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Introduction to

Risk Management
05/15/96
Introduction to Risk
Management

Warning
This workbook is the product of, and copy-
righted 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
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by any method, printed, electronic, or
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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:

+ Identify the major categories of risk associated with a bank activity


or product

+ Recognize the development, implementation and review process for


risk management policies in the bank

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


management

+ Identify the phases of the credit risk management process

+ Understand the fundamental issues of market risk management

+ Identify other major categories of risk related to bank activities


and products

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xii 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 terms or phrases in the left margin which


Mapping – highlight significant points in the lesson.

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INTRODUCTION xiii

] 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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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:

n Identify the major categories of risk in banking

n Identify specific types of risk which fall into each category

n Match some types of banking activities or products with their predominant


risk categories

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1-2 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 1-3

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:

n Direct lending risk


n Contingent lending risk
n Issuer risk

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n Counterparty pre-settlement risk


n Counterparty settlement risk
n Clearing risk

Lending Risk

Associated with Lending risk is associated with extensions of credit and/or credit-
extensions of sensitive products, such as loans and overdrafts, where the bank bears the
credit 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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Example 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 Issuer risk occurs in underwriting and distribution activities when the
underwriting and bank commits to purchase a security or other debt instrument from an
distribution 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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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 Pre-settlement risk is the risk that a counterparty may default on a
default before contractual obligation to the bank before settlement date of the
contract value contract. Pre-settlement risk is measured in terms of the current
date 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 Settlement risk occurs on the maturity date when the bank
default on simultaneously exchanges funds with a counterparty for the same value
contract date and cannot verify that payment has been received until after the
value date 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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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 The yield curve represents the relationship between interest rates
changes in the (yield) and time to maturity. Interest rate fluctuations affect the value
yield curve 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 Changes in the level of the yield curve for a specific instrument


affect interest rate level sensitive positions.

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n 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 Changes in commodity prices can affect the value of net positions in
affect value of foreign currencies, equities, precious metals and other commodities.
net positions 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 Volatility in options is a market-focused risk associated with the
of an option 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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Funding Liquidity Risk

Inability to Funding liquidity risk is the risk that funds will not be available to
meet obligations meet financial commitments when they are contractually due.
when 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 Trading liquidity risk is the risk that the bank will not be able to
liquidate a instantly liquidate price risk positions without changing market prices,
position to meet attracting the attention of other market participants, or compromising
funding needs 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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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
n Country (including political risk and transfer risk)
n Fiduciary
n Documentation
n Disclosure
n Legal and regulatory
n Systems

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


categories.

Equity Risk

Risk of fluctuation Equity risk occurs when the bank invests in, holds, or receives equity,
in value of equity-like securities, or other junior securities in non-affiliated
equities 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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Political (Sovereign) Risk

Government Political risk is the risk that the actions of a sovereign government (such
actions or as nationalization or expropriation) or independent events (such as war,
independent riots, or civil commotion) may affect the ability of customers in that
events 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 Transfer risk is the risk that a borrower will be unable (due to legal or
funds movement 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 Fiduciary risk occurs when the bank is charged with the responsibility
behalf of a of acting as a trustee for any third party. The risk is reduced by having
third party 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:

n Failure to establish a clear agreement in the documentation,


which could result in the bank being charged with inappropriate
conduct

n Failure to disclose all relevant information, which could result in


a client charging the bank with breach of fiduciary duty

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


fiduciary responsibility

n Failure to comply with applicable policies or laws

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Documentation Risk

Unenforceable Documentation risk is the risk that the documentary evidence on


documentary which we depend to enforce our rights under contracts or transactions
evidence 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 Disclosure risk occurs when we act as an agent for other investors,
information either as an underwriter or as an advisor on a transaction. The bank
reporting 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, Legal and regulatory risk occurs whenever the bank, a related
or criminal corporate entity (such as a non-bank subsidiary or affiliate), a
sanctions or transaction, or a customer is subject to a change in exposure resulting
litigation 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 Systems risk refers to those risks arising from the operational
aspects of a aspects of the product, including systems which can be both external
product 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 market-
focused  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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RISK CATEGORIES 1-25

