

demonstrated ability to weather a downturn. + Citibank is confident in management in all key

positions. + Quality and timeliness of financial disclosure

above average.

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CITIBANK’S RISK RATINGS Citibank’s Corresponding Risk Standard & Rating Poor Rating 4

BBB

Definition Satisfactory credit quality; increasing risk factors Good credit quality / low risk

Characteristics + Company well positioned in an industry that may

be moderately cyclical. + Good debt capacity, coverage, and other financial

ratios. Debt service coverage is better than average for the industry. + Sound management at all key positions. + Banks are not primary source of funding.

5*

BB

Acceptable (average) credit quality, but less stable

+ Company well regarded in industry, but not

necessarily a market leader. + Average debt service coverage, leverage levels,

other financial ratios. + Able to weather a downturn, but with some

difficulty. + Sound management in most key positions.

6*

B

Higher than average risk; evidence of quality risks; risk rating may change

+ Company is not a market leader. + Industry may be cyclical. + Debt capacity, coverage, and other financial ratios

are acceptable, but not necessarily consistent over several years. + Could weather a downturn for a short time. + Citibank is comfortable with management, but

would like more depth at key positions. 7*

CCC

Substantial credit risk and variability potential; risk rating likely to change

+ Company has weakened competitive position. + Industry may be heavily regulated, or new,

unfavorable regulations are forthcoming. + Company is close to full leverage, earnings are

under pressure. There is a willingness to pay higher spreads. Some suppliers may require Letters of Credit. + Citibank may lack confidence in management’s

ability to deal effectively with problems. + There may be present or expected material

change, such as changes in the industry, in company management, in economic or political trends, etc. The implications of these changes are not clear.

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CITIBANK’S RISK RATINGS Citibank’s Corresponding Risk Standard & Rating Poor Rating 8*

CC

Definition Special mention

Characteristics The borrower has credits which: + show evidence of weakness in its financial

condition; or + are subject to an unrealistic repayment program;

or + lack adequate collateral, credit information, or

documentation. 9*

C

Substandard credit quality

+ The borrower has credits for which the normal

repayment of principal and interest are in jeopardy. + While no loss may be foreseen, a protracted

work-out period is possible. 10 *

D

Doubtful Loss

+ The borrower has credits for which full payment

appears questionable. + A degree of eventual loss is anticipated, and

vigorous action is required to avert or minimize the loss.

* Credits rated below investment grade (i.e. 5 or higher) may be more subject to adverse classifications.

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Customer (Obligor) Risk Ratings Debt rating models

Customer risk ratings are assigned by using a debt rating model ( DRM), if one is available, that has been approved for use by a member of the Credit Policy Committee. A debt rating model is a statistical model that matches the profile of an individual customer against established standard profiles for each risk rating to determine the appropriate risk rating for the customer. DRMs analyze both the quantitative financial data of the customer and, for non-investment grade debt, qualitative factors, including: n

Reliability of financial information

n

Industry and competitive conditions

n

Quality of management

n

Environment in which the customer operates

Where an approved debt rating model is not available, risk ratings must be assigned on a judgmental basis according to guidelines that have been established to control this process. The customer risk rating is determined by the loss norm applicable to unsecured senior obligations of the customer.

Facility Risk Ratings Adjust customer risk rating

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To assign the final risk rating, which determines the loss norm associated with a facility, it may be necessary to adjust the customer risk rating up or down to reflect specific considerations that will impact the loss in the event of default. These factors include: n

Collateral type and value

n

Documentation, which includes protective covenants and escape clauses in the agreement

n

Quality of the guarantees, and the strength of the guarantor

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n

Product type, e.g. loan, forward contracts, securities, etc.

n

Tenor, relative to market trends and prices

n

Country issues, including the local legal system, political and economic conditions, and any cross-border issues which might affect the transaction

The quality of a customer is heavily weighted in establishing a facility risk rating and, therefore, most facilities of the same customer will have the same risk rating. Cash-collateralized facilities are exceptions. Risk-Adjusted Earnings Premium shareholder income (PSI)

The expected return on the relationship is an important component of the account planning process and the development of risk acceptance criteria. As we have seen, booked assets are assigned risk ratings based on the customer's and/or the facility's risk profile. The same risk rating used in the portfolio management system is applied to Citibank's customer-focused management process ( CFMP). In this process, the concept of premium shareholder income (PSI) is used to target customers and to make transaction decisions based on actual and potential risk-adjusted earnings. PSI is derived by looking at a combination of the following: revenues,

expenses, taxes, and calculations of expected loss and capital charges. "Expected loss" represents the reasonably expected rate of loss on a given portfolio of a specific risk rating. "Capital charges" is an attempt to capture the volatility surrounding the losses we anticipate. – – – –

Revenue Expenses Margin Expected Loss Capital Charge Taxes PSI

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Summary A portfolio management system provides analytical tools for portfolio decisions based on an established portfolio strategy. Portfolio management should include: n

A target profile or concentration limits to achieve diversification in terms of industries, geography, and risk ratings

n

A target market that is expected to generate an acceptable level of return on risk

n

Pricing, origination, and distribution programs to meet these objectives

Risk rating is a key element of a portfolio management system. The risk rating scale at Citibank rates each customer and each facility from 1 to 10, with 1 being the highest quality rating and 10 the lowest quality. Customer risk ratings are assigned using debt rating models where available or by judgmental criteria. They reflect the loss norm that has been calculated or estimated for unsecured obligations of the borrower; these ratings may be adjusted up or down for particular facilities. The loss norm represents the probability of default in the next 12 months multiplied by the present value of expected credit costs in the event of default. Earnings must be risk-adjusted to reflect revenues, expenses, taxes, and calculations of expected loss and capital charge. The result of this adjustment is the premium shareholder income ( PSI).

