146 MANAGING LIABILITIES There are different metrics for money supply, from M 1 to M 9 . M 1 is the more limited definition of money supply, representing the money that can be spent right away; it represents the gross sum of all currency and demand deposits held by every consumer and business in a country. Checking account deposits are about three-quarters of M 1 ; hence M 1 is much larger than M 0 . The Fed targeted M 1 for many years. Then it switched to M 2 , which is equal to M 1 plus time deposits in the banking system. Like M 1 ,M 2 varies over time in relation to reserve bank policies, investment policies, propensity to consume, and other factors. As Exhibit 8.1 shows, from January to March 2001 the money supply exploded, rising at a 12 percent annual rate. The last time M 2 surged at a similar pace was in late 1998, in the aftermath of the Russian bond default and the col- lapse of Long Term Capital Management. Other central banks use different metrics. For instance, the German Bundesbank tracks M 3 , which includes: currency in circulation, demand deposits with banks, demand deposits with postal giro system, time deposits, and savings deposits. No matter which metrics the monetary authorities follow, rapid growth in supply of money can lead to inflation. Money supply is increased by increasing either the monetary base or the velocity of circulation of money, or both. Not only the reserve bank but also the banking sector as a whole impacts on the money supply. The quantity theory of money links money supply to gross national product (GNP): Exhibit 8.1 The Rapid Growth of M 2 in a Matter of Three Months (January to March 2001) RATE OF M 2 GROW TH (NO TE D IFFERENCE ) January 1,2 001 March 1,2001 (NOTE DIFFERENCE) MS = MB • v GNP = P • Q where: P = price level Q = output of the economy 147 Market Liquidity and the Control of Risk Money supply impacts on the output of the economy as well as on the price level. The algorithm to remember is that credit, and therefore debit, and money supply grow together. When added to the monetary base, the banking system’s liabilities make up the basic components of the money supply at the different M i (M 1 ,M 2 ,M 3 , etc.) levels. A rapid growth pattern of M i leads to fears it might be followed by inflation. There is practically no limit to the amount the banking system can expand the money supply, said Marriner Eccles, chairman of the Fed in the Franklin Roosevelt years. Eccles was against lever- age. His father had taught him that “A business, like an individual, could remain free only if it kept out of debt.” 4 All this is relevant to our discussion because money supply underpins Paul Samuelson’s two classes: transaction liquidity and general market liquidity. The notions presented in the preceding paragraphs also serve to bring attention to the fact that Dr. Samuelson’s classification of the demand for money—transactions and liquidity proper—gives altogether a very simplified picture. Shifts in demand for money can be most rapid and unpredictable, therefore altering the overall pattern— and globalization further promotes pattern changes. The simplification and idealization of a real-world situation is meaningful only when we know what we are after and appreciate the approximations we make. Financial analysts should map eco- nomic and financial relations into models only after they really understand the critical factors influ- encing the market and its behavior. Subsequently, what mathematics can describe computers can bring to life through experimentation. LIQUIDITY RISK, VOLATILITY, AND FINANCIAL STATISTICS Many knowledgeable financial analysts have suggested that even if the books do not say so, liq- uidity risk is the biggest exposure a financial institution can take because it impacts on the institu- tion’s reserves and on its liabilities in the short, medium, and longer term. Drexel failed because it could not roll its commercial paper. Therefore, a Treasury functions properly when it understands the liabilities structure of the firm and associates it to projected liquidity. This structure can be mod- eled, and it should be kept under perspective with every new commitment and with every examina- tion of current obligations Liquidity must be measured both in qualitative and quantitative terms—not in a quantitative way alone. Dr. Henry Kaufman says that liquidity has to do with the feel of the market. Reference has been already made to the fact that liquidity is no real problem when the market goes up. It becomes a challenge when: • The banking system gets destabilized, as in Japan from 1990 until today. • Market psychology turns negative with the prices of stocks and the other commodities going south. The regulation of liquidity is so much an art because ways and means we have available are essentially imperfect. This has been demonstrated by the brief discussion on money supply metrics. Contrary to what might seem to be the case, overleveraging is an enemy of liquidity—and it could make the survival of some big banks problematic, as in the case of huge loans to telecommunica- tions companies discussed in Chapter 1. 