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 Commodity Prices Systems Direct


Pre-settlement Fiduciary Country Issuer
Lending Interest Rate Trading Equity
Disclosure Contingent Political Price
Volatility in Options Documentation Funding Settlement
Transfer Legal & Regulatory Liquidity Counterparty
Convertibility

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ANSWER KEY

Question 1: In the spaces below, write the major risk categories. You may select from the
following list:

Clearing Commodity Prices Systems Direct


Pre-settlement Fiduciary Country Issuer
Lending Interest Rate Trading Equity
Disclosure Contingent Political Price
Volatility in Options Documentation Funding Settlement
Transfer Legal & Regulatory Liquidity Counterparty
Convertibility

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RISK CATEGORIES 1-27

PROGRESS CHECK 1
(Continued)

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

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 Risk management in Citibank is a decentralized process guided by


process 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 There are five major organizational groups that participate in


organizational Citibank's risk management process. These groups are responsible for
groups 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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CITIBANK'S RISK MANAGEMENT ORGANIZATION 2-3

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 As the highest decision-making body within Senior Management,


tolerance the Management Committee allocates key corporate resources. Its
levels and leadership drives our corporate and credit cultures. The Management
goals / Committee's role in the risk process is to:
objectives
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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CREDIT POLICY COMMITTEE (CPC)

Establishes The CPC is a senior-level staff group that establishes policies for
policies for credit risk and equity risk. These include approval hierarchies, rules
credit risk and and standards covering credit products, and limits for portfolio
equity risk 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 The Chairman of the CPC reports to the Chairman of Citicorp /


responsibilities Citibank and provides reports on credit to the Management Committee
and the Board of Directors. The reports include:

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CITIBANK'S RISK MANAGEMENT ORGANIZATION 2-5

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

Monitoring and The CPC also acts as one check and balance for the credit process.
advisory role 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:

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

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

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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 The MRPC's responsibilities include, but are not limited to:
responsibilities
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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CITIBANK'S RISK MANAGEMENT ORGANIZATION 2-7

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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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 Line Management is the core of Citibank's decentralized credit risk
management management system. The bank depends on Line Management to:
responsibilities
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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CITIBANK'S RISK MANAGEMENT ORGANIZATION 2-9

n 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.)

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

Portfolio A portfolio is an aggregate of transactions. A business must be aware


management of and manage trends and concentrations within its portfolio. For
responsibilities 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:

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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n Performing standard, periodic portfolio reviews to monitor


portfolio and process quality
n Correcting portfolio deficiencies as needed

Staffing and Like CPC and MRPC, Line Management also has a role in staffing and
development development. Specifically, Line Management must:
responsibilities
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 The highest professional designation in the credit process at Citibank


experts 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 Senior Securities Officers (SSO) are specialists who apply their
underwriting experience and expertise to risk and process decisions for
and distribution underwriting and distribution activities. These capabilities have
activities 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 Analyzing risk / return ratios

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2-12 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 Business Risk Review assesses portfolio risk and the risk
evaluation of management process from a business unit perspective. It provides an
business risk independent evaluation of Citibank's business risk exposures and the
management 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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CITIBANK'S RISK MANAGEMENT ORGANIZATION 2-15

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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þ 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 Senior Credit Officers Risk Manager


Board of Directors Senior Securities Officers Management Committee
Corporate Division Line Management Regional Treasurer
Market Risk Policy Committee Credit Policy Committee 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 Senior Credit Officers Risk Manager


Board of Directors Senior Securities Officers Management Committee
Corporate Division Line Management Regional Treasurer
Market Risk Policy Committee Credit Policy Committee 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 Citibank's organization and credit activities are built around two basic
commercial customer constituencies: individuals and commercial enterprises. We
customer will focus on the commercial credit model, which
constituencies 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

Three phases To manage the credit process with predictable results, we must
of the credit understand the dynamic and interactive nature of each phase of the
process 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 Group Executive Vice-presidents, with approval of the Credit Policy
different risk Committee, set specific concentration limits to control Citibank's
dimensions 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 Our goal is to achieve our risk-adjusted earnings objective and satisfy
objective with our customers' needs while maintaining a sound credit portfolio.
customer needs Credit policies help us to achieve this balance. Credit policies
include:

Policies that define appropriate behavior.