You have completed Unit Three: Managing Credit Risk in Citibank. Please proceed to Progress Check 3.2 to check your understanding. Then continue with the final unit in this course: Managing Market Risk in Citibank.

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PROGRESS CHECK 3.2

Directions: Select the correct answer for the following questions. There is only one correct answer unless otherwise stated in the question. Check your answers with the Answer Key on the next page. If you answer any of the questions incorrectly, return to the appropriate section of the text and review the material. Question 12: Check four objectives of a portfolio management system. ____ a) Identify a customer's position within the industry. ____ b) Communicate the risk profile of the portfolio. ____ c) Achieve risk-adjusted earnings that conform to corporate objectives. ____ d) Develop a credit policy manual. ____ e) Structure origination activities within parameters of concentration limits. ____ f) Obtain financial information for each customer. ____ g) Evaluate the acceptability of potential losses.

Question 13: The loss norm associated with a risk rating assigned to a customer or facility represents: ____ a) a comparison, on average, of the amount of loss that resulted from the default of other customers and facilities. ____ b) the probability of default within twelve months multiplied by the economic loss in the event of default. ____ c) the reliability and validity of the average loss resulting from transactions in a specific industry. ____ d) the average present value of a transaction over a twelve month period multiplied by the average loss resulting from market rate fluctuations.

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ANSWER KEY

Question 12: Check four objectives of a portfolio management system b) Communicate the risk profile of the portfolio. c) Achieve risk-adjusted earnings that conform to corporate objectives. e) Structure origination activities within parameters of concentration limits. g) Evaluate the acceptability of potential losses.

Question 13: The loss norm associated with a risk rating assigned to a customer or facility represents: b) the probability of default within twelve months multiplied by the economic loss in the event of default.

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PROGRESS CHECK 3.2 (Continued)

Question 14: A debt rating model: ____ a) matches the individual profiles of customers against each other. ____ b) analyzes only the quantitative financial data of a customer. ____ c) must be used for assigning risk ratings. ____ d) must be approved by a member of the Credit Policy Committee.

Question 15: Premium shareholder income is the result of: ____ a) adjusting annual earnings to reflect expected loss and capital charges. ____ b) subtracting the loss norm from annual earnings. ____ c) estimating the cost of credit and capital over a twelve month period. ____ d) adjusting after tax income to reflect earnings and the loss norm.

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ANSWER KEY

Question 14: A debt rating model: d) must be approved by a member of the Credit Policy Committee.

Question 15: Premium shareholder income is the result of: a) adjusting annual earnings to reflect expected loss and capital charges.

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Unit 4

Unit 4

UNIT 4: MANAGING MARKET RISK IN CITIBANK

INTRODUCTION

In Unit Three, we focused on the process of planning, originating, and managing credit exposures. In this unit, we will present an overview of Citibank's market risk management philosophy and the centrally established policies and procedures that serve as guidelines for a decentralized market risk management process.

UNIT OBJECTIVES

When you complete this unit, you will be able to:

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Recognize some characteristics of price risk and liquidity risk management

n

Identify segments of the market risk management organization

n

Recognize the five steps of the Market Risk Policy Committee risk management process

n

Understand the liquidity and price risk limit approval process in Citibank

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MANAGING MARKET RISK IN CITIBANK

OVERVIEW OF THE MARKET RISK PROCESS

Market risk is a generic term for price risk and liquidity risk. It is fundamental to our business of providing financial services to customers and intermediating markets. Market risk is most effectively managed by professionals who have close, ongoing relationships with customers, products, and markets. Market risk management, like credit risk management, is a dynamic process that combines corporate parameters with Line Management responsibilities for identifying, analyzing, and controlling risk. Essential elements of the market risk process include limits, regular reporting, and continuous validation of the adequacy and integrity of policies, assumptions, practices, and procedures at both the policy and line level. Managing Price Risk Sensitivity of earnings to market factors changes

Price risk exposure is the sensitivity of earnings to changes in three types of market factors: interest rates, commodity prices (including foreign exchange rates), and volatilities in options. A business will assume price risk commensurate with its objectives and earnings, its capacity to manage risk, and the sophistication of the local markets. Price risk management is a decentralized process balanced by strong centralized controls. An effective price risk management system provides techniques for: n

Assessing profit and loss to date at any point in time

n

Analyzing profit and loss sensitivity to changes in market factors

n

Monitoring and controlling the risk

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The bank's market risk management system accommodates the diverse price risks and risk management systems of the various businesses. It provides a meaningful measure and control of price risk through: n

