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Citi CMB Advanced Risk Issues Seeing Around Corners Why are we here? Tarrytown, NY October 1 – 4, 2007


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Title: Citi CMB Advanced Risk Issues Seeing Around Corners Why are we here? Tarrytown, NY October 1 – 4, 2007

Citi CMBAdvanced Risk Issues Seeing Around
Corners Why are we here?Tarrytown,
NYOctober 1 4, 2007
Citi CIBAdvanced Risk Issues
Revenue Growth and Risk Management in a Complex
Global Bank
Basel II Federal Reserve Board Susan Schmidt
Bies 2006
  • The largest institutions have moved away from the
    traditional banking strategy of holding assets on
    the balance sheet to strategies that emphasize
    redistribution of assets and actively managing
  • These dramatic changes to the risk profiles of
    many banking organizations have only accelerated
    with the continued evolution of many, often
    complex, financial tools, such as
    securtitizations and credit derivatives.

  • The changes in the financial system since 1998
    confront us with a mix of benefits and
  • The larger size and scope of the core
    institutions, the greater opportunities for
  • risk transfer and hedging provided by innovation
    in derivatives,
  • improvements in risk management,
  • The larger role played by a much expanded number
    and more diverse mix of private fund managers
    seem likely to have improved the stability and
    resilience of the financial system across a
    broader range of circumstances

The Economist Survey of International Banking
May, 2006
  • Banks the world over are scrambling to become
  • But at some point diseconomies of scale will also
    start creeping in, with management finding it
    harder to summarize everything that is going on
    in the bank
  • This includes the neglect of concealed risks and
    the failure of internal controls
  • This problem afflicted Citigroup in 2002 2005
    when it was rocked by a string of compliance
  • Risk management, the rock on which any
    contemporary bank rests, scarcely existed as a
    profession outside the insurance industry until
    the 1970s

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The alchemists of finance May, 2007
Global investment banks are taking ever more
risk, and are devising ever more sophisticated
ways of spreading it
  • International banking May 2007
  • Risk and reward

Worried about credit risk? You should fret more
about pension funds than banks
The alchemists of finance
INTERNATIONAL BANKING A discussion with Henry
Tricks, Finance Editor of The Economist May
17, 2007                    Investment banking
is highly competitive. Everyone is following each
other down the same path there's a herding
instinct. With your competitors, you take bigger
and bigger risks. The trick is not to be left
holding the hand-grenade at the end, and we're
not sure when the end will come.
Survey of International Banking, May 2007The
alchemists of finance
  • Thanks to technological and financial wizardry,
    loans are now made with little contact between
    borrower and lender, and are shuffled around the
    financial system like so many cards at a poker
  • international investment banks have become vast
    financial-liquidity factories, turning loans into
    tradable securities, selling them on and earning
    record profits as a reward
  • Thanks to the relentless deal-making between
    financial institutions, if (or rather when)
    liquidity dries up, risks that the banks think
    they have outsourced to hedge funds, insurance
    companies and pension funds might cascade back
    onto their books.

Fed, Other Regulators Turn Attention to Risk in
Banks LBO Lending May 18,2007  Page C1
  • The leading arrangers of leveraged loans have
    exposure that is far smaller than the total
    because they typically "syndicate" the loans.
    What they keep, they often hedge with
    credit-default swaps.
  • But banks are still exposed to default in the
    period before they have syndicated or hedged a
    loan. Even a short-term bridge loan exposes the
    lender to the risk that the borrower won't be
    able to find longer-term financing, or will
  • One worry for regulators is that an abrupt
    deterioration in the markets could suddenly leave
    many banks with long-term exposure they hadn't
    counted on.

Federal Reserve Board of GovernorsCredit Risk
Supervision Sabeth SiddiqueMay, 2007
  • It is unsafe and unsound to be in credit risk
    trading without an understanding of the risks
    being traded
  • Banks should not be trading credit risk on
    technical factors
  • There is a large, new risk Pipeline Risk.
    The risk that a market event will dry up
    liquidity in the middle of a syndication or
    creation of credit default protection

Banks in trouble The game is up Aug 16th 2007
Securitisation life after death
A New World Disorder for Debt Traders System of
Risk DispersalProves to Be a Bit Erratic WSJ
August 10, 2007 Page C1
  • Welcome to the new world of finance.
  • Markets have taken on an increasingly important
    role since the financial crises of the 1980s and
  • When banks make loans, they are now often bundled
    into securities that are sold in pieces to
    investors around the world, changing hands many
    times. It spreads risk, which policy makers
    believe keeps the overall financial system sound
    and stable.
  • But the downsides to this system could be
    serious. A financial architecture that dispersed
    risk also helped to create it. And when troubles
    emerge -- as they have in the U.S. housing market
    -- they can show up just about any place in the
    world and in ways nobody predicted.

