B593F Banking and Financial Institutions

Individual case write-up

Riabkov Kostiantyn

CITIGROUP 2007: FINANCIAL REPORTING AND REGULATORY CAPITAL

Please prepare a report on the case. The report should be (i) a four-page memorandum of analysis
and recommendations covering each case study question, and (ii) any accompanying exhibits
(tables, models, graphs) you wish to include as appendices. Please address the case study
questions in separate paragraphs. Please also make sure that you only include exhibits that make a
major contribution to the analysis and do not duplicate the discussion in the report. The conclusions
should be written as if you were making recommendations to a major decision maker. Please
indicate how you have arrived at your conclusions I care about the thinking process and logic
rather than the correctness of the answer.
This is an individual assignment; all reports will be checked for plagiarism and possible collusion.
Please include the following disclaimer in the report: "I confirm that this essay is my own unaided
work, except as specified within; all sources are fully acknowledged and referenced". The
submission deadline is Monday, 23 May 2016. The report must be submitted on Moodle. The report
is worth 40% of your final grade.

Case Questions
1. What are the primary line items within Citigroups balance sheet and income statement? Using
the balance sheet as a reference, what happens during a run on the bank?
2. What are the major US regulatory capital provisions, particularly for the tier 1 capital ratio? Using
Citigroup, estimate the major calculations underlying its 2007 tier 1 capital ratio.
3. Describe the major provisions of fair value accounting under SFAS 157. What does a measure like
net income capture as the firm moves towards fair value?
4. Assume Citigroup experiences continuing losses in its trading account assets in Q1 2008,
requiring a (net of tax) fair value decrease (considered to be permanent) of $50 billion. How would
this be recognized in the financial statements? How would this affect the tier 1 capital ratio?
5. Under the scenario above, what strategic options can Citigroup management consider?

DISCLAIMER: I confirm that this essay is my own unaided work, except as specified within; all
sources are fully acknowledged and referenced.

Question 1.
In regards to ease the analysis for this question and exclude the influence of a general over-time
growth trend for the company, hereafter I apply the relative evaluation approach: I recalculate each
item in the balance sheet as a proportion to total assets (to liabilities together with shareholders
equity for the right side of the statement). For the income statement I induce the same technique
although here all the line items are normalized with respect to the upper line in the statement,
interest revenue. I also assume that the term primary items relates to the accounts that exceed
5% in normalized values for the balance sheet and 10% for the income statement; they are
represented below.
Table 1. Summary of the primary items, both asset and liabilities sides in absolute and normalized
(%) terms:
Assets
Consumer
Loans
Tr. Acc.
Assets
Fed. Funds
Sold
Investments
Corporate
Loans
Other Assets

2007
$5923
07
$5389
84
$2740
66
$2150
08
$1856
86
$1688
75

2006
$51292
1
$39392
5
$28281
7
$27359
1
$16627
1
$10093
6

07,
%
27.1
%
24.6
%
12.5
%
9.8
%
8.5
%
7.7
%

06,
%
27.2
%
20.9
%
15.0
%
14.5
%
8.8
%
5.4
%

Liabiliti
es
2007
2006
Int. Dep., out.
$5168
US
38
$4271
L.T. Debt
12
Fed. Funds
$3042
Purch.
43
Int. Deposits,
$2251
US
98
Tr. Acc.
$1820
Liabilities
82
S.T.
$1464
Borrowings
88

07,
$4432
75
$2884
94
$3492
35
$1950
02
$1458
87
$1008
33

%
06, %
23.6 23.5
%
%
19.5 15.3
%
%
13.9 18.5
%
%
10.3 10.3
%
%
8.3
7.7
%
%
6.7
5.4
%
%

On the assets side the largest accounts are

Consumer Loans, Trading Account Assets,
Corporate and Consumer Loans, Investments,
Federal Funds Sold and Other Assets. On the
liabilities side the outstanding items are InterestBearing Deposits inside and outside the US,
Long-Term Debt, Federal Funds purchased,
Liabilities on Trading accounts and Short-Term Borrowings. In the shareholders` equity section only
the Retained Earnings line is worth mentioning: it was 5.6% and 6.9% in FY2007 and FY2006
respectively.
The major items on the income statement are Interest Revenues and Interest Expenses: they yield
a Net Interest revenue of about 52% in 2005 and only 38% in 2007. This line is followed by the
Commissions Account that is the biggest determinant of the Total Non-Interest Revenue (around
19%), Provisions for Credit Losses (increased from 10% to 14% during this period) and
Compensations and Benefits that is about one-third of the Interest revenue of the firm.
Assets
Loan Losses
Other Assets
Dep From Banks
Trading Accounts Assets
Fed. Funds Sold