Potential loss amount ( PLA) limits, which limit the potential P&L (profits and losses account) impact derived from trading portfolios

n

Earnings at risk ( EAR) limits, which limit the potential decrease in future earnings derived from accrual portfolios

This amount of earnings that may be placed at risk is limited to a percentage of forecasted annual earnings. To observe a price risk limit, we must: n

Know our current profit and loss to date

n

Calculate the sensitivity to changes in market prices

n

Estimate the amount that potentially could be at risk on existing positions due to standard changes in market prices

The standard change in a market price is usually based on its historic volatility or in the volatility implied in options, although it is sometimes necessary to base it on management judgment. Trading portfolio marked-tomarket daily

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Citibank's trading portfolios are managed to support customer needs and to take advantage of short-term market opportunities. Trading portfolio price risks are marked-to-market daily, with gains and losses reflected in current earnings. Marking-to-market is accomplished by simulating the orderly liquidation of a position, which means determining the price at which each position may be liquidated if it becomes necessary to do so. To ensure that the potential impact of changes in market prices on earnings is controlled within acceptable limits, trading portfolios are subject to well-defined price risk limits which, when exceeded, trigger specific management actions.

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Accrual portfolio

MANAGING MARKET RISK IN CITIBANK

Citibank’s accrual portfolios consist of all assets and liabilities (including some derivative contracts) that are not intended to be sold prior to maturity. Transactions in an accrual portfolio are represented either by non-negotiable instruments or negotiable instruments used to hedge exposures of accounts that are intended to be held until maturity. Profits and losses in these portfolios are “accrued” during the life of the contracts. This means that the mark-to-market value does not affect the profit and loss ( P&L) account — it is only used for management decision purposes. Therefore, price risk associated with an accrual portfolio should be differentiated from price risk generated in a trading portfolio. Managing Liquidity Risk

Essential for maintaining reputation in the market

Citibank defines liquidity as having funds available at all times to meet fully and promptly all contractual obligations. Effective liquidity management is also essential to maintaining market confidence, attaining the flexibility necessary to capitalize on business expansion opportunities, and protecting the corporation's capital base. Liquidity risk affects the life of the corporation, because without liquidity a business may be forced to shut down. The liquidity of each Citibank business and legal entity is managed through a well-defined process that includes liquidity risk limits and global and local contingency funding plans. There are two types of risk in liquidity management: funding liquidity risk and trading liquidity risk.

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Funding Liquidity Risk Funds not available when needed

Liquidity limits

Funding liquidity risk is the risk that funds will not be available to meet financial commitments when they are contractually due or that funds will not be available to take advantage of attractive business opportunities. The process for achieving funding liquidity consists of: n

Liability management, which focuses on diversification of sources and instruments, market share, and maturities

n

Asset sales (where we sell off individual assets) and asset securitization (where we create and sell a new instrument that represents many individual loans)

n

A contingency funding plan, which is a formal plan for maintaining liquidity under adverse conditions

Managing funding liquidity risk is accomplished by setting limits on the amount of cummulative negative cash flows for a given period. These limits are monitored daily and enforced through information gathered in the Maximum Cumulative Outflow Report (MCO) — a cash flow forecast based on “business-as-usual” assumptions. Limits are also set on cross currency funding activity, where assets in one currency are funded with liabilities in another currency.

Contingency funding plan

Additionally, management is required to prepare a Contingency Funding Plan (CFP), which is an analysis of liquidity assuming potential adverse scenarios. The results of this analysis show the appropriateness of current or requested MCO limits.

Liquidity triggers

To cover specific market structures and practices, management is also required to set some triggers on balance sheet ratios and/or market share per product. These ratios are intended to alert management against a possible adverse balance sheet structure or potential liquidity problems.

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Trading Liquidity Risk Inability to liquidate price risk positions

Trading liquidity risk is the risk that the bank will not be able to instantly liquidate price risk positions without changing market prices, attracting the attention of other market participants, or compromising on counterparty quality. Trading liquidity is achieved by taking risk positions with specific characteristics that relate position size to a marketable amount. Characteristics to avoid include: n

A large percentage of market share

n

Infrequently traded currencies and instruments

n

Tenors of unusual length

n

Excessive concentration of maturities

n

Maturities that fall on a week-end or holiday

Trading liquidity is also the result of good credit standing. Not having trading liquidity may affect our ability to do business. It is important to be perceived as a good counterparty so that other market participants will want to provide lines for trading activities.

MARKET RISK MANAGEMENT ORGANIZATION

The market risk management organization at Citibank consists of the Market Risk Policy Committee ( MRPC), the Regional Treasurer, the Country Treasurer, and the Country Asset and Liability Committee (ALCO). Let's look at the responsibilities of each of these organizational elements.

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MRPC Oversees market risk management process

The Market Risk Policy Committee ( MRPC) establishes corporate policy and standards, and oversees the market risk management process. It acts as a check and balance for the risk management process in each business to ensure that market risks are properly recognized and appropriately managed, that excessive concentrations are avoided, and that the return on the assumed risk is satisfactory. This process fits Citibank's policy of decentralized Line Management with strong centralized reporting and controls and the bank's need to adapt to the volatile nature of market risks in an efficient and timely manner.

