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Introduction to Risk Management 05/15/96 Introduction to Risk Management Warning This workbook is the product of, and copyrighted by, Citicorp North America, Inc It is solely for the internal use of Citicorp North America, Inc., and may not be used for any other purpose It is unlawful to reproduce the contents of these materials, in whole or in part, by any method, printed, electronic, or otherwise; or to disseminate or sell the same without the prior written consent of Training and Development Centers - Asia Pacific / CEEMEA / Latin America Please sign your name in the space below Table of Contents Table of Contents INTRODUCTION Introduction: Risk Management Module vii Overview vii Introduction to Risk Management xi Overview xi Objectives xi Topics xii The Workbook xii UNIT 1: Risk Categories Introduction 1-1 Unit Objectives 1-1 Major Risk Categories 1-2 Credit Risk 1-3 Lending Risk 1-4 Direct Lending Risk 1-4 Contingent Lending Risk 1-4 Issuer Risk 1-5 Counterparty Risk 1-6 Pre-settlement Risk 1-6 Settlement Risk 1-7 Clearing Risk .1-8 Summary — Credit Risk 1-8 Market Risk 1-9 Price Risk 1-9 Interest Rates 1-9 Commodity Prices 1-10 Volatility in Options 1-11 Liquidity Risk .1-11 v05/15/96 p01/07/00 Version 2.0 ii TABLE OF CONTENTS 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 1-25 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 Version 2.0 v05/15/96 p01/07/00 TABLE OF CONTENTS iii 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 2-17 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 v05/15/96 p01/07/00 Version 2.0 iv TABLE OF CONTENTS 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 Version 2.0 v05/15/96 p01/07/00 MANAGING MARKET RISK IN CITIBANK 4-25 PROGRESS CHECK (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 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 v05/15/96 p01/10/00 Version 2.0 4-26 MANAGING MARKET RISK IN CITIBANK 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 Version 2.0 v05/15/96 p01/10/00 Appendices APPENDIX GLOSSARY Assets and Liability Committee (ALCO) Committee in each country that makes sure the country maintains adequate liquidity, has sufficient capital to meet regulatory and business needs, and has appropriate funding for business growth Business Risk Review Group that reviews the policies and rules set by the CPC and MRPC and the practices of Line Management to ensure that portfolios are structured to achieve Management Committee's goals Clearing Risk Risk that the bank may not be reimbursed on the same value date for payments that are made on behalf of customers Concentration Limits Limits set by Group Executive Vice-presidents, with approval of the Credit Policy Committee to control Citibank's exposure to various portfolio risk dimensions Contingent Lending Risk Risk that potential customer obligations will become actual obligations and will not be settled on time Country Risk Risk that economic problems, political disturbances, or sovereign actions within a country may make it impossible to get money out of a country or to convert local currency into a foreign currency Country Treasurer Individual who ensures that the country's liquidity risk management process complies with MRPC policy and is flexible enough to encourage transactions while protecting country liquidity Credit Policy Committee Senior-level staff group that establishes policies for credit risk and equity risk, including approval hierarchies, rules and standards covering credit products, and limits for portfolio concentrations v05/15/96 p01/10/00 Version 2.0 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 Model that matches the profile of an individual customer against established standard profiles for each risk rating to determine the appropriate risk rating for the customer Direct Lending Risk Risk that actual customer obligations will not be settled on time Disclosure Risk Risk that as an agent for other investors, either as an underwriter or as an advisor on a transaction, the bank fails to disclose certain information or discloses incorrect information Documentation Risk Risk that the documentary evidence on which we depend to enforce our rights under contracts or transactions may not be complete, correct, or enforceable