Citibank 2015 Annual Report Download - page 269

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Valuation Process for Fair Value Measurements
Price verification procedures and related internal control procedures are
governed by the Citigroup Pricing and Price Verification Policy and
Standards, which is jointly owned by Finance and Risk Management.
For fair value measurements of substantially all assets and liabilities
held by the Company, individual business units are responsible for valuing
the trading account assets and liabilities, and Product Control within
Finance performs independent price verification procedures to evaluate
those fair value measurements. Product Control is independent of the
individual business units and reports to the Global Head of Product Control.
It has authority over the valuation of financial assets and liabilities. Fair
value measurements of assets and liabilities are determined using various
techniques, including, but not limited to, discounted cash flows and internal
models, such as option and correlation models.
Based on the observability of inputs used, Product Control classifies the
inventory as Level 1, Level 2 or Level 3 of the fair value hierarchy. When
a position involves one or more significant inputs that are not directly
observable, price verification procedures are performed that may include
reviewing relevant historical data, analyzing profit and loss, valuing
each component of a structured trade individually, and benchmarking,
among others.
Reports of inventory that is classified within Level 3 of the fair value
hierarchy are distributed to senior management in Finance, Risk and the
business. This inventory is also discussed in Risk Committees and in monthly
meetings with senior trading management. As deemed necessary, reports may
go to the Audit Committee of the Board of Directors or to the full Board of
Directors. Whenever an adjustment is needed to bring the price of an asset or
liability to its exit price, Product Control reports it to management along with
other price verification results.
In addition, the pricing models used in measuring fair value are governed
by an independent control framework. Although the models are developed
and tested by the individual business units, they are independently validated
by the Model Validation Group within Risk Management and reviewed by
Finance with respect to their impact on the price verification procedures. The
purpose of this independent control framework is to assess model risk arising
from models’ theoretical soundness, calibration techniques where needed,
and the appropriateness of the model for a specific product in a defined
market. To ensure their continued applicability, models are independently
reviewed annually. In addition, Risk Management approves and maintains
a list of products permitted to be valued under each approved model for a
given business.
Securities Purchased Under Agreements to Resell and
Securities Sold Under Agreements to Repurchase
No quoted prices exist for these instruments, so fair value is determined using
a discounted cash-flow technique. Cash flows are estimated based on the
terms of the contract, taking into account any embedded derivative or other
features. These cash flows are discounted using interest rates appropriate
to the maturity of the instrument as well as the nature of the underlying
collateral. Generally, when such instruments are recorded at fair value, they
are classified within Level 2 of the fair value hierarchy, as the inputs used in
the valuation are readily observable. However, certain long-dated positions
are classified within Level 3 of the fair value hierarchy.
Trading Account Assets and Liabilities—Trading Securities
and Trading Loans
When available, the Company uses quoted market prices in active markets
to determine the fair value of trading securities; such items are classified as
Level 1 of the fair value hierarchy. Examples include government securities
and exchange-traded equity securities.
For bonds and secondary market loans traded over the counter, the
Company generally determines fair value utilizing valuation techniques,
including discounted cash flows, price-based and internal models, such as
Black-Scholes and Monte Carlo simulation. Fair value estimates from these
internal valuation techniques are verified, where possible, to prices obtained
from independent sources, including third-party vendors. Vendors compile
prices from various sources and may apply matrix pricing for similar bonds
or loans where no price is observable. A price-based methodology utilizes,
where available, quoted prices or other market information obtained from
recent trading activity of assets with similar characteristics to the bond
or loan being valued. The yields used in discounted cash flow models are
derived from the same price information. Trading securities and loans priced
using such methods are generally classified as Level 2. However, when less
liquidity exists for a security or loan, a quoted price is stale, a significant
adjustment to the price of a similar security or loan is necessary to reflect
differences in the terms of the actual security or loan being valued, or prices
from independent sources are insufficient to corroborate valuation, a loan or
security is generally classified as Level 3. The price input used in a price-
based methodology may be zero for a security, such as a subprime CDO,
that is not receiving any principal or interest and is currently written down
to zero.
When the Company’s principal market for a portfolio of loans is the
securitization market, the Company uses the securitization price to determine
the fair value of the portfolio. The securitization price is determined from
the assumed proceeds of a hypothetical securitization in the current market,
adjusted for transformation costs (i.e., direct costs other than transaction
costs) and securitization uncertainties such as market conditions and
liquidity. As a result of the severe reduction in the level of activity in
certain securitization markets since the second half of 2007, observable
securitization prices for certain directly comparable portfolios of loans
have not been readily available. Therefore, such portfolios of loans are
generally classified as Level 3 of the fair value hierarchy. However, for other
loan securitization markets, such as commercial real estate loans, price
verification of the hypothetical securitizations has been possible, since these
markets have remained active. Accordingly, this loan portfolio is classified as
Level 2 of the fair value hierarchy.
For most of the lending and structured direct subprime exposures, fair
value is determined utilizing observable transactions where available,
other market data for similar assets in markets that are not active and
other internal valuation techniques. The valuation of certain asset-backed
security (ABS) CDO positions utilizes prices based on the underlying assets of
the ABS CDO.