For Banks, a 300 Billion Hangover By JACQUELINE
FOLLOWS A BOOM, embarrassing details emerge
showing just how eager the players were to
participate in the insanity. In the current bust,
these revealing nuggets are buried in the lending
commitments of some of the largest pending LBOs.
In their bid to win LBO business amid the boom,
lenders surrendered many of their exit options to
private-equity shops.
Heading for the rocks Will financial turmoil sink
the world economy?
Has dispersing risk really made the world safer?
  • Events of the past month have shown that while
    risk can be dis-intermediated by banks, it cannot
    be eliminated.
  • Arguably, it migrates to elements of the
    financial system, such as hedge funds, insurers
    and pension funds, which are less qualified to
    manage it.
  • And banks, which had been thought to have become
    safer as a result of the disintermediation of
    risk, now face increased risk exposure.
  • Some are being forced to assume responsibility
    for the liabilities of off-balance-sheet vehicles
    which cannot be refinanced. Others have been left
    holding large loans for leveraged buy-outs which
    they underwrote but cannot syndicate in current
    market conditions.

August 12, 2007 Fair Game A Week When Risk Came
something that everybody assured us was
contained, the sub prime mortgage mess
certainly has spread.
As a result, risk models are miscalibrated for
the current market environment,
The only trouble is, financial markets do not
always trade in a way that is typical or
predictable. And when they deviate from the norm,
all the wonderful and smart trades stop behaving
according to plan. ANALYSTS CALL IT MODEL
Moodys 2005 Securities Industry Outlook
  • For all global trading and market-making firms,
    highly-skilled risk management - broadly defined
    - is an absolute necessity for the business
  • A robust corporate culture remains critical for
    balancing short-term competitive pressures and
    the long-term interests of a franchise.

Moodys 2005 Securities Industry Outlook
  • A firm needs to know when to say no. One manager
    described his firm's business philosophy in this
    way, "It is not about this trade -it is about the
    next trade".
  • Firms that fail to achieve this balance expose
    themselves to open-ended risks and jeopardize
    their credit ratings.

World comes to an end. Goldman Sachs net income
surges September 20 2007
  • It verges on the unseemly to achieve a nearly 20
    per cent increase in fixed-income trading from
    the previous quarter after stripping out a
    one-off gain on a disposal.
  • That means Goldman was able to increase
    fixed-income revenues even after taking its lumps
    on leveraged loan write-downs a painful 1.5bn,
    after its fee cushion.
  • There were a couple of other nuggets that
    underscore how good Goldmans risk management
    appears to be. For instance, leveraged loan debt
    that it sold in the market recently fetched
    prices in line with or slightly above the
    negative marks Goldman had pencilled in. That may
    be so for others as well, but Goldman has said it

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Why are we here?
Moodys 2005 Securities Industry Outlook
  • A firm needs to know when to say no. One manager
    described his firm's business philosophy in this
    way, "It is not about this trade -it is about the
    next trade".
  • Firms that fail to achieve this balance expose
    themselves to open-ended risks and jeopardize
    their credit ratings.

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Whose fault is it?
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BMO warns on large natural gas losses May 17 2007
  • BMO Financial Group, parent of the Bank of
    Montreal, has sharply lifted its estimate of
    losses from natural gas trading, dismissed two
    commodity traders, and is investigating possible
    fraud in the trading and valuation of the
  • The losses are now estimated at C680m (US619m)
    before tax, or C327m after tax. Last months
    estimate was between C350m-C450m.
  • Standard Poors placed the banks ratings on
    review, saying the loss is disproportionate to
    its total trading revenues, and does not reflect
    BMO's stated strategy of being a low-risk bank.

JP Morgan misled Athens over bondMay 20 2007
  • The bond was arranged by JP Morgan for the Greek
    government to fund military expenditure. After
    its issue, it was sold to four pension funds at
    an unfavorable price, via a chain of pre-planned
  • Seven weeks ago, JP Morgan wrote to the Greek
    government saying that it had sold the entire
    bond issue to North believing the fund would be a
    buy and hold investor. It denied any knowledge
    of the planned chain of transactions.
  • Its allegations threaten to fuel a growing
    political scandal in Greece about structured
    bonds arranged by investment banks. This
    controversy has already triggered mass strikes in
    Greece, forced the removal of a cabinet minister
    and prompted a government investigation into the

Russia reopens 22 billion lawsuit against Bank
of NY
  • The claim was for unpaid taxes on money taken out
    of Russia via an illegal scheme facilitated by
    the Bank of New York, more than 10 years ago
  • At the time of the scandal, there were rumors
    that Russian officials and businessmen had
    benefited from the scheme.
  • Two Russian emigrants - one of whom was a Bank of
    New York vice-president - admitted laundering at
    least 7bn through the bank, using accounts at
    the bank to channel funds from Moscow to parties
    all around the world. They were sentenced to five
    years probation last year.