Earnings-at-risk Limit Measure of aggregate price risk which is intended to limit the negative variance from the monthly budget for trading revenues Equity Risk Risk of fluctuation in the value of equities when the bank invests in, holds, or receives equity, equity-like securities, or other junior securities in non-affiliated entities Fiduciary Risk Risk associated with the responsibility of acting as a trustee for third parties Funding Liquidity Risk Risk that funds will not be available to meet financial commitments when they are contractually due or that funds will not be available to take advantage of attractive business opportunities Issuer Risk Risk that the market value of a security or other debt instrument that the bank intends to hold for a short period of time may change when the perceived or actual credit standing of the issuer changes, thereby exposing the bank to a financial loss Version 2.0 v05/15/96 p01/10/00 GLOSSARY G-3 Legal / Regulatory Risk Risk that occurs whenever the bank, a related corporate entity (such as a non-bank subsidiary or affiliate), a transaction, or a customer is subject to a change in exposure resulting from regulatory, civil or criminal sanctions, or litigation Lending Risk Risk associated with extensions of credit and/or credit-sensitive products, such as loans, overdrafts, placements, letters of credit, and guarantees, where the bank bears the full risk for the entire life of the transaction Line Management Individuals who are responsible for developing procedures to implement the policies and rules established by the CPC and MRPC Liquidity Continuous availability of funds to meet fully and promptly all contractual obligations Liquidity Risk Risk that Citibank will be unable to fulfill its contractual obligations when they are due Loss Norm Probability of default within the next 12 months, expressed as a percentage, multiplied by the economic loss in the event of default (LIED), also expressed as a percentage; the resulting loss norm is expressed in basis points Management Committee Committee that establishes the risk tolerance level for the bank and sets the goals and objectives for risk management activities Market Risk Generic term for price risk and liquidity risk Market Risk Policy Committee (MRPC) Committee that establishes corporate policy and standards, and oversees the market risk management process Marking-toMarket Process of determining the current market value of a position; simulating the liquidation of a position Maximum Cumulative Outflow Report (MCO) Report used to monitor and manage limits on the amount of negative cash flows for a given period v05/15/96 p01/10/00 Version 2.0 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 (Sovereign) Risk Risk that the actions of a sovereign government (such as nationalization or expropriation) or independent events (such as war, riots, or civil commotion) may affect the ability of customers in that country to meet their obligations to Citibank Premium Shareholder Income (PSI) Risk-adjusted earnings that reflect both the expected cost of credit and the cost of capital necessary to fund an asset Pre-settlement Risk Risk that the trading partner fails before maturity date and the market rate changes, resulting in a contract rate that is more attractive than the prevailing market rate Price Risk Risk resulting from one or several financial contracts of such a nature that a change in financial market prices would impact our profit and loss statement Problem Classification System Classification system that categorizes exposures by severity of actual and potential risk of loss Regional Treasurer Individual who acts as liaison between the MRPC and the countries / ALCOs for balance sheet and liquidity management issues Risk Acceptance Criteria (RAC) Standards for extending credit to ensure that individual exposures and the overall portfolio are consistent with business objectives Risk Ratings Ratings assigned to customers and facilities on a scale of one to ten, with one being the best rating Version 2.0 v05/15/96 p01/10/00 GLOSSARY G-5 Senior Credit Officers Customer experts who are responsible for preserving the integrity of credit policies and exercising balanced, independent credit judgment Senior Securities Officers Specialists who apply