Liabilities, Liquidity, and Cash Management Balancing Financial Risks TEAMFLY Team-Fly ® Liabilities, Liquidity, and Cash Management Balancing Financial Risks Dimitris N. Chorafas JOHN WILEY & SONS, INC. Copyright @ 2002 by John Wiley & Sons, Inc. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 750-4744. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 605 Third Avenue, New York, NY 10158- 0012, (212) 850-6011, fax (212) 850-6008, E-Mail: PERMREQ@WILEY.COM. This publication is designed to provide accurate and authoritative information in regard to the subject matter cov- ered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other pro- fessional services. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. This title is also available in print as ISBN 0-471-10630-5. Some content that appears in the print version of this book may not be available in this electronic edition. For more information about Wiley products, visit our web site at www.Wiley.com v Preface In all fields of inquiry, whether financial, scientific, or any other, there is danger of not seeing the woods for the trees. Nowhere is this danger greater than in the analysis of assets and liabilities as well as in cash management, in a leveraged financial environment with derivative instruments that change from assets to liabilities, and vice versa, depending on their fair market value. This book is for financial officers, analysts, traders, investment advisors, loans officers, account- ants, and auditors whose daily activities are affected by the management of liabilities and the con- trol of exposure. Senior executives have expressed the opinion that, for the next 10 years, the key words are: leverage, profitability, cash flow, liquidity, inventories, sales growth, and company size. Many senior managers and financial analysts are of the opinion that, at the dawn of the twenty- first century, in an environment charged by credit risk, there have occurred some incidents that, although important in themselves, were even more important as part of a pattern of uncertainty and nervousness in the financial markets. Suddenly, and emotionally, earning announcements and prof- it warnings made investors and traders commit all their attention to stock market bears, as if in a highly leveraged environment this were a secure way of taking care of their liabilities. The underlying thesis among many of the knowledgeable people who participated in my research is that at the present time, there is an overriding need for a focused process of liabilities management. The separate aspects of this problem acquire full significance only when considered in relation to one another, in an integrative way. Since a rigorous study of financial exposure is best done through pooled experience, it is clear that the acquisition, organization, and use of knowledge are essential factors in analysis. This process of meticulous acquisition, proper organization, and use of knowledge is often called the scientific method: • Reaching conclusions against experience, through observation and experiment • Operating on the principle of increasing certitude in regard to obtained results • Being able, in large measure, to take effective action and proceed to new subjects of inquiry These three points describe the principles underpinning choices made in the organization of this book, which is divided into four parts. Part One addresses liabilities management, taking as an example the market bubble of telecoms stocks and its aftermath. Chapter 1 explains why this has happened and what facts led to the credit crunch that crippled the ambitions of telephone operators. Chapter 2 extends this perspective of telecoms liabilities toward the suppliers of the telephone industry and their woes, with a case study on Lucent Technologies and its huge loss of capitaliza- tion. The downfall of Xerox was chosen as an example of what happens when product planning sna- fus undermine rather than underpin a company’s financial staying power. vi Derivative instruments have a great deal to do with the mountain of liabilities—and their mis- management—as Chapter 3 documents. Oil derivatives were chosen as a case study on leveraging power. Chapter 4 focuses on the reputational and operational risks associated with globalization. It also underlines the fact that certified public accountants face unusual circumstances when con- fronted by reputational risk. It has been said that company size and the amount of resources under management are good enough assurance against turbulence. I do not think so. Size, measured by volume of output, capi- tal invested, and people employed, is clearly only one aspect of managing a given entity