Latin america training and development center

Introduction to
Risk Management
05/15/96

Introduction to Risk
Management
Warning
This workbook is the product of, and copy-
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America, Inc., and may not be used for any
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Table of Contents

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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

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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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TOPICS
This workbook is divided into four units:
Unit 1: Risk Categories
Unit 2: Citibank's Risk Management Organization
Unit 3: Managing Credit Risk in Citibank
Unit 4: Managing Market Risk in Citibank
THE WORKBOOK
This workbook is designed to give you complete control over your own learning. The
material is divided into workable sections, each containing everything you need to master
the content. You can move through the workbook at your own pace and go back to review
ideas that you didn’t completely understand the first time. Each unit contains:
Objectives –
which point out important elements in the
lesson that you are expected to learn.
Text –
which is the "heart" of the workbook. These
sections explain the content in detail.
Key Terms –
which also appear in the Glossary. They
appear in bold face the first time they appear
in the text.
Instructional
Mapping –
terms or phrases in the left margin which

highlight significant points in the lesson.
INTRODUCTION xiii
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]
Progress Checks –
which do exactly what they say — check your
progress. Appropriate questions are
presented at the end of each unit, or within
the unit in some cases. You will not be graded
on these by anyone else; they are to help you
evaluate your progress. Each set of questions
is followed by an Answer Key. If you have an
incorrect answer, we encourage you to review
the corresponding text and find out why you
made an error.
In addition to these unit elements, the workbook includes:
Appendix – Glossary
which contains definitions of all key terms used
in the workbook.
Index –
which helps you locate glossary items in the
workbook.
Since this is a self-instruction workbook, your progress will not be supervised. We
expect you to complete it to the best of your ability and at your own speed. You are
ready to begin!
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Unit 1

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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
1-2 RISK CATEGORIES
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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.
RISK CATEGORIES 1-3
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Figure 1.1: Major categories and sub-categories of risk
CREDIT RISK
Credit risk is the risk that financial obligations to Citibank will not
be paid on time and in full as expected or contracted, resulting in a
financial loss for the bank. Credit risk is a customer-related risk
because the dimension of the risk depends on the customer's
willingness and ability to fulfill all obligations to the bank. There
are six types of credit risk:
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
extensions of

credit
Lending risk is associated with extensions of credit and/or credit-
sensitive products, such as loans and overdrafts, where the bank bears the
full risk for the entire life of the transaction. There are two types of
lending risk: direct and contingent.
Direct Lending Risk
Direct lending risk is the risk that actual customer obligations will
not be settled on time. Direct lending risk occurs in products ranging
from loans and overdrafts to credit cards and residential mortgages. It
exists for the entire life of the transaction.
Contingent Lending Risk
Contingent lending risk is the risk that potential customer
obligations will become actual obligations and will not be settled on
time. Contingent lending risk occurs in such products as letters of
credit, and guarantees. It exists for the entire life of the transaction.
RISK CATEGORIES 1-5
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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
underwriting and
distribution
Issuer risk occurs in underwriting and distribution activities when the
bank commits to purchase a security or other debt instrument from an
issuer or seller and there is a risk that the instrument cannot be sold
within a predetermined holding period to an investor or purchaser. If
this happens, the bank as the holder of the instrument
is exposed to direct lending risk and unintended price risk.
Issuer risk is the risk that the market value of a security or other debt
instrument that the bank intends to hold for a short period of time may
change when the perceived or actual credit standing of the issuer
changes, thereby exposing the bank to a financial loss. Issuer risk is
interrelated with price risk. (See page 1-7).