Standards or by which behavior can be measured for


performance compliance with policies and objectives.
criteria
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 Citibank's objective is to build strong customer relationships and
targeted diversified product portfolios. We target industry sectors in which we
earnings can achieve a strong market position and adequate returns on capital.
objective 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 A target market definition identifies the acceptable profile of


analysis: customers and the products we will offer them. A target market
customer profile 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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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 Risk acceptance criteria are the terms and conditions for selecting
criteria: customers within the target market. Once a business has developed
screening a business strategy and identified a target market, it must establish
tools 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 Origination refers to the process of soliciting a customer, responding


transaction 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 An analysis of a company is initiated to determine if the company


potential qualifies as a potential customer. Information sources include
customers 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:

n 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 Citibank uses a three-initial credit approval system and names a


credit approval responsible officer for each transaction. A transaction may also
system 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 Once a credit transaction has been approved, processes must be in
management 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 Anticipation, early detection, and timely reporting of potential


managing problems are the keys to identifying and managing troubled exposures
troubled successfully. The objective is to recognize problems / weaknesses
exposures 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:

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.

Classified The commercial credit model uses a judgmental process for classifying
credit credits. There are five classification categories: one category for sound
process 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 The objective of remedial management is to minimize losses that


minimize loss 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 Definition Characteristics
I Current 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.

IA (Other Assets Credits show evidence of + Environmental / operational indicators:


Especially weakness in borrower’s − clear evidence of adverse changes
Mentioned) financial condition or credit − absence of controls (frequent accidents; messy
worthiness; inventory)
− labor problems
Credits may be subject to − lack of management depth / key management
unrealistic repayment departures
program; lacking adequate − cash draining subsidiaries
collateral, credit − over-reliance on single product / supplier / customer
information, or − products subject to intense competition or
documentation. 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 + Other indicators:
Especially − failed syndication or sell-down, reflecting market
Mentioned) assessment
(Continued) − 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

II (Substandard) Normal repayment of + Indicators are the same as for IA, but in a more
principal and interest may aggravated situation;
be or has been + Other indicators:
jeopardized; − credit line frozen due to political pressure, legal
action, etc.
No loss is yet foreseen,
− bank locked in due to lack of alternative funding
but protracted workout
sources
period is possible.
− ineffective creditor coordination
− assets may be pledged to third parties
− debt restructuring required
− bankruptcy, foreclosure, forced liquidation

III (Doubtful) Full payment appears + Key indicator here is the prospect of loss.
questionable on basis of Characteristics are more adverse than IA and II.
current information; + Other indicators:
− auditor’s disclaimer of opinion or a qualification as
Certain degree of loss, as
to continued viability of company
yet undetermined, is
− uncertain collateral coverage
possible.
− 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

IV (Loss) Credit is regarded as The amount of loss can be determined by:


uncollectable. + 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 Origination and underwriting for distribution to investors also take


transactions to place in the second phase of the credit process. The same standards
third parties 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 After placing an asset with third party investors, the bank may act as an
transaction 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 Senior Managers and Line Managers continually monitor the portfolio
and adjust to improve portfolio performance. They track portfolio and process
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)

n 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 The credit performance of Line Management is subject to independent


review by BRR 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?

Five components For BRR credit review purposes, the credit risk management process is
of BRR business organized as a business flow consisting of five components:
flow
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 Ensure that the selection of specific RACs is


Criteria (RAC) consistent with business strategies and target
markets and appropriate for a given
environment.