and its projects. Size alone, however, is a double-edged sword, because the company tends to lean more on leverage and less on rigorous control. Liquidity management is the theme of Part Two. Chapter 5 dramatizes the aftermath of liabili- ties and of a liquidity squeeze through two case studies: Nissan Mutual Life and General American. It also explains the role of sensitivity analysis, gap analysis, stress testing, and value-added solu- tions. The contributions of real-time financial reporting and virtual balance sheets constitute the theme of Chapter 6. The lack of real-time management planning and control and of appropriate tools and their effec- tive use increases the risks associated with liquidity management as well as the likelihood of default. Chapter 7 explains why this is the case; it also presents a family of liquidity and other ratios that can be used as yardsticks. Chapter 8 focuses on market liquidity, the factors entering into money supply, and the ability to mark to model when marking to market is not feasible. The theme of Part Three is cash management. Chapter 9 focuses on the different meanings of cash and of cash flow. It also explains the development and use of a cash budget and how cash crunches can be avoided. Based on these notions, the text looks into factors affecting the liquidity of assets as well as on issues draining cash resources—taking Bank One as an example. The next two chapters address the role played by interest rates and the control of exposure relat- ing to them. The subject of Chapter 11 is money markets, yield curves, and interest rates as well as their spillover. Matters pertaining to the ongoing brain drain are brought under perspective because any analysis would be half-baked without paying attention to human capital. Chapter 12 directs the reader’s thoughts on mismatch risk profiles and how they can be analyzed and controlled. The canvas on which this scenario is plotted is the implementation of an interest rate risk control system among savings and loans by the Office of Thrift Supervision (OTS). The frame- work OTS has established for sensitivity to market risk and post-check portfolio value analysis is a classical example of good management. The book concludes with Part Four which considers credit risk, certain less known aspects of leverage, and the action taken by regulators. Chapter 13 elaborates on credit risk associated with technology companies. It takes the bankruptcy of Daewoo as an example, and demonstrates how mismanagement holds bad surprises for all stakeholders, including those personally responsible for the company’s downfall. Because good sense often takes a leave, banks make life difficult for themselves by putting the rules of lending on the back burner and getting overexposed to certain companies and industries. Chapter 14 shows how yield curves can be used as gateway to more sophisticated management con- trol solutions, and documents why creative accounting damages the process of securitization. Chapter 15 explains why lack of integration of credit risk and market risk control is counterpro- ductive, making it difficult to calculate capital requirements in a way commensurate with the expo- sure being assumed. PREFACE vii The last chapter brings the reader’s attention to management blunders and technical miscalcula- tions which lead to panics. It explains the risks embedded in turning assets into runaway liabilities; shows the difficulty in prognosticating the aftermath of mounting debt; presents a case study with British Telecom where money thrown at the problem made a bad situation worse; suggests a solu- tion to market panics by borrowing a leaf out of J.P. Morgan’s book; and discusses how the New Economy has redefined the nature and framework of risk. As I never tire repeating, entities which plan for the future must pay a great deal of attention to the quality of liabilities management, including levels of leverage, liquidity thresholds, and cash man- agement. These are very important topics because the coming years will be, by all likelihood, char- acterized by a growing amount of credit risk. A balance sheet heavy in the liabilities side means reduced credit risk defenses. Credit risks, market risks, and reputational risks can be effectively controlled if management indeed wants to do so. But as a growing number of examples demonstrates, the current internal con- trols system in a surprisingly large number of institutions is not even remotely good enough. In many cases, it is simply not functioning while in others inept management fails to analyze the sig- nals it receives, and to act. This is bad in connection to the management of assets, but it becomes