Regional Treasurer Balance sheet and liquidity management

Regional Treasurers are responsible for geographic regions or countries. The role of the Regional Treasurer is to act as liaison between the MRPC and the countries / ALCOs for balance sheet and liquidity management issues. Principal liquidity risk responsibilities include managing:

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n

Regulatory capital and balance sheet liquidity gap risks

n

Liquidity relating to specific geographic markets and currencies

n

Exchanges and clearing houses

n

Availability of counterparties

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Country Treasurer Funding strategy and process

The Country Treasurer is responsible for ensuring that the country's liquidity risk management process complies with MRPC policy and procedures. S/he is responsible for developing a funding approach and funding process that is flexible enough to encourage transactions, yet rigorous enough to protect country liquidity. Success depends on: n

An understanding of the price risk characteristics and impact on liquidity of products offered by the country's businesses

n

Knowledge of factors that influence market demand for the country's business

n

Skills in building consensus on funding objectives and strategies among representatives to the Country ALCO

ALCO Liquidity, sufficient capital and appropriate funding

The Country Asset and Liability Committee ( ALCO) ensures that the country maintains adequate liquidity, has sufficient capital to meet regulatory and business needs, and has appropriate funding for business growth. ALCO must make sure that individual business strategies are consistent with these objectives and that the resulting total country balance sheets, based on Risk-adjusted Asset Principles (RAAP) and Generally Accepted Accounting Principles ( GAAP), don't differ materially from forecast. The Country ALCO, including the CCO (chairman), and Country Treasurer are jointly responsible for the following issues affecting the liquidity of each of the country's legal vehicles: n

Diversification of funding sources, maturities, and instruments

n

Contingency plans for each vehicle that are consistent with the business operations and market capacity

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Compliance with local and US regulations on the flow of funds between legal vehicles, which affect contingency funding plans and allocation of country liquidity limits

In this context, the corporate role of the CCO (in addition to this individual's role as manager of a business) is extremely important. Strategies for funding in normal and contingency environments

A Country Funding and Liquidity Plan and a Contingency Funding Plan are prepared jointly by the Country Treasurer and the Country ALCO at least annually. They include an overview of the funding situation and strategies for funding in normal and contingency environments for each vehicle in a country. On the basis of their review of each vehicle's funding position and requirements, the Country Treasurer, the Country Corporate Officer, the Country ALCO, and the Regional Treasurer determine the appropriate liquidity limits for each vehicle and recommend to the MRPC the consolidated country liquidity limits.

RISK MANAGEMENT PROCESS

The MRPC incorporates five major steps in the risk management process: 1) Risk identification 2) Risk measurement and risk/return evaluation 3) Evaluation of risk management capacity 4) Limit setting 5) Ongoing validation Let's define each step of the process.

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Risk Identification Businesses identify the risks associated with their activities and establish plans for measuring and managing those risks in formal product programs. Product programs identify and quantify price and liquidity risks and describe the procedures and operating systems for controlling these risks. The MRPC approves product programs according to corporate standards and may compare products across businesses to identify excessive risk concentrations.

Risk Measurement Market exposures vary by business. The risk measurement and management processes developed by each business must accommodate individual needs within the overall framework of a sensitivity approach. MRPC requires all risk management systems to meet the following standards: n

Accurate measurement of price and liquidity risks that facilitates the on-line management of those risks

n

Capacity to translate price risk sensitivities into potential loss amounts or earnings at risk

n

Methodology for avoiding excesses in a country's price risk limits

n

Means for assuring satisfactory returns on both price risk and liquidity risk

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Evaluation of Risk Management Capacity The capacity of a business to manage price and liquidity risk is the result of: n

Staff experience

n

Systems efficiency and reliability

n

Market depth

Processing systems are verified on a regular basis to ensure that they adhere to corporate standards and are evaluated for their capacity to accommodate increased volume and additional products. Limit Setting Requested at business level; approved by MRPC

Market risk positions are controlled by price risk limits based on the size and nature of a business. Most important, however, the size of price risk limits is based on the relationship of the limits to expected associated profits. Price risk limits are requested at the business level and reviewed at higher levels of the business organization. Final approval is granted by MRPC. Requests for liquidity risk limits from different businesses within a country are aggregated by the Country Treasurer and approved by ALCO at the country level. Thereafter, approval for one single liquidity risk limit for the country as a whole is requested through the Regional Treasurer from MRPC, which establishes corporate liquidity policy and finally approves liquidity risk limits.

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Ongoing Validation Identify and manage evolving risk elements

Market risk management is an evolving process. Various factors such as market changes, product developments, and technological advances affect market risk management policies and procedures. MRPC ensures that current policies and practices effectively identify and manage these evolving risk elements.

LIMIT APPROVAL PROCESS Three signatures plus approval by MRPC member

Many individuals participate in the approval process and indicate by signing off. However, the approval authority and accountability must be clearly identified and consist of three signatures plus final approval by an MRPC member. In addition to the business manager, Country Treasurers and Country Corporate Officers are required to sign all price risk limits to indicate concurrence on liquidity and regulatory issues. The approving parties may require an additional sign-off by a business or product specialist. The limit-setting processes for price and liquidity exposures are closely linked. However, there are differences in the review and approval processes, especially in countries where markets are not well developed.