Ρ Staffing and Evaluate (1) staffing adequacy and continuity,


Organization (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 Determine that exposures booked for sale are


Analysis 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 Determine that sales occur as expected and


Trading 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 Review Objectives

Ρ Risk Verify that the business' procedures and MIS


Administration reports are adequate to manage credit risks.

Ρ Problem Assess the business' effectiveness in recognizing


Recognition 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 Determine the effectiveness of remedial action for


Management 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 Assess adequacy of the tools used to monitor


and Strategy 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 Set performance


and develop credit objectives and portfolio
policies. composition criteria.

I. Portfolio Strategy Credit Policy Committee Management Committee


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

Solicit customer
and evaluate risk.

Line Management

Approve using:
II. Credit Origination + Credit Program
and Maintenance + Credit Transaction

Line
Management
Monitor and maintain credit. Distribute to investors.

Normal Remidial Line Management


management management

Line Management

Monitor and assess Conduct independent


III. Performance reviews of portfolio
Assessment portfolio and process.
and process.
and Reporting

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

I. 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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þ 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 M = Monitoring and maintenance A = Approval


E = Evaluation D = Distribution
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 M = Monitoring and maintenance A = Approval


E = Evaluation D = Distribution
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; The composition of the bank's portfolio is managed by limiting


build in concentrations of risk and building in flexibility and liquidity. A
flexibility portfolio management system allows the Management Committee
and liquidity 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:

n 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 In addition to the Credit Classification System, which you saw in


language for the last section, a risk rating scale is another important tool for
comparing managing the bank's portfolio. Risk ratings are intended to provide
credit exposures 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 non-
investment grade. Citibank risk ratings are defined in terms of "loss
norms."

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Loss Norms

Probability of The assignment of a risk rating is a statement that a customer and


default multiplied facility display similar characteristics to other customers and facilities
by potential loss 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 Definition Characteristics
1 AAA Largely risk free + 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 / + Excellent current and historical cash flows, very


minimal risk 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 / + Includes branches or wholly owned subsidiaries of


low risk companies with A rating by S&P, or guaranteed
by AAA-2 rated banks.
Excellent credit
quality / very low risk + 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 Definition Characteristics
4 BBB Satisfactory credit + Company well positioned in an industry that may
quality; increasing be moderately cyclical.
risk factors + Good debt capacity, coverage, and other financial

Good credit ratios. Debt service coverage is better than


quality / low risk average for the industry.
+ Sound management at all key positions.

+ Banks are not primary source of funding.

5* BB Acceptable (average) + Company well regarded in industry, but not


credit quality, but necessarily a market leader.
less stable + 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 + Company is not a market leader.
risk; evidence of + Industry may be cyclical.
quality risks; risk
rating may change + 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 + Company has weakened competitive position.


and variability + Industry may be heavily regulated, or new,
potential; risk rating unfavorable regulations are forthcoming.
likely to change
+ 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 Definition Characteristics
8* CC Special mention 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 + The borrower has credits for which the normal


credit quality repayment of principal and interest are in
jeopardy.
+ While no loss may be foreseen, a protracted
work-out period is possible.

10 * D Doubtful + The borrower has credits for which full payment


Loss 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 Customer risk ratings are assigned by using a debt rating model ( DRM),
models 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 To assign the final risk rating, which determines the loss norm
risk rating 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 The expected return on the relationship is an important component of


shareholder the account planning process and the development of risk acceptance
income (PSI) 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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þ 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:

n 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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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 Price risk exposure is the sensitivity of earnings to changes in three


earnings to types of market factors: interest rates, commodity prices (including
market factors foreign exchange rates), and volatilities in options. A business will
changes 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 Citibank's trading portfolios are managed to support customer needs
marked-to- and to take advantage of short-term market opportunities. Trading
market daily 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 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 Citibank defines liquidity as having funds available at all times to
maintaining meet fully and promptly all contractual obligations. Effective
reputation in liquidity management is also essential to maintaining market
the 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 Funding liquidity risk is the risk that funds will not be available to meet
available financial commitments when they are contractually due or that funds
when needed 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

