Citi CMBAdvanced Risk Issues Seeing Around Corners

“Why are we here?”

Tarrytown, NYOctober 1 – 4, 2007

2October 2007

Revenue GrowthRevenue Growth andand

Risk ManagementRisk Management in ain a

Complex Global BankComplex Global Bank

Citi CIBAdvanced Risk Issues

3October 2007

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.

4October 2007

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

5October 2007

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

6October 2007

7October 2007

Global investment banks are taking ever more risk, and are devising ever more

sophisticated ways of spreading it

The alchemists of finance – May, 2007

8October 2007

Worried about credit risk? You should fret more about pension funds than banks

International banking – May 2007

Risk and reward

9October 2007

INTERNATIONAL BANKINGA 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.”

The alchemists of finance

10October 2007

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 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.

11October 2007

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.

12October 2007

Federal Reserve Board of GovernorsCredit 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

13October 2007

Banks in troubleThe game is up

Aug 16th 2007

14October 2007

Securitisation: life after death

15October 2007

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 '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.

16October 2007

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.

17October 2007

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.

18October 2007

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.

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

As a result, “risk models are miscalibrated for the current market environment,”

19October 2007

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.

20October 2007

““Firms that fail to achieve this Firms that fail to achieve this balance expose themselves to open-balance expose themselves to open-ended risks and jeopardize their credit ended risks and jeopardize their credit ratings.ratings.

A firm needs to know when to say no. A firm needs to know when to say no. One manager described his firm's One manager described his firm's business philosophy in this way, "It is business philosophy in this way, "It is not about this trade -it is about the not about this trade -it is about the next next trade".trade".

Moody’s 2005 Securities Industry Outlook

21October 2007

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 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.

22October 2007

23October 2007

“Why are we here?”

25October 2007

““Firms that fail to achieve this Firms that fail to achieve this balance expose themselves to open-balance expose themselves to open-ended risks and jeopardize their credit ended risks and jeopardize their credit ratings.ratings.

A firm needs to know when to say no. A firm needs to know when to say no. One manager described his firm's One manager described his firm's business philosophy in this way, "It is business philosophy in this way, "It is not about this trade -it is about the not about this trade -it is about the next next trade".trade".

Moody’s 2005 Securities Industry Outlook

26October 2007

27October 2007

28October 2007

Whose fault is it?Whose fault is it?

29October 2007

30October 2007

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”.

31October 2007

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 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.

32October 2007

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.

33October 2007

Market Cap (intraday):245.18B

34October 2007

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, there’s a new phrase on the tongues of bank executives: reputational risk.

35October 2007

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, 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.

36October 2007

Citigroup's Japan MisstepMay 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.

37October 2007

38October 2007

39October 2007

40October 2007

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."

41October 2007

July, 2003July, 2003

42October 2007

43October 2007

Moody’s 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- 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.

44October 2007

45October 2007

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.

46October 2007

47October 2007

48October 2007

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.

49October 2007

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.

50October 2007

Citigroup in Japan retail expansionFT.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.

51October 2007

The dark side of debtThe Economist – Sept 23, 2006

“Lending is a sober business punctuated by odd moments of lunacy”…..

52October 2007

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……”

53October 2007

“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.”

54October 2007

“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.”

55October 2007

Jaime Caruana - Chairman Basel IIBack 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.

56October 2007

Sandler O’Neill Equity ResearchDave 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

57October 2007

58October 2007

59October 2007

Advanced Risk IssuesWhy 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

Underwriting Risk and Conflicts

60October 2007

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”

61October 2007

Lessons Learned…….Why do smart bankers sometimes do bad

deals?

““It is difficult to get a man to It is difficult to get a man to understand something when his understand something when his

salary depends upon his not salary depends upon his not understanding it.”understanding it.”

Upton SinclairUpton Sinclair

(from “An Inconvenient Truth”)(from “An Inconvenient Truth”)

62October 2007

Revenue GrowthRevenue Growth andand

Risk ManagementRisk Management in ain a

ComplexComplex GlobalGlobal BankBank

Citi CIBAdvanced Risk Issues