Price Risk Limits Business level managers request price risk limits and submit them to higher levels of the business organization for review. The three signatures include two from the business organization and one from risk management (Country Risk Manager, Regional / Division Risk Manager). The MRPC reviews and approves price risk limits that have been recommended by senior line management.

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MRPC approval of limits depends on the committee's evaluation of: n

The risk / return trade-offs that result from market risks

n

The size and distribution of aggregate price risks

n

A capacity of a business to manage the price risk implied by the recommendation

Liquidity Risk Limits Liquidity management is a business and corporate responsibility. The MRPC develops a process to protect liquidity across businesses, vehicles, currencies, and countries with enough flexibility to encourage transaction efficiency. It establishes corporate liquidity policy and approves liquidity limits requested by vehicles and countries through Country Treasurers, Regional Treasurers, and Country ALCO. The Country Treasurer (through ALCO and its chairman, the CCO) is responsible for managing liquidity in the country. After discussion with each of the local businesses, s/he prepares a Funding and Liquidity Plan for the country that complies with local and US regulations governing the flow of funds between vehicles and businesses.

SUMMARY

Market risk management is a dynamic process combining line market management with effective corporate supervision. Increasinglycomplex financial products and instruments and closer relationships between markets create an environment of continuously evolving exposures. Limits and regular reporting are essential elements of the market risk management process, along with ongoing validation of the adequacy of policies and procedures.

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Price risk exposure is the sensitivity of earnings to changes in interest rates, commodity prices (including foreign exchange rates), and volatilities in options. "Potential Loss Amount ( PLA) and “Earningsat-risk (EAR) limits" are the measures of price risks and limit the earnings impact of standard changes in market prices. The size of these limits relates directly to budgeted associated trading profits. Price risks in trading portfolios are marked-to-market daily to reflect gains and losses in earnings and to ensure that these risks remain within clearly defined limits. Accrual portfolios are represented by all assets and liabilities that are not intended to be sold prior to maturity. Profits and losses are not marked to market, but are “accrued” during the life of the contracts. Funding liquidity risk is managed by putting limits on the amount of the cummulative negative cash flows for a given period and by analyzing liquidity under stress conditions. There are also triggers for market shares and balance sheet ratios. Trading liquidity risk is controlled by avoiding concentrations as well as maintaining the bank's credit standing and its image as a good trading partner. The market risk management organization is headed by the Market Risk Policy Committee ( MRPC), which ensures that market risks are recognized and managed and that excessive concentrations across businesses are avoided. Regional Treasurers act as a liaison between the MRPC and the country ALCO for balance sheet and liquidity management issues. The Treasurer in each country is responsible for developing a funding strategy and funding plans assuming different contingencies that protect the country's liquidity. The Country Asset and Liability Committee, chaired by the CCO, ensures liquidity, sufficient capital, appropriate funding, and a country balance sheet consistent with the budget / forecast. The MRPC risk management process includes risk identification, risk measurement and risk / return analysis, evaluation of risk management capacity, limit setting, and ongoing validation.

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The limit approval process for both price risk and liquidity risk requires three signatures in addition to final approval by a member of the MRPC. Business level managers request price risk limits and submit them to higher levels of the business organization for review. A single liquidity limit is requested for the country as a whole through Country Treasurers, Country ALCO, and Regional Treasurers.

Congratulations! You have completed the final unit of the Introduction to Risk Management course. Please answer the questions in Progress Check 4 to check your understanding of the introductory material on how we manage market risk in Citibank .

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PROGRESS CHECK 4

Directions: Select the correct answers for the following questions. There is only one correct answer unless otherwise stated in the question. Check your answers with the Answer Key on the next page. you answer any of the questions incorrectly, return to the appropriate section of the text and review the material.

Question 1: Price risk exposure is: ____ a) the volume of business that is exposed to changes in market prices. ____ b) a situation in which we hold positions that are sensitive to market changes in their prices. ____ c) a position that should be avoided because it will decrease profits. ____ d) a type of credit risk in which earnings are exposed to improper pricing practices.

Question 2: To observe a potential loss amount limit, we must: (Select two) ____ a) trigger the mark-to-market process when a loss on existing positions occurs. ____ b) understand the amount that potentially can be lost on existing positions. ____ c) determine the price at which each position will be liquidated if markingto-market indicates a profit. ____ d) calculate current profits and losses each day by simulating the liquidation of positions.

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ANSWER KEY

Question 1: Price risk exposure is: b) a situation in which we hold positions that are sensitive to market changes in their prices.

Question 2: To observe a potential loss amount limit, we must: (Select two) b) understand the amount that potentially can be lost on existing positions. d) calculate current profits and losses each day by simulating the liquidation of positions.

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PROGRESS CHECK 4 (Continued)

Question 3: Select three elements of the funding

management process.

____ a) Diversification of liability sources and instruments ____ b) Creation and sale of new instruments that represent many smaller transactions ____ c) A formal plan for maintaining liquidity under different adverse conditions ____ d) Limits on the amount of positive and negative cash flows for a given period ____ e) A liquidity maintenance fund for use in contingent business environments.