Liquidity limits 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 Additionally, management is required to prepare a Contingency Funding


funding plan 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 Trading liquidity risk is the risk that the bank will not be able to instantly
liquidate price liquidate price risk positions without changing market prices, attracting
risk positions 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 The Market Risk Policy Committee ( MRPC) establishes corporate


market risk policy and standards, and oversees the market risk management
management process. It acts as a check and balance for the risk management
process 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 Regional Treasurers are responsible for geographic regions or


and liquidity countries. The role of the Regional Treasurer is to act as liaison
management between the MRPC and the countries / ALCOs for balance sheet and
liquidity management issues.

Principal liquidity risk responsibilities include managing:

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 The Country Treasurer is responsible for ensuring that the country's
and process 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, The Country Asset and Liability Committee ( ALCO) ensures that the
sufficient capital country maintains adequate liquidity, has sufficient capital to meet
and appropriate regulatory and business needs, and has appropriate funding for
funding 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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n 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 A Country Funding and Liquidity Plan and a Contingency Funding
funding in normal Plan are prepared jointly by the Country Treasurer and the Country
and contingency ALCO at least annually. They include an overview of the funding
environments 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 Market risk positions are controlled by price risk limits based on
business level; the size and nature of a business. Most important, however, the size
approved by of price risk limits is based on the relationship of the limits to
MRPC 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 Market risk management is an evolving process. Various factors


manage evolving such as market changes, product developments, and technological
risk elements 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 Many individuals participate in the approval process and indicate
plus approval by by signing off. However, the approval authority and accountability must
MRPC member 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. Increasingly-
complex 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 “Earnings-
at-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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þ 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 marking-
to-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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MANAGING MARKET RISK IN CITIBANK 4-21

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
_____ Country Treasurer growth.
_____ 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) Ensures that the country maintains liquidity, has


sufficient capital, and has appropriate funding for
b Country Treasurer 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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MANAGING MARKET RISK IN CITIBANK 4-23

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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MANAGING MARKET RISK IN CITIBANK 4-25

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

Business Risk Group that reviews the policies and rules set by the CPC and MRPC
Review 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 set by Group Executive Vice-presidents, with approval of the


Limits Credit Policy Committee to control Citibank's exposure to various
portfolio risk dimensions

Contingent Risk that potential customer obligations will become actual


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

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

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G-2 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 that matches the profile of an individual customer against


Model established standard profiles for each risk rating to determine the
appropriate risk rating for the customer

Direct Lending Risk that actual customer obligations will not be settled on time
Risk

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 that the documentary evidence on which we depend to enforce


Risk our rights under contracts or transactions may not be complete,
correct, or enforceable

Earnings-at-risk Measure of aggregate price risk which is intended to limit the


Limit 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 Risk that funds will not be available to meet financial commitments
Liquidity Risk 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 G-3

Legal / Risk that occurs whenever the bank, a related corporate entity
Regulatory (such as a non-bank subsidiary or affiliate), a transaction, or a
Risk 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 Individuals who are responsible for developing procedures to


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

Market Risk Generic term for price risk and liquidity risk

Market Risk Committee that establishes corporate policy and standards, and
Policy Committee oversees the market risk management process
(MRPC)

Marking-to- Process of determining the current market value of a position;


Market simulating the liquidation of a position

Maximum Report used to monitor and manage limits on the amount of negative
Cumulative cash flows for a given period
Outflow Report
(MCO)

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G-4 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 Risk that the actions of a sovereign government (such as


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

Premium Risk-adjusted earnings that reflect both the expected cost of credit
Shareholder and the cost of capital necessary to fund an asset
Income (PSI)