Market Cap (intraday)245.18B
Wall Street Journal 9 Feb, 2004Size, Smiles and
ScandalsA Question of CredibilityEnron.
Worldcom. Adelphia. HealthSouth. Parmalat.
  • The list of companies tarnished by scandal over
    the past couple of years contains many of the
    same names that banks were tripping over one
    another to do business with not long ago.
  • Money-center banks lost millions of dollars on
    loans to these companies. Settling multiple
    regulatory inquiries cost banks billions.
  • So these days, theres a new phrase on the
    tongues of bank executives reputational risk.

May 10, 2004Citigroup to Pay 2.65 Billion in
Deal With WorldCom Investors
  • Citigroup, said today that it would set aside
    4.95 billion in the second quarter to cover
    legal costs, including a pretax payment of 2.95
    billion to settle claims with investors in
    Worldcom Inc.
  • The payment will go to investors who bought
    WorldCom bonds at public offerings made in 2000
    and 2001, as well as securities purchased in the
    open market between April 29, 1999, and June 25,
  • The balance of the second-quarter reserve will go
    toward a potential settlement of class-action
    lawsuits filed by investors in the Enron
  • To provide itself additional cushioning to deal
    with suits still pending, Citigroup said that
    after settling the WorldCom matter, it would have
    a "litigation reserve" of 6.7 billion on a
    pretax basis.

Citigroup's Japan MisstepMay Bruise Bank's
Global ImageWSJ September 22, 2004
  • The forced closure of Citigroup Inc.'s
    private-banking business in Japan likely will
    have little direct impact on its bottom line, but
    the bank's reputation is taking yet another hit.
  • The banking colossus has lost 8 billion, or 3,
    of its market value since Japan's Financial
    Services Agency last week ordered subsidiary
    Citibank N.A. to shutter the business
  • So far this week, a prominent Wall Street analyst
    has downgraded the stock and credit-rating
    company Moody's Investors Service Inc. has warned
    that Citigroup must keep squeaky clean in order
    to receive ratings upgrades in the future.

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Business Week 4 October, 2004"CLAWS AND FANGS"
  • "The constraint on Citi's growth is not its
    market size, nor its capital," says Bernstein's
    Mason. "It may well be that Citi can't achieve
    its growth ambitions because it cannot safeguard
    itself properly from regulatory and reputation
  • "Citi has become so large that it is simply not
    possible to mandate behavior. The challenge now
    is to create a culture, to inculcate a shared set
    of values that guide employee behavior."

July, 2003
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Moodys US Banking CommentaryJanuary, 2006
  • Before discussing Citigroup's quarter we would
    like to remind you that we recently assigned a
    positive rating outlook to Citibank's Aa1/A-
  • Finally, to achieve an upgrade to Aaa at the
    banks, management's efforts to instill more
    robust controls and a more effective culture must
  • Management will need to maintain its focus on
    strengthening business practices, despite
    shareholder pressures for growth, since we see
    cultural change as a multi-year process.
  • We would interpret a major new reputation or
    regulatory problem as a failure of management's
    control initiatives. This could preclude an
    upgrade of the banks.

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New York, September 26, 2006 -- Moody's Investors
Service upgraded the ratings of Citibank N.A. to
Aaa for long-term deposits and to A for financial
strength Citigroup has a well-recognized
brand, and management has built leading global
franchises in credit cards, consumer finance,
international consumer banking, wealth management
and wholesale banking. These businesses have
produced strong and consistent earnings even
during difficult economic or market conditions.
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NEW YORK (Standard Poor's) Feb. 14,
2007--Standard Poor's Ratings Services said
today that it raised its counterparty credit
rating on Citigroup Inc. (Citi) to 'AA/A-1' from
  • The long-term counterparty credit rating on
    Citibank N.A. was raised to 'AA'..
  • Strong earnings generation from an
    extraordinarily diverse set of businesses allows
    Citi to cover some of the high risks that it
  • Citi has also achieved a substantial change in
    its control environment in the aftermath of a
    wave of heavy litigation expenses and criticism
    of its business practices from regulators around
    the world. The period of adjustment is over, and
    Citi has been investing heavily to stimulate
    organic growth.