Question 4: Select three types of positions to avoid in order to achieve trading liquidity. ____ a) Tenors of unusual length ____ b) Instruments that represent other instruments ____ c) Tenors of less than one year ____ d) A large percentage of market share ____ e) Infrequently traded currencies and instruments

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ANSWER KEY

Question 3: Select three elements of the funding liquidity management process. a) Diversification of liability sources and instruments b) Creation and sale of new instruments that represent many smaller transactions c) A formal plan for maintaining liquidity under different adverse conditions

Question 4: Select three types of positions to avoid in order to achieve trading liquidity. a) Tenors of unusual length d) A large percentage of market share e) Infrequently traded currencies and instruments

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PROGRESS CHECK 4 (Continued)

Question 5: Match the segment of the Market Risk Management Organization with its role / responsibility. _____ MRPC

a) Acts as liaison.

_____ Regional Treasurer

b) Ensures that the country maintains liquidity, has sufficient capital, and has appropriate funding for growth.

_____ Country Treasurer _____ ALCO

c) Ensures that the country's liquidity risk management process complies with corporate policy and procedures. d) Establishes corporate policy and standards and oversees the market risk management process.

Question 6: Risk measurement and management processes developed by each business must: ____ a) provide a system for preventing the business from assuming price risk positions. ____ b) be approved by the country's ALCO. ____ c) allow for the individual needs of a business while adhering to MRPC standards. ____ d) provide a formula for calculating a satisfactory risk/return ratio.

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ANSWER KEY

Question 5: Match the segment of the Market Risk Management Organization with its role / responsibility. d

MRPC

a) Acts as liaison.

a

Regional Treasurer

b

Country Treasurer

b) Ensures that the country maintains liquidity, has sufficient capital, and has appropriate funding for growth.

c

ALCO

c) Ensures that the country's liquidity risk management process complies with corporate policy and procedures. d) Establishes corporate policy and standards and oversees the market risk management process.

Question 6: Risk measurement and management processes developed by each business must: c) allow for the individual needs of a business while adhering to MRPC standards.

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PROGRESS CHECK 4 (Continued)

Question 7: Identify the five major steps that MRPC incorporates in the risk management process: ____ a) Setting price and liquidity risk limits ____ b) Evaluating and updating policies and procedures to accommodate evolving factors that affect market risk ____ c) Identifying target markets for risk-taking activities ____ d) Rating customers to establish their "riskiness" for the bank ____ e) Assessing a business for its capacity to manage price and liquidity risk ____ f) Appointing the risk management team for each country ____ g) Assuring that each business meets MRPC standards for measuring risk ____ h) Assuring that each business establishes business plans that identify and quantify price risks and liquidity risks and describe the risk management process for controlling risks

Question 8: Select three characteristics that MRPC evaluates before approving a business's price risk limit request. ____ a) Size and distribution of aggregate price risks ____ b) Two approving signatures from the business organization ____ c) Capacity of a business to manage the recommended price risk limit ____ d) Ability to generate enough business to satisfy customer needs ____ e) Risk / return trade-offs that result from market risks

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ANSWER KEY

Question 7: Identify the five major steps that MRPC incorporates in the risk management process: a) Setting price and liquidity risk limits b) Evaluating and updating policies and procedures to accommodate evolving factors that affect market risk e) Assessing a business for its capacity to manage price and liquidity risk g) Assuring that each business meets MRPC standards for measuring and managing risk h) Assuring that each business establishes business plans that identify and quantify price risks and liquidity risks and describe the risk management process for controlling risks

Question 8: Select three characteristics that MRPC evaluates before approving a business's price risk limit request. a) Size and distribution of aggregate price risks c) Capacity of a business to manage the recommended price risk limit e) Risk / return trade-offs that result from market risks

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PROGRESS CHECK 4 (Continued)

Question 9: The limit approval process for price risk and liquidity risk requires: ____ a) sign-off by a business or product specialist. ____ b) concurrence from regulatory agencies that limits do not violate any rules and regulations. ____ c) that approval authority and accountability be assigned to business level managers for final review and approval of limit requests. ____ d) that approval authority and accountability be clearly identified and consist of three signatures plus final approval by MRPC.

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ANSWER KEY

Question 9: The limit approval process for price risk and liquidity risk requires: d) that approval authority and accountability be clearly identified and consist of three signatures plus final approval by MRPC.

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Appendices

APPENDIX GLOSSARY Assets and Liability Committee (ALCO)

Committee in each country that makes sure the country maintains adequate liquidity, has sufficient capital to meet regulatory and business needs, and has appropriate funding for business growth

Business Risk Review

Group that reviews the policies and rules set by the CPC and MRPC and the practices of Line Management to ensure that portfolios are structured to achieve Management Committee's goals

Clearing Risk

Risk that the bank may not be reimbursed on the same value date for payments that are made on behalf of customers

Concentration Limits

Limits set by Group Executive Vice-presidents, with approval of the Credit Policy Committee to control Citibank's exposure to various portfolio risk dimensions

Contingent Lending Risk

Risk that potential customer obligations will become actual obligations and will not be settled on time