their experience and expertise to risk and process decisions for underwriting and distribution activities Settlement Risk Risk that the counterparty will fail on the maturity date of a contract involving an exchange of assets The risk is that we deliver our side of the transaction but not receive delivery from the counterparty Systems Risk Risk arising from the operational aspects of the product, including systems which can be both external and internal to the bank Target Market Segment of the market that is of interest to a business unit based on the risk profile and perceived potential return Trading Liquidity Risk Risk that the bank will not be able to liquidate assets quickly enough when cash is needed, or liquidate price risk positions when an adverse price change is expected Transfer (Cross-border) Risk Risk that funds either cannot be converted into foreign currency funds or that converted funds cannot be moved past an exchange control border Yield Curve Interest rates for different maturity dates based on the expectations of market participants for the trend of future interest rates v05/15/96 p01/10/00 Version 2.0 G-6 GLOSSARY (This page is intentionally blank) Version 2.0 v05/15/96 p01/10/00 Index INDEX A Asset and Liability Committee (ALCO) B Business Risk Review 4-6, 4-8, 4-14 2-2, 2-5, 2-9, 2-13, 2-15, 3-1, 3-20, 3-21, 3-23, 3-24, 3-26 C Clearing Risk Concentration Limits 47 Contingent Lending Risk Country Risk Country Treasurer Credit Policy Committee 1-4, 1-8 3-3—3-5, 3-8, 3-18, 3-20, 3-39, 3-40, 31-3—1-5 1-14, 1-15, 1-24, 4-12 2-7, 4-6, 4-8, 4-9, 4-11—4-13, 4-15 2-2, 2-4—2-6, 2-8—2-10, 2-12, 2-13, 2-15, 3-3—3-5, 3-18, 3-26, 3-39, 3-45 1-2, 1-3, 1-6—1-8, 1-12—1-14, 1-16, 1-22—1-24, 2-4, 2-8—2-10, 2-15, 3-1, 3-19, 3-20, 3-22, 3-42, 3-43, 4-2 Credit Risk D Debt-rating Model Direct Lending Risk Disclosure Risk Documentation Risk 3-39, 3-42—3-44 1-3—1-5, 1-7 1-14, 1-18, 1-20, 1-24 1-14, 1-18, 1-20, 1-24 E Earnings-at-risk Limit Equity Risk 4-3, 4-10, 4-14 1-14, 1-15, 1-20, 1-24, 2-4 F Fiduciary Risk Funding Liquidity Risk 1-14, 1-17, 1-20, 1-24 1-12, 1-14, 4-4, 4-5, 4-14 v05/15/96 p01/10/00 Version 2.0 1-2 I Issuer Risk L Legal / Regulatory Risk Lending Risk Line Management Liquidity Liquidity Risk Loss Norm M Management Committee Market Risk Market Risk Policy Committee (MRPC) Marking-to-Market Maximum Cumulative Outflow Report (MCO) N Net Position O Origination INDEX 1-3, 1-54, 1-8, 1-12—1-14 1-14, 1-19, 1-21, 1-24 1-4 2-1, 2-2, 2-4, 2-5, 2-8—2-10, 2-12—2-15, 3-1, 3-3, 3-4, 3-8, 3-9, 3-18, 3-20, 3-23, 3-39, 4-2, 4-7, 4-10, 4-12 1-8, 1-11, 1-12, 4-1, 4-4—4-9, 4-11—4-15 1-8, 1-9, 1-11—1-14, 4-1, 4-2, 4-4—4-8, 4-10, 4-11, 4-13—4-15 3-40, 3-41, 3-45, 3-47 2-2, 2-3, 2-5, 2-6, 2-8, 2-9, 2-12, 2-13, 2-15, 3-3, 3-4, 3-5, 3-18, 3-39 1-2, 1-7—1-9, 1-12—1-14.1, 1-24, 2-1, 2-6, 2-7, 2-12, 4-1—4-3, 4-6, 4-7, 4-11—4-15 2-2, 2-6—2-8, 2-15, 4-1, 4-6—4-15 4-3 4-5 1-10 3-3, 3-9, 3-14, 3-17, 3-18, 3-20, 3-21, 3-26, 3-39, 3-40, 3-47 Version 2.0 v05/15/96 p01/10/00 INDEX P Political (Sovereign) Risk Premium Shareholder Income (PSI) Pre-settlement Risk Price Risk I-3 1-14—1-16, 1-20, 1-22 3-46, 3-47 1-4, 1-6—1-8, 1-12—1-14, 3-19 1-5, 1-6, 1-8, 1-9, 1-12, 1-13, 4-1—4-4, 4-6, 4-8, 4-10—4-15 R Regional Treasurer Risk Acceptance Criteria (RAC) Risk Ratings 2-7, 4-6, 4-7, 4-9, 4-11, 4-13—4-15 2-9, 3-3, 3-4, 3-7—3-9, 3-21, 3-25, 3-26, 3-46 3-1, 3-5, 3-9, 3-19, 3-20, 3-23, 3-24, 3-39—3-47 S Senior Credit Officers Senior Securities Officers Settlement Risk Systems Risk 2-6, 2-10, 2-11, 2-13, 2-15 2-6, 2-10, 2-11, 2-15 1-4, 1-7, 1-12—1-14 1-14, 1-19, 1-20, 1-24 T Target Market Trading Liquidity Risk Transfer (Cross-border) Risk 2-5, 2-9, 3-3, 3-4, 3-7—3-9, 3-11, 3-18, 3-21, 3-25, 3-26, 3-47 1-12, 1-14, 4-4, 4-6, 4-14 1-14, 1-15, 1-16, 1-20, 1-21 Y Yield Curve 1-9 v05/15/96 p01/10/00 Version 2.0 ... disseminate or sell the same without the prior written consent of Training and Development Centers - Asia Pacific / CEEMEA / Latin America Please sign your name in the space below Table of Contents... Warning This workbook is the product of, and copyrighted by, Citicorp North America, Inc It is solely for the internal use of Citicorp North America, Inc., and may not be used for any other purpose... 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