an unmitigated disaster with the management of liabilities. I am indebted to a long list of knowledgeable people, and of organizations, for their contribution to the research which made this book feasible. Also to several senior executives and experts for con- structive criticism during the preparation of the manuscript. The complete list of the cognizant exec- utives and organizations who participated in this research is shown in the Acknowledgements. Let me take this opportunity to thank Tim Burgard for suggesting this project and seeing it all the way to publication, and Louise Jacob for the editing work. To Eva-Maria Binder goes the cred- it for compiling the research results, typing the text, and making the camera-ready artwork and index. Dimitris N. Chorafas Valmer and Vitznau July 2001 Preface To Dr. Henry Kaufman for his leadership in the preservation of assets and his clear view of the financial landscape ix ACKNOWLEDGMENTS (Countries are listed in alphabetical order.) The following organizations, through their senior executives and system specialists, participat- ed in the recent research projects that led to this book. AUSTRIA National Bank of Austria Dr. Martin Ohms Finance Market Analysis Department 3, Otto Wagner Platz Postfach 61 A-1011 Vienna Association of Austrian Banks and Bankers Dr. Fritz Diwok Secretary General 11, Boersengasse 1013 Vienna Bank Austria Dr. Peter Fischer Senior General Manager, Treasury Division Peter Gabriel Deputy General Manager, Trading 2, Am Hof 1010 Vienna Creditanstalt Dr. Wolfgang Lichtl Market Risk Management Julius Tandler Platz 3 A-1090 Vienna Wiener Betriebs- and Baugesellschaft mbH Dr. Josef Fritz General Manager 1, Anschützstrasse 1153 Vienna GERMANY Deutsche Bundesbank Hans-Dietrich Peters Director Hans Werner Voth Director Wilhelm-Epstein Strasse 14 60431 Frankfurt am Main Federal Banking Supervisory Office Hans-Joachim Dohr Director Dept. I Jochen Kayser Risk Model Examination Ludger Hanenberg Internal Controls 71-101 Gardeschützenweg 12203 Berlin European Central Bank Mauro Grande Director 29 Kaiserstrasse 29th Floor 60216 Frankfurt am Main Deutsches Aktieninstitut Dr. Rüdiger Von Rosen President Biebergasse 6 bis 10 60313 Frankfurt-am-Main Commerzbank Peter Bürger Senior Vice President Strategy and Controlling Markus Rumpel Senior Vice President Credit Risk Management Kaiserplatz 60261 Frankfurt am Main Deutsche Bank Professor Manfred Timmermann Head of Controlling Hans Voit Head of Process Management Controlling Department 12, Taunusanlage 60325 Frankfurt ACKNOWLEDGMENTS Dresdner Bank Dr. Marita Balks Investment Bank, Risk Control Dr. Hermann Haaf Mathematical Models for Risk Control Claas Carsten Kohl Financial Engineer 1, Jürgen Ponto Platz 60301 Frankfurt Volkswagen Foundation Katja Ebeling Office of the General Secretary 35 Kastanienallee 30519 Hanover Herbert Quandt Foundation Dr. Kai Schellhorn Member of the Board Hanauer Strasse 46 D-80788 Munich GMD First–Research Institute for Computer Architecture, Software Technology and Graphics Prof. Dr. Ing. Wolfgang K. Giloi General Manager 5, Rudower Chaussee D-1199 Berlin FRANCE Banque de France Pierre Jaillet Director Monetary Studies and Statistics Yvan Oronnal Manager, Monetary Analyses and Statistics G. Tournemire Analyst Monetary Studies 39, rue Croix des Petits Champs 75001 Paris Secretariat Général de la Commission Bancaire– Banque de France Didier Peny Director Control of Big Banks and International Banks 73, rue de Richelieu 75002 Paris F. Visnowsky Manager of International Affairs Supervisory Policy and Research Division Benjamin Sahel Market Risk Control 115, Rue Réaumur 75049 Paris Cedex 01 Ministry of Finance and the Economy, Conseil National de la Comptabilité Alain Le Bars Director International Relations and Cooperation 6, rue Louise Weiss 75703 Paris Cedex 13 HUNGARY Hungarian Banking and Capital Market Supervision Dr. Janos Kun Head, Department of Regulation and Analyses Dr. Erika Vörös Senior Economist Department of Regulation and Analyses Dr. Géza Nyiry Head Section of Information Audit Csalogany u. 9-11 H-1027 Budapest Hungarian Academy of Sciences Prof.Dr. Tibor Vamos Chairman Computer and Automation Research Institute Nador U. 7 1051 Budapest ICELAND The National Bank of Iceland Ltd. Gunnar T. Andersen Managing Director International Banking & Treasury Laugavegur 77 155 Reykjavik ITALY Banca d’Italia Eugene Gaiotti Research Department Monetary and Financial Division Ing. Dario Focarelli Research Department 91, via Nazionale 00184 Rome Istituto Bancario San Paolo di Torino Dr. Paolo Chiulenti Director of Budgeting Roberto Costa Director of Private Banking Pino Ravelli Director Bergamo Region 27, via G. Camozzi 24121 Bergamo x [...]