Country Risk

Risk that economic problems, political disturbances, or sovereign actions within a country may make it impossible to get money out of a country or to convert local currency into a foreign currency

Country Treasurer

Individual who ensures that the country's liquidity risk management process complies with MRPC policy and is flexible enough to encourage transactions while protecting country liquidity

Credit Policy Committee

Senior-level staff group that establishes policies for credit risk and equity risk, including approval hierarchies, rules and standards covering credit products, and limits for portfolio concentrations

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GLOSSARY

Credit Risk

Risk that financial obligations to Citibank will not be paid on time and in full as expected or contracted, resulting in a financial loss for the bank

Debt-rating Model

Model that matches the profile of an individual customer against established standard profiles for each risk rating to determine the appropriate risk rating for the customer

Direct Lending Risk

Risk that actual customer obligations will not be settled on time

Disclosure Risk

Risk that as an agent for other investors, either as an underwriter or as an advisor on a transaction, the bank fails to disclose certain information or discloses incorrect information

Documentation Risk

Risk that the documentary evidence on which we depend to enforce our rights under contracts or transactions may not be complete, correct, or enforceable

Earnings-at-risk Limit

Measure of aggregate price risk which is intended to limit the negative variance from the monthly budget for trading revenues

Equity Risk

Risk of fluctuation in the value of equities when the bank invests in, holds, or receives equity, equity-like securities, or other junior securities in non-affiliated entities

Fiduciary Risk

Risk associated with the responsibility of acting as a trustee for third parties

Funding Liquidity Risk

Risk that funds will not be available to meet financial commitments when they are contractually due or that funds will not be available to take advantage of attractive business opportunities

Issuer Risk

Risk that the market value of a security or other debt instrument that the bank intends to hold for a short period of time may change when the perceived or actual credit standing of the issuer changes, thereby exposing the bank to a financial loss

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GLOSSARY

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Legal / Regulatory Risk

Risk that occurs whenever the bank, a related corporate entity (such as a non-bank subsidiary or affiliate), a transaction, or a customer is subject to a change in exposure resulting from regulatory, civil or criminal sanctions, or litigation

Lending Risk

Risk associated with extensions of credit and/or credit-sensitive products, such as loans, overdrafts, placements, letters of credit, and guarantees, where the bank bears the full risk for the entire life of the transaction

Line Management

Individuals who are responsible for developing procedures to implement the policies and rules established by the CPC and MRPC

Liquidity

Continuous availability of funds to meet fully and promptly all contractual obligations

Liquidity Risk

Risk that Citibank will be unable to fulfill its contractual obligations when they are due

Loss Norm

Probability of default within the next 12 months, expressed as a percentage, multiplied by the economic loss in the event of default (LIED), also expressed as a percentage; the resulting loss norm is expressed in basis points

Management Committee

Committee that establishes the risk tolerance level for the bank and sets the goals and objectives for risk management activities

Market Risk

Generic term for price risk and liquidity risk

Market Risk Policy Committee (MRPC)

Committee that establishes corporate policy and standards, and oversees the market risk management process

Marking-toMarket

Process of determining the current market value of a position; simulating the liquidation of a position

Maximum Cumulative Outflow Report (MCO)

Report used to monitor and manage limits on the amount of negative cash flows for a given period

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GLOSSARY

Net Position

Difference between assets plus any unliquidated purchases on one side and liabilities plus any unliquidated sales on the other side in a commodity such as foreign exchange

Origination

Process of soliciting a customer, responding to customer requests, evaluating risk, and setting up a transaction within the guidelines of well-defined target market criteria, product configurations, and risk acceptance criteria

Political (Sovereign) Risk

Risk that the actions of a sovereign government (such as nationalization or expropriation) or independent events (such as war, riots, or civil commotion) may affect the ability of customers in that country to meet their obligations to Citibank

Premium Shareholder Income (PSI)

Risk-adjusted earnings that reflect both the expected cost of credit and the cost of capital necessary to fund an asset

Pre-settlement Risk

Risk that the trading partner fails before maturity date and the market rate changes, resulting in a contract rate that is more attractive than the prevailing market rate

Price Risk

Risk resulting from one or several financial contracts of such a nature that a change in financial market prices would impact our profit and loss statement

Problem Classification System

Classification system that categorizes exposures by severity of actual and potential risk of loss

Regional Treasurer

Individual who acts as liaison between the MRPC and the countries / ALCOs for balance sheet and liquidity management issues

Risk Acceptance Criteria (RAC)

Standards for extending credit to ensure that individual exposures and the overall portfolio are consistent with business objectives

Risk Ratings

Ratings assigned to customers and facilities on a scale of one to ten, with one being the best rating

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GLOSSARY

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Senior Credit Officers

Customer experts who are responsible for preserving the integrity of credit policies and exercising balanced, independent credit judgment

Senior Securities Officers

Specialists who apply their experience and expertise to risk and process decisions for underwriting and distribution activities

Settlement Risk

Risk that the counterparty will fail on the maturity date of a contract involving an exchange of assets. The risk is that we deliver our side of the transaction but do not receive delivery from the counterparty.