Pre-settlement Risk that the trading partner fails before maturity date and the market
Risk 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 that categorizes exposures by severity of actual


Classification and potential risk of loss
System

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

Risk Acceptance Standards for extending credit to ensure that individual exposures and
Criteria (RAC) 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 G-5

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

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

Settlement Risk that the counterparty will fail on the maturity date of a contract
Risk 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 Segment of the market that is of interest to a business unit based


Market on the risk profile and perceived potential return

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

Transfer Risk that funds either cannot be converted into foreign currency
(Cross-border) funds or that converted funds cannot be moved past an exchange
Risk 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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G-6 GLOSSARY

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Index
INDEX

A
Asset and Liability Committee (ALCO) 4-6, 4-8, 4-14

B
Business Risk Review 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 1-4, 1-8
Concentration Limits 3-3—3-5, 3-8, 3-18, 3-20, 3-39, 3-40, 3-
47
Contingent Lending Risk 1-3—1-5
Country Risk 1-14, 1-15, 1-24, 4-12
Country Treasurer 2-7, 4-6, 4-8, 4-9, 4-11—4-13, 4-15
Credit Policy Committee 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
Credit Risk 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

D
Debt-rating Model 3-39, 3-42—3-44
Direct Lending Risk 1-3—1-5, 1-7
Disclosure Risk 1-14, 1-18, 1-20, 1-24
Documentation Risk 1-14, 1-18, 1-20, 1-24

E
Earnings-at-risk Limit 4-3, 4-10, 4-14
Equity Risk 1-14, 1-15, 1-20, 1-24, 2-4

F
Fiduciary Risk 1-14, 1-17, 1-20, 1-24
Funding Liquidity Risk 1-12, 1-14, 4-4, 4-5, 4-14

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1-2 INDEX

I
Issuer Risk 1-3, 1-54, 1-8, 1-12—1-14

L
Legal / Regulatory Risk 1-14, 1-19, 1-21, 1-24
Lending Risk 1-4
Line Management 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
Liquidity 1-8, 1-11, 1-12, 4-1, 4-4—4-9, 4-11—4-15
Liquidity Risk 1-8, 1-9, 1-11—1-14, 4-1, 4-2, 4-4—4-8, 4-10,
4-11, 4-13—4-15
Loss Norm 3-40, 3-41, 3-45, 3-47

M
Management Committee 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
Market Risk 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
Market Risk Policy Committee 2-2, 2-6—2-8, 2-15, 4-1, 4-6—4-15
(MRPC)
Marking-to-Market 4-3
Maximum Cumulative Outflow 4-5
Report (MCO)

N
Net Position 1-10

O
Origination 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 I-3

P
Political (Sovereign) Risk 1-14—1-16, 1-20, 1-22
Premium Shareholder Income (PSI) 3-46, 3-47
Pre-settlement Risk 1-4, 1-6—1-8, 1-12—1-14, 3-19
Price Risk 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 2-7, 4-6, 4-7, 4-9, 4-11, 4-13—4-15
Risk Acceptance Criteria (RAC) 2-9, 3-3, 3-4, 3-7—3-9, 3-21, 3-25, 3-26, 3-46
Risk Ratings 3-1, 3-5, 3-9, 3-19, 3-20, 3-23, 3-24, 3-39—3-47

S
Senior Credit Officers 2-6, 2-10, 2-11, 2-13, 2-15
Senior Securities Officers 2-6, 2-10, 2-11, 2-15
Settlement Risk 1-4, 1-7, 1-12—1-14
Systems Risk 1-14, 1-19, 1-20, 1-24

T
Target Market 2-5, 2-9, 3-3, 3-4, 3-7—3-9, 3-11, 3-18, 3-21,
3-25, 3-26, 3-47
Trading Liquidity Risk 1-12, 1-14, 4-4, 4-6, 4-14
Transfer (Cross-border) Risk 1-14, 1-15, 1-16, 1-20, 1-21

Y
Yield Curve 1-9

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