FY2007
($16,117)
$168,875
$69,366
$538,984
$274,066

FY2006
($8,940)
$100,936
$42,522
$393,925
$282,817

FY'07, %
-0.7%
7.7%
3.2%
24.6%
12.5%

FY'06, %
-0.5%
5.4%
2.3%
20.9%
15.0%

>15%1
55.3%
44.1%
40.5%
17.9%
-16.5%

1 Relative deviation = (Normalized Value 07/Normalized Value 06)-1, where Normalized value=Account/Total Assets

Investments
Liabilities
L.T. Debt
S.T. Borrowings
Fed. Funds
Purch.
S.E.
Retained
Earnings

$215,008

$273,591

9.8%

14.5%

-32.3%

$427,112
$146,488

$288,494
$100,833

19.5%
6.7%

15.3%
5.4%

27.5%
25.1%

$304,243

$349,235

13.9%

18.5%

-25.0%

$121,920

$129,267

5.6%

6.9%

-18.8%

During the 2006-2007 period the financials of Citigroup changed significantly, and several accounts
experienced far greater changes than other. Further analysis of the Balance Sheet was performed: I
analyzed the normalized balance sheet and calculated the deviation amid fiscal years; then I
filtered the values and obtained the data on the highest relative deviation across periods. The items
that have the most significant change and are in the primary list are marked with bold. The data
is represented in the table below.
Generally, a major problem that any financial institution experiences during the bank run is a lack
of short-term liquidity. However, there might be another reason why the bank can find itself in all
kinds of troubles: insolvency. Below I analyze if Citigroup had the problems described above during
2006-2007; the change in bank`s position during this period can be characterized in the following
way2:
Solvency: we can observe a significant increase in loan losses that reaches almost 100% growth on
the year-over-year basis or about 55% after accounting for growth in assets. It is reasonable to
assume that these losses leaded to a decrease in retained earnings ($7347 mil in absolute value
and about 19% relatively to liabilities & shareholders` equity), that means that this financial
institution used own capital as a buffer against damages. Although, despite an increase in potential
non-payment damages, the bank`s financial position looks safe and sound as of 2007.
Liquidity problems: while it is not the case that in 2007 Citigroup had any liquidity issues, analysis
of company`s financials suggests that starting from 2006 the bank was rapidly increasing its asset
base (both highly and moderately liquid). Cash increased from 1.4% to 1.7%, deposits from other
banks also rose by 40%, as well as Trading account assets and other assets. Interestingly, the bank
also cut its investments by more than third. Another factor to account for is a significant increase in
Provision for credit losses account: it increased from $6,738 mil in 2006 to $17,424 mil dollars in
2007. In this light the simple conclusion arises: Citi tried to accumulate as much assets as possible
to cover potential losses and avoid a liquidity trap. Another aspect is that in 2007, financial
liabilities grew by about 25% in long-term debt and by additional 25% in short-term borrowings.
However, there is no significant evidence of the run on the bank at the moment: one of the most
widespread characteristic, Total Deposits to Total Loans ratio, decreases very slightly since 2006,
from 94% to 92% respectively, which means there was no significant run on Citibank yet.

Question 2.
In 2007 there were three major regulatory capital provisions:

Minimum of 4% for the bank`s Tier 1 capital ratio: ratio of a bank's core equity capital to its
total risk-weighted assets3;
Minimum of 8% for the total capital ratio: bank's capital expressed as a percentage of a
bank's risk weighted credit exposures3;

2 Please, keep in mind that the following changes (if the opposite is not specified explicitly) are calculated based on the
accounts that are normalized with respect to total assets or revenue

Minimum 3% for the leverage ratio: Tier 1 capital / Average total consolidated assets value.

Tier 1 capital ratio for Citigroup for the FY2007 equals 7.12% that is significantly higher than
required minimum of 4%; the major calculations are the following. The upper line stands for
Common shareholders` equity, it is also the most significant determinant of the tier 1 capital
($113,598 mil dollars); it is adjusted than for non-cumulative perpetual preferred stock, mandatory
redeemable securities ($23,594 mil), minority interest, less net unrealized gains and losses, pension
liabilities adjustments, goodwill ($41,204) and other intangibles. Thereafter the risk-weighted assets
are calculated (it proves to be impossible to recalculate the risk-weighted assets as the data
provided in the case study is insufficient): using the value from the case study of $1,253,321 it is
straightforward to estimate the tier 1 capital ratio.

Question 3.
Financial Accounting Standards Board summarizes SFAS 157 as a statement that defines fair value,
establishes a framework for measuring fair value in generally accepted accounting principles
(GAAP), and expands disclosures about fair value measurements. 4 It was implemented to increase
consistency, transparency, perspicuity and comparability of fair value estimations between the
banks and other financial institutions.
The major provisions of this statement are the following: 5
1) Implementing a standardized definition of fair value: the price that would be received to sell
an asset or paid to transfer a liability in an orderly transaction between market participants at the
measurement date;
2) Fair value should be market based instead of using an entity-specific approach; for this purposes
SFAS 157 introduced a differentiation into three groups of assets depending on their of market
prices observability. They were ranked as level one (based on market valuation), two (market and
income) and three (income and cost) fair valuations. The first type reflects well-defined market
prices, while the last one means evaluating assets based on the best assumptions of a responsible
officer;
3) It clarifies the following terms: orderly transaction, market participants, assets, liabilities, risk and
other;
4) It introduces new requirements for disclosure of financials:

The company must disclose fair value measurement at the reporting date;
It must specify the group a certain asset belongs to;
Disclose and discuss the valuation techniques and changes in these techniques over time if
any;
For valuation of non-recurring assets under the Level Three type, the company must include
description on developing and using the inputs;

Definition from the Wikipedia: wikipedia.org

4 FASB official website: http://www.fasb.org/summary/stsum157.shtml

5 Summary of FAS 157, Fair Value Measurements, http://www.bvresources.com/

For recurring assets under the Level Three type the inputs require reconciliation of beginning
and ending balances, together with mentioning of total gains and losses and transfers
between the groups.

The major consequence of moving from historical prices approach to fair value based pricing is an
attempt to make banks and other financial institutions to capture and report the present value of
future cash flows associated with an asset or a liability 6 instead of using its historical costs. It
means that after introducing the new accounting standards (SFAS 157 and later statements) the
financials should better represent current and future financial position of the company instead of
historical one; for instance, Net Income and other comprehensive measures are now affected by
adjustments of asset prices through unrealized gains or losses (for both assets and liabilities
outstanding accounts). In addition, fair value accounting reduces management`s ability to
manipulate the results on company`s performance. However, there are side costs for implementing
these rules: they are greater volatility in periodic reports and significant losses if the market
conditions worsen.

Question 4.
Lets first consider the effect of this decrease in fair value of trading account assets on the income
statement7. Mainly, it will appear through either Principal Transactions account, as it includes a
majority of realized and unrealized gains and losses from trading activities, or adjustment of the
income statement for the Gains and Losses at a final stage of accounting cycle. Net income, as a
result, will almost certainly decrease to a negative value, meaning that the revenues are negative,
hence Retained Earnings will suffer significant losses, effecting the balance sheet (more about it in
the next paragraph).
Now let`s evaluate the direct effect on the balance sheet: other things remaining equal, it will
decrease the line Trading Accounts from $538 to $488 billion dollars, resulting in a decrease of total
assets. To balance the statement, the liabilities and shareholders` equity side should also decrease,
and my best guess is that in case of Citigroup the Retained Earnings or any other S.E. account will
drop as a buffer for losses: it belongs to own funds and the bank had enough resources to cover this
onetime loss. However, if this financial institution continues to experience these losses in future,
very soon it will run out of own funds and will be urged to ask for a financial support from
government or induce a fire sell of its assets or even recognize itself insolvent.
The biggest impact on the tier 1 capital ratio will occur through a decrease in Total Shareholders`
Equity account among other adjustments for incurred losses, resulting in a significant drop in the
tier 1 capital itself; at the same time the denominator of the ratio will also shrink (risk-weighted
assets) because of a $50 billion dollars loss. However, I expect that even though both sides of the
fraction decrease, a cut in shareholders` equity (hence, in tier 1 capital) will have a larger effect on
the ratio, and the latter will decrease sharply.

Question 5.

6 A. Bose, Fair Value Is It Fair?, https://financialexecutives.org/eweb/upload/chapter/Pittsburgh/FairValueIsItFair.pdf

7 In the case it is stated that significant part of assets that were priced at a fair value were hedged or insured; considering
no additional information is provided for this question, I pass over this aspect

There are several suggestions in case of significant losses in the asset base to avoid potential
insolvency and illiquidity:
The first and the most obvious step in case of continuing and significant losses is to reduce all the
expenses that can be cut: stop the dividend payout (that was increasing over time and paid on a
regular basis), diminish investments expenditures to minimum, and of course, cut the bonuses and
a number of employees.
The second step would be to sell everything that could be sold at a reasonable price without critical
consequences for the core business. As an example the company can dispose of its branches or
businesses in non-core markets, or sell off any non-core or risky businesses or assets around the
world.
The third step is to accumulate as much high- and medium-liquid assets as it is possible through
short-term borrowing from outside lenders or current shareholders, if possible, as if there is a risk of
insolvency and customers can occupy this information, a bank run becomes a large threat for a
financial institution.
Another action to be made is to reduce long-term crediting or at least to decrease growth in this
activity: during a crisis the bank cannot afford to release significant amount of available highly
liquid assets due to the aspects described above; in addition the financial institution should claim to
collect all available sources from its borrowers if it is allowed to by the law.
It is also reasonable to create a special committee that would develop the strategy and monitor
bank`s current position; in addition to that, complete or partial change of top management can be a
successful tool to improve bank`s performance.
Finally, if all these measures proved to be insufficient, management can ask for a government
intervention (sometimes government offers or even forces to accept the aid) financial assistance in
return for a significant stake in the firm via various financial instruments (mainly convertibles) that
must be repaid on a specific conditions.