Systems Risk

Risk arising from the operational aspects of the product, including systems which can be both external and internal to the bank

Target Market

Segment of the market that is of interest to a business unit based on the risk profile and perceived potential return

Trading Liquidity Risk

Risk that the bank will not be able to liquidate assets quickly enough when cash is needed, or liquidate price risk positions when an adverse price change is expected

Transfer (Cross-border) Risk

Risk that funds either cannot be converted into foreign currency funds or that converted funds cannot be moved past an exchange control border

Yield Curve

Interest rates for different maturity dates based on the expectations of market participants for the trend of future interest rates

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GLOSSARY

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Index

INDEX A Asset and Liability Committee (ALCO) B Business Risk Review

4-6, 4-8, 4-14

2-2, 2-5, 2-9, 2-13, 2-15, 3-1, 3-20, 3-21, 3-23, 3-24, 3-26

C Clearing Risk Concentration Limits 47 Contingent Lending Risk Country Risk Country Treasurer Credit Policy Committee

1-4, 1-8 3-3—3-5, 3-8, 3-18, 3-20, 3-39, 3-40, 31-3—1-5 1-14, 1-15, 1-24, 4-12 2-7, 4-6, 4-8, 4-9, 4-11—4-13, 4-15 2-2, 2-4—2-6, 2-8—2-10, 2-12, 2-13, 2-15, 3-3—3-5, 3-18, 3-26, 3-39, 3-45 1-2, 1-3, 1-6—1-8, 1-12—1-14, 1-16, 1-22—1-24, 2-4, 2-8—2-10, 2-15, 3-1, 3-19, 3-20, 3-22, 3-42, 3-43, 4-2

Credit Risk

D Debt-rating Model Direct Lending Risk Disclosure Risk Documentation Risk

3-39, 3-42—3-44 1-3—1-5, 1-7 1-14, 1-18, 1-20, 1-24 1-14, 1-18, 1-20, 1-24

E Earnings-at-risk Limit Equity Risk

4-3, 4-10, 4-14 1-14, 1-15, 1-20, 1-24, 2-4

F Fiduciary Risk Funding Liquidity Risk

1-14, 1-17, 1-20, 1-24 1-12, 1-14, 4-4, 4-5, 4-14

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1-2

I Issuer Risk L Legal / Regulatory Risk Lending Risk Line Management

Liquidity Liquidity Risk Loss Norm M Management Committee Market Risk Market Risk Policy Committee (MRPC) Marking-to-Market Maximum Cumulative Outflow Report (MCO) N Net Position O Origination

INDEX

1-3, 1-54, 1-8, 1-12—1-14

1-14, 1-19, 1-21, 1-24 1-4 2-1, 2-2, 2-4, 2-5, 2-8—2-10, 2-12—2-15, 3-1, 3-3, 3-4, 3-8, 3-9, 3-18, 3-20, 3-23, 3-39, 4-2, 4-7, 4-10, 4-12 1-8, 1-11, 1-12, 4-1, 4-4—4-9, 4-11—4-15 1-8, 1-9, 1-11—1-14, 4-1, 4-2, 4-4—4-8, 4-10, 4-11, 4-13—4-15 3-40, 3-41, 3-45, 3-47

2-2, 2-3, 2-5, 2-6, 2-8, 2-9, 2-12, 2-13, 2-15, 3-3, 3-4, 3-5, 3-18, 3-39 1-2, 1-7—1-9, 1-12—1-14.1, 1-24, 2-1, 2-6, 2-7, 2-12, 4-1—4-3, 4-6, 4-7, 4-11—4-15 2-2, 2-6—2-8, 2-15, 4-1, 4-6—4-15 4-3 4-5

1-10

3-3, 3-9, 3-14, 3-17, 3-18, 3-20, 3-21, 3-26, 3-39, 3-40, 3-47

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INDEX

P Political (Sovereign) Risk Premium Shareholder Income (PSI) Pre-settlement Risk Price Risk

I-3

1-14—1-16, 1-20, 1-22 3-46, 3-47 1-4, 1-6—1-8, 1-12—1-14, 3-19 1-5, 1-6, 1-8, 1-9, 1-12, 1-13, 4-1—4-4, 4-6, 4-8, 4-10—4-15

R Regional Treasurer Risk Acceptance Criteria (RAC) Risk Ratings

2-7, 4-6, 4-7, 4-9, 4-11, 4-13—4-15 2-9, 3-3, 3-4, 3-7—3-9, 3-21, 3-25, 3-26, 3-46 3-1, 3-5, 3-9, 3-19, 3-20, 3-23, 3-24, 3-39—3-47

S Senior Credit Officers Senior Securities Officers Settlement Risk Systems Risk

2-6, 2-10, 2-11, 2-13, 2-15 2-6, 2-10, 2-11, 2-15 1-4, 1-7, 1-12—1-14 1-14, 1-19, 1-20, 1-24

T Target Market Trading Liquidity Risk Transfer (Cross-border) Risk

2-5, 2-9, 3-3, 3-4, 3-7—3-9, 3-11, 3-18, 3-21, 3-25, 3-26, 3-47 1-12, 1-14, 4-4, 4-6, 4-14 1-14, 1-15, 1-16, 1-20, 1-21

Y Yield Curve

1-9

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