Risks in Commercial Banking: Citi Bank Case Study
In the previous article, we have learned about the various risks which are commonly associated with commercial banking. We specifically tried to understand the risks which are associated with commercial lending.
The risks can be understood with the help of theory. However, practical examples help the reader really clarify the risks and the scale of losses that can ensue if the process is not managed correctly.
In the recent past, Citibank had been acting as the commercial banker for Revlon corporation. Citibank had not even lent out its own money to the company. It was acting as an agent and was transferring payments to the creditors of Revlon. However, an operational error occurred at Citibanks end. The end result is that there is a big chance that Citibank may lose $500 million of its own funds!
This is probably the biggest blunder in the history of commercial banking. This is also the reason why its study is important to understand the true scale of losses that can occur if a robust system is not put into place.
What Happened?
Revlon is a global cosmetics company which had a very strong business model with rich cash flows. However, of late, Revlon company has been facing some financial trouble. It was struggling to make ends meet and were under financial duress.
Revlon had appointed Citibank as its corporate banker. This meant that Citi took care of a lot of Revlons payments activities. This meant Citi would pay Revlons vendors as well as its creditors.
Revlon had taken a $900 million loan which was not due until 2023. Citibank was supposed to make an interest-only payment of $8 million to Revlons creditors. This amount was approved by Revlon.
However, due to an operational error at Citibanks end, Citibank ended up paying the entire $900 million dollars instead of the $8 million interest. Since Revlon had only authorized $8 million, the entire sum was paid out of Citis own coffers!
The Next Steps
As soon as Citibank realized this huge blunder, they immediately started taking steps to reverse the same. Citibank send out legal notices to all creditors who had received the money wired by Citibank. Attempts were made to recoup these funds. However, Citibank was able to recoup less than half of the funds.
Around $500 million worth of funds are outstanding today and the creditors which received these funds are not willing to pay them back saying that they received the funds that they were owed.
The Current Status
- After the creditors decided not to pay Citibank back, Citi took the case to the courts. It argued that since the creditors are well aware that Revlon is not in the financial position to make such a payment, they should return back the money to Citi.
Keeping the money with the full knowledge of Revlons financial positions would be like deliberately impoverishing the shareholders of Citibank. However, the United States legal system was not convinced by the arguments being presented by Citibank. According to them, any payments which are made via wire transfer are irrevocable by nature.
Hence, courts cannot forcefully ask the creditors to return the fund. If they dont return the funds of their own accord, Citibank does not have any legal recourse against the creditors!
- In the meanwhile, the financial situation at Revlon company went from bad to worse. As a result, Revlon company has also filed for bankruptcy. Now, Citibank has sued Revlon stating that since Citibank has paid back the loan owed by Revlon, it has now effectively become Revlons creditor. However, now the matter is being argued in court since there is no direct debt agreement between Citibank and Revlon.
Hence, there are no terms and conditions such as interest rates, seniority, collateral, tenure, etc. Also, since Revlon is already under bankruptcy, other creditors of Revlon are resisting the inclusion of Citibank as another creditor since it would lead to a lower payoff for them.
- Right now, Citibank is trying to get creditor status from Revlon since it believes that unless such a status has been given to them, it would mean that the legal system is aiding the wrong enrichment of Revlons shareholders at the expense of Citibanks shareholders.
Firstly, obtaining creditor status itself seems like an uphill task. Even if such a status is received, it will be next to impossible to recoup the entire $500 million plus interest from an ailing corporation like Revlon.
How did it happen?
The Citibank Revlon case has sent shivers down the spine of the commercial banking industry. They do already have systems in place to ensure that only the correct amount is transferred only to the correct beneficiary.
However, in the case of Citibank, this error happened because of manual intervention in the process. The entire commercial banking industry is taking another look at their payments process.
Now, if the transaction had gone through without any errors, Citibank would have earned less than 1% of the transacted value as commission to make the payment. However, the loss which has accrued now is close to $500 million! This shows the asymmetry inherent in commercial banking and the huge losses which can occur. This case study shows the reason why commercial banking operations are considered to be such a huge risk.
The bottom line is that commercial banking operations can be very risky. Unless banks are able to create a robust system that enables them to manage their operations in a better manner, they should be wary of recklessly expanding their operations.
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