Citi CMB
Advanced Risk Issues
Seeing Around Corners
“Why are we here?”
Tarrytown, NY
October 1 – 4, 2007
Citi CIB
Advanced Risk Issues
Revenue Growth and
Risk Management in a
Complex Global Bank
October 2007
2
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 risks.
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.
October 2007
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The changes in the financial system since 1998 confront us
with a mix of benefits and challenges.
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
October 2007
4
The Economist
Survey of International Banking – May, 2006
Banks the world over are scrambling to become larger…
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 problems
Risk management, the rock on which any contemporary
bank rests, scarcely existed as a profession outside the
insurance industry until the 1970’s
October 2007
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October 2007
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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
October 2007
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International banking – May 2007
Risk and reward
Worried about credit risk?
You should fret more about pension funds than banks
October 2007
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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.”
October 2007
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Survey of International Banking, May 2007
“The 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 table.
international investment banks have become vast financialliquidity 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.
October 2007
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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 default.
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.
October 2007
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Federal Reserve Board of Governors
Credit Risk Supervision – Sabeth Siddique
May, 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
October 2007
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Banks in trouble
The game is up
Aug 16th 2007
October 2007
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Securitisation: life after death
October 2007
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A New World Disorder for Debt Traders
System of Risk Dispersal
Proves 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 '90s.
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.
October 2007
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For Banks, a $300 Billion Hangover
By JACQUELINE DOHERTY
August 27, 2007
IN EVERY BUST THAT 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.
October 2007
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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.
October 2007
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August 12, 2007
Fair Game
A Week When Risk Came Home to Roost
By GRETCHEN MORGENSON
FOR 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 MISBEHAVIOR
October 2007
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Moody’s 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 model.
“A robust corporate culture remains critical
for balancing short-term competitive
pressures and the long-term interests of a
franchise.
October 2007
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Moody’s 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.
October 2007
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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 writedowns – a painful $1.5bn, after its fee cushion.
•There were a couple of other nuggets that underscore how good
Goldman’s 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 publicly.
October 2007
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“Why are we here?”
Moody’s 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.
October 2007
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Whose fault is it?
October 2007
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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 portfolio.
The losses are now estimated at C$680m (US$619m) before
tax, or C$327m after tax. Last month’s estimate was between
C$350m-C$450m.
Standard & Poor’s placed the bank’s 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”.
October 2007
30
JP Morgan ‘misled’ Athens over bond
May 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 deals
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 issue.
October 2007
31
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.
October 2007
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October 2007
Market Cap (intraday):245.18B
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Wall Street Journal 9 Feb, 2004
Size, Smiles and Scandals
A Question of Credibility
Enron. 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, there’s a new phrase on the tongues of
bank executives: reputational risk.
October 2007
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May 10, 2004
Citigroup 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, 2002.
The balance of the second-quarter reserve will go toward a
potential settlement of class-action lawsuits filed by investors in
the Enron Corporation…
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.
October 2007
35
Citigroup's Japan Misstep
May Bruise Bank's Global Image
WSJ 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.
October 2007
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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
risk."
"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."
October 2007
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July, 2003
October 2007
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October 2007
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Moody’s US Banking Commentary
January, 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- ratings.
Finally, to achieve an upgrade to Aaa at the banks,
management's efforts to instill more robust controls and a more
effective culture must succeed.
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.
October 2007
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New York, September 26, 2006
-- Moody's Investors Service
upgraded the ratings of Citibank N.A. to Aaa for longterm 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.
October 2007
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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 'AA-/A-1+'.
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 incurs.
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.
October 2007
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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 license.
October 2007
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Citigroup in Japan retail expansion
FT.com, 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.
October 2007
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The dark side of debt
The Economist – Sept 23, 2006
“Lending is a sober business punctuated
by odd moments of lunacy”…..
October 2007
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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, there’s a bad lender……”
October 2007
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“Open Secrets – Enron, intelligence, and the perils of too
much information”
The New Yorker – Jan 7, 2007
“There have been scandals in corporate history
where people are really making stuff up, but this
wasn’t a criminal enterprise of that kind…”
“Enron was close to having complied with the
accounting rules…they 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.”
October 2007
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“Open Secrets – Enron, intelligence, and the perils
of too much information”
The New Yorker – Jan 7, 2007
“In order for an economy to have an
adequate system of financial reporting….it
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.”
October 2007
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Jaime Caruana - Chairman Basel II
Back to the Future
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.
October 2007
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Sandler O’Neill Equity Research
Dave Bushnell
A recurring theme in [Bushnell’s] comments was the need to
balance effectively between risk and reward
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 management’s 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
October 2007
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Advanced Risk Issues
Why are We Here?
Industry Structure and Risk Analysis
Management and Strategy Assessment
Global Portfolio Management – Running a Modern Bank
Operational Risk
Market Risk and Convergence Risk
Country Risk
Deal Structure Risk
Problem Recognition
Derivatives Risk
October 2007
Underwriting Risk and Conflicts
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Lessons Learned…….
Why do smart bankers sometimes do bad
deals?
Mistakes about the use of Citi’s capital – risk / reward
Missing the most important risk decision - Choose clients
very carefully
Lack of understanding of industry dynamics and risks
Lack of understanding of client’s motivation for doing a deal
Pressure to generate revenue
Going along with the “herd”
October 2007
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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”)
October 2007
61
Citi CIB
Advanced Risk Issues
Revenue Growth and
Risk Management in a
Complex Global Bank
October 2007
62