January 29, 2007 -- Shopaholic Citigroup WSJ
  • London-based Prudential announced that it would
    sell its troubled Egg online banking business to
    Citigroup for roughly 1.13 billion
  • Citigroup has been on a shopping binge ever since
    the Federal Reserve let it out of the penalty box
    in April.
  • The central bank decided to bar Citigroup from
    making any deals back in March 2005 after a
    parade of regulatory tangles, including an uproar
    over a European bond gambit the company's traders
    lovingly christened "Dr. Evil" and Japan's
    decision to yank Citigroup's private-banking

Citigroup in Japan retail, Jan
29 2007
  • Citigroup on Monday said it would significantly
    expand its retail and corporate banking
    operations in Japan, just a few weeks after
    scaling back its consumer finance business.
  • The move follows a tumultuous time for Citigroup
    in Japan.
  • In 2004, the bank was ordered by the authorities
    to close its private banking business, and last
    year it was hit with a business improvement order
    for customer data processing errors.

The dark side of debtThe Economist Sept 23,
  • Lending is a sober business punctuated by odd
    moments of lunacy..

In an Uncertain World by Robert E. Rubin
However, the global financial crisis (1997) was
far from solely the fault of the countries that
got into trouble.. I do believe that a
significant share of blame for the crisis should
go to private investors and creditors. They
systematically under-weighted the risks of
investing in and lending to underdeveloped
markets over a number of years, and consequently
supplied capital greatly in excess of what would
have been sound and sensible.. For every bad
borrower, theres a bad lender
Open Secrets Enron, intelligence, and the
perils of too much informationThe New Yorker
Jan 7, 2007
  • There have been scandals in corporate history
    where people are really making stuff up, but this
    wasnt a criminal enterprise of that kind
  • Enron was close to having complied with the
    accounting rulesthey were going over the edge
    just a little bit
  • And this kind of financial fraud, where people
    are simply stretching the truth, falls into the
    area that analysts and short-sellers are supposed
    to ferret out.

Open Secrets Enron, intelligence, and the
perils of too much informationThe New Yorker
Jan 7, 2007
  • In order for an economy to have an adequate
    system of financial is vital that
    there be a set of financial intermediaries, who
    are at least as competent and sophisticated at
    receiving, processing, and interpreting financial
    information as the companies delivering it.

Jaime Caruana - Chairman Basel IIBack to the
  • Despite the significant progress made in the
    banking industry in the use of models and new
    technologies, banks still depend largely on risk
    managers expert judgement.
  • Quantifying risk involves making assumptions and
    judgements. And no model, and no software
    package, no matter now sophisticated, can ever
    replace the skills of a trained, experienced and
    conscientious risk manager.
  • That is why we have made sure that the Basel II
    framework is much more than numbers and models.
    Such judgement should be reinforced, however,
    with the best possible information, techniques
    and tools for processing that information.

Sandler ONeill Equity ResearchDave Bushnell
  • A recurring theme in Bushnells comments was
    the need to balance effectively between risk and
  • The real key to superior performance is to
    effectively manage risk, not try to eliminate it
  • No is an unacceptable answer when evaluating
    the commitment of resources to a new project
    (deal). No, because and Yes, if are much
    better answers
  • Changes in managements appetite for and approach
    to the management of risk in recent years have
    been focused on operational risk, not market or
    credit risk
  • As long as management is making the right
    specific (local) risk related decisions, global
    risk is a manageable task

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Advanced Risk IssuesWhy are We Here?
  • Industry Structure and Risk Analysis
  • Management and Strategy Assessment
  • Global Portfolio Management Running a Modern
  • Operational Risk
  • Market Risk and Convergence Risk
  • Country Risk
  • Deal Structure Risk
  • Problem Recognition
  • Derivatives Risk
  • Underwriting Risk and Conflicts

Lessons Learned.Why do smart bankers sometimes
do bad deals?
  • Mistakes about the use of Citis capital risk /
  • Missing the most important risk decision -
    Choose clients very carefully
  • Lack of understanding of industry dynamics and
  • Lack of understanding of clients motivation for
    doing a deal
  • Pressure to generate revenue
  • Going along with the herd

Lessons Learned.Why do smart bankers sometimes
do bad deals?
It is difficult to get a man to understand
something when his salary depends upon his not
understanding it. Upton Sinclair (from An
Inconvenient Truth)
Citi CIBAdvanced Risk Issues
Revenue Growth and Risk Management in a Complex
Global Bank