... Budgeting and the Elaboration of Alternative Budgets 169 Benefits to Be Gained through Adequacy of Cash Figures 172 Cash Flow, Operating Cash Flow, and Free Cash Flow 175 Earnings, Cash Flow, and Price-to-Earnings Growth 178 Applying the Method of Intrinsic Value 180 Cash on Hand, Other Assets, and Outstanding Liabilities 183 Handling Cash Flows and Analyzing the Liquidity of Assets 184 Art of Estimating Cash. .. 164 Cash Flow Studies and the Cash Budget 11 163 Basic Notions in Cash Management and the Cash Crunch 10 Cash, Cash Flow, and the Cash Budget 215 Mismatched Risk Profiles and Control by the Office of Thrift Supervision 219 Interest-Rate Risk Measurement and Office of Thrift Supervision Guidelines 220 Practical Example on the Role of Basis Points in Exposure 222 Sensitivity to Market Risk and Post-Shock... Analysis, Value-Added Solutions, and Gap Analysis 84 Proper Recognition of Assets and Liabilities, and the Notion of Stress Testing 88 Redimensioning the Balance Sheet through Asset Disposal 91 Weight of Liabilities on a Company’s Balance Sheet 93 Virtual Balance Sheets and Real-Time Control 97 Virtual Financial Statements and Their Contribution to Management 6 Assets, Liabilities, and the Balance... Economist, Monetary and Economic Department Ingo Fender Committee on the Global Financial System 2, Centralplatz 4002 Basle POLAND AM FL Y Clearstream André Lussi President and CEO 3-5 Place Winston Churchill L-2964 Luxembourg Securities and Exchange Commission Beata Stelmach Secretary of the Commission 1, Pl Powstancow Warszawy 0 0-9 50 Warsaw TE SWEDEN Crédit Suisse Ahmad Abu El-Ata Managing Director,... Liquidity and the Control of Risk 143 Different Types of Market Liquidity and Money Supply 144 Liquidity Risk, Volatility, and Financial Statistics 147 xviii Contents Marking to Market and Marking to Model 150 Liquidity Premium and the Control of Excess Liquidity 153 Maturity Ladder for Liquidity Management 155 The Role of Valuation Rules on an Institution’s Liquidity Positions 157 PART THREE CASH MANAGEMENT. .. sophisticated approach to assets and liabilities management (ALM) has been evident for many years Volatile global markets, changing regulatory environments, and the proliferation of new financial products, with many unknowns, have made the management of liabilities and of assets in the balance sheet a critical task Modern tools such as simulation, experimentation, and real-time financial reporting help in... in Loans Policies and Their Aftermath 191 Draining Cash Resources: The Case of Bank One 193 Establishing Internal Control and Performance Standards 195 Money Markets, Yield Curves, and Money Rates 201 Money Market Instruments and Yield Volatility 202 Spillover Effects in the Transnational Economy 205 Major Factors Contributing to Global “Capital and Brains” Flows 209 Yield Structure and Yield Curves... Apple Computer’s Blues and the Dot-Coms 25 Lucent Technologies’ Hangover 28 Downfall of Xerox 31 Shift from Real to Virtual Economy and the Challenge of the Service Industry 34 Financial Staying Power and Business Turf 37 Liabilities and Derivatives Risk 41 Risk and Return Embedded into Derivatives Contracts 42 Why an Industrial Company Is Interested in Derivatives 46 Oil Derivatives and the Impact on the... Liquidity and Capital Resources: The View from Lucent Technologies 125 Who Is Responsible for Liquidity Management? 127 Unrealistic Assumptions Characterizing a Famous Model 130 Liquidity Ratios and Activity Ratios in the Service of Management 131 Computation of Leverage and Default Including Derivatives Exposure 134 Contingency Planning for Liquidity Management 8 104 Forward-Looking Statements and Virtual... banks and other entities in the form of loans, credit lines, or similar instruments Commercial paper, such as short-term “IOUs,” of variable-rate, floating-rate, or variableamount securities Unpaid invoices by suppliers, salaries, wages, and taxes Certificates of deposit, time deposits, bankers’ acceptances, and other short-term debt Exposure assumed against counterparties through derivative financial . THREE CASH MANAGEMENT 161 9 Cash, Cash Flow, and the Cash Budget 163 Basic Notions in Cash Management and the Cash Crunch 164 Cash Flow Studies and the Cash Budget 167 Flexible Budgeting and the. Adequacy of Cash Figures 172 Cash Flow, Operating Cash Flow, and Free Cash Flow 175 Earnings, Cash Flow, and Price-to-Earnings Growth 178 Applying the Method of Intrinsic Value 180 10 Cash on Hand,. Team-Fly ® Liabilities, Liquidity, and Cash Management Balancing Financial Risks Dimitris N. Chorafas JOHN WILEY & SONS, INC. Copyright @ 2002 by John Wiley & Sons, Inc.