Citibank 2012 Annual Report Download - page 124

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MARKET RISK
Market risk encompasses liquidity risk and price risk, both of which arise in
the normal course of business of a global financial intermediary such as Citi.
For a discussion of funding and liquidity risk, see “Capital Resources and
Liquidity—Funding and Liquidity” and “Risk Factors—Liquidity Risks”
above. Price risk losses arise from fluctuations in the market value of trading
and non-trading positions resulting from changes in interest rates, credit
spreads, foreign exchange rates, equity and commodity prices, and in their
implied volatilities.
Market Risk Management
Each business is required to establish, with approval from Citi’s market
risk management, a market risk limit framework for identified risk factors
that clearly defines approved risk profiles and is within the parameters of
Citi’s overall risk tolerance. These limits are monitored by independent
market risk, Citi’s country and business Asset and Liability Committees
and the Global Finance and Asset and Liability Committee. In all cases,
the businesses are ultimately responsible for the market risks taken and for
remaining within their defined limits.
Market Risk Management and Stress Testing
Market (price) risks are measured in accordance with established standards
to ensure consistency across businesses and the ability to aggregate risk.
The measurement used for non-trading and trading portfolios, as well as
associated stress testing processes, are described below.
Price Risk—Non-Trading Portfolios
Net Interest Revenue and Interest Rate Risk
One of Citi’s primary business functions is providing financial products that
meet the needs of its customers. Loans and deposits are tailored to customer
requirements with regard to tenor, index (if applicable) and rate type. Net
interest revenue (NIR), for interest rate exposure purposes, is the difference
between the yield earned on the non-trading portfolio assets (including
customer loans) and the rate paid on the liabilities (including customer
deposits or company borrowings). NIR is affected by changes in the level of
interest rates. For example:
•฀ At any given time, there may be an unequal amount of assets and
liabilities that are subject to market rates due to maturation or repricing.
Whenever the amount of liabilities subject to repricing exceeds the
amount of assets subject to repricing, a company is considered “liability
sensitive.” In this case, a company’s NIR will deteriorate in a rising-rate
environment.
•฀ The assets and liabilities of a company may reprice at different speeds or
mature at different times, subjecting both “liability-sensitive” and “asset-
sensitive” companies to NIR sensitivity from changing interest rates. For
example, a company may have a large amount of loans that are subject
to repricing in the current period, but the majority of deposits are not
scheduled for repricing until the following period. That company would
suffer from NIR deterioration if interest rates were to fall.
NIR in any particular period is the result of customer transactions and
the related contractual rates originated in prior periods, as well as new
transactions in the current period; those prior-period transactions will be
impacted by changes in rates on floating-rate assets and liabilities in the
current period.
Due to the long-term nature of portfolios, NIR will vary from quarter to
quarter even assuming no change in the shape or level of the yield curve
as assets and liabilities reprice. These repricings are a function of implied
forward interest rates, which represent the overall market’s estimate of future
interest rates and incorporate possible changes in the federal funds rates, as
well as the shape of the yield curve.
Interest Rate Risk Measurement
Citi’s principal measure of risk to NIR is interest rate exposure (IRE). IRE
measures the change in expected NIR in each currency resulting solely from
unanticipated changes in forward interest rates. Factors such as changes
in volumes, credit spreads, margins and the impact of prior-period pricing
decisions are not captured by IRE. IRE also assumes that businesses make no
additional changes in pricing or balances in response to the unanticipated
rate changes.
For example, if the current 90-day LIBOR rate is 3% and the one-year-
forward rate (i.e., the estimated 90-day LIBOR rate in one year) is 5%, the
+100 bps IRE scenario measures the impact on the company’s NIR of a
100 bps instantaneous change in the 90-day LIBOR to 6% in one year.
The impact of changing prepayment rates on loan portfolios is
incorporated into the results. For example, in the declining interest rate
scenarios, it is assumed that mortgage portfolios prepay faster and that
income is reduced. In addition, in a rising interest rate scenario, portions of
the deposit portfolio are assumed to experience rate increases that may be less
than the change in market interest rates.
Mitigation and Hedging of Risk
In order to manage changes in interest rates effectively, Citi may modify
pricing on new customer loans and deposits, enter into transactions with
other institutions or enter into off-balance-sheet derivative transactions that
have the opposite risk exposures. Citi regularly assesses the viability of these
and other strategies to reduce its interest rate risks and implements such
strategies when it believes those actions are prudent.
Stress Testing
Citigroup employs additional measurements, including stress testing the
impact of non-linear interest rate movements on the value of the balance
sheet; the analysis of portfolio duration and volatility, particularly as they
relate to mortgage loans and mortgage-backed securities; and the potential
impact of the change in the spread between different market indices.