148 MANAGING LIABILITIES Timely and effective liquidity management, therefore, should be a steady preoccupation of cred- it institutions. After all, they have huge liabilities made up of financial assets of households, busi- nesses, and governments—and, usually, their own capital is only a small percentage of their total footings, as Kaufman aptly suggests. Sometimes interest on liquidity management takes a back seat because of an ill-conceived wealth effect. Its importance depends on absolute value and composition of wealth, on the impact of mon- etary policy, and on changes in consumption and investment decisions. Changes in financial struc- ture toward greater recourse to securities markets are likely to reinforce the importance of wealth effect, as households and nonfinancial corporations probably will hold a larger share of their wealth in the form of financial market instruments such as corporate bonds and/or equity. However, this mechanism can be weakened by the fact that: • Credit institutions also hold in their portfolio debt securities, shares, and other equity issued by nonfinancial entities. • The control of exposure of the private sector to price fluctuations in such instruments is not keeping pace with developments in these markets. This is another reason that making an institution’s financial staying power is so important. Tier-1 banks establish liquidity limits based on two levels of reference: (1) liquidity risk, by risk type, risk factor, currency, and market; and (2) liquidity volume, by open position and individual security in their portfolio or in which they are interested for future investments. What do regulators look for when they examine a financial institution’s ability to survive? Four questions are topmost: 1. Does it have risk limits of a type appropriate to our business? 2. Do its policies constrain the trading to the risk/reward ratio desired by top management? 3. Does it have real-time monitoring of all transactions? of tick-by-tick exposure? 4. Is top management sensitive to deviations and the breaking of limits? The component elements underpinning these queries form, so to speak, the infrastructure on which a control model operates. Beyond this, a valid internal control model needs an input from every operating department. It also requires building a modular capital code to permit flexible risk control, splitting financial exposure according to counterparty, instruments being handled, and their volatility. As far as the control structure is concerned: • Liquidity and volatility are those prevailing in the market. • Cash flow has to be carefully calculated by channel of activity. • Interest-rate risk must be tractable intraday. (See Chapters 11 and 13.) The input from regulators must include a great deal of clear definitions and guidelines. For instance, how many degrees of freedom do we have in handling commercial mortgages? Valid approaches will invariably involve taking a look at securitized products and working by analogy: Can we manage the loan book as if it were a bond book? We can develop securitization models that reflect policies and practices with house mortgages but embed a stronger credit risk factor for corporates. A similar type of prudence should prevail in 149 Market Liquidity and the Control of Risk connection with cash flow estimates (see Chapter 9) as well as with cash holdings. It is wrong to place the cash book into the banking book, a practice followed because of cash management rea- sons. The cash book is part of the trading book. In the absence of clear regulatory directives, it may be wise to look at what some of the best- managed financial institutions are doing: How do they massage and mine market data, and what do they get out of their models? In short, how do they increase their business acuity in performing in different environments? Said Brandon Davies, of Barclays Bank: “As we get more sophisticated we find we consume time and thought trying to develop solutions other banks do already.” The economic turnover ratio is a model that can extend what has been discussed about ratios in Chapter 7. It addresses market liquidity by measuring the total value of all trades divided by a coun- try’s market capitalization. A thorough analysis also looks at stock market volatility and the open- ness of a country’s capital market. Current account information is also important. Based on U.S. Department of Commerce statis- tics, Exhibit 8.2 shows the pattern of physical goods imports over three decades: 1970 to 2000. The exponential growth shown in this figure finds its counterpart in trade deficit connected to physical goods and the U.S. current account deficit. Both are shown in Exhibit 8.3. The careful reader will appreciate the similitude of these two patterns. It is also wise to examine how closely different indicators are correlated with economic growth. In principle, countries with the most liquid stock markets tend to grow fastest. Stock market liq- uidity is a convenience, but price changes can distract attention from the need to assess corporate value regularly and to evaluate the way corporate governance behaves. Exhibit 8.2 Statistics on Three Decades of Imports of Physical Goods in the United States $ B ILLION S 1970 1980 1990 2000 1,200 0 600 1,000 400 200 800 1,400 Exhibit 8.2 Statistics on Three Decades of Imports of Physical Goods in the United States $ B ILLION S 1970 1980 1990 2000 1,200 0 600 1,000 400 200 800 1,400 150 MANAGING LIABILITIES Mathematical models and simulation provide a great deal of assistance in studying current account deficits and the analysis of factors characteristic of corporate governance. Investing in equi- ties demands the ability to analyze an entity’s intrinsic value (see Chapter 9) and ignore emotion when stocks become volatile. The best strategy is to follow a company, its products, and its instru- ments closely and make a long-term commitment. Only when fundamentals change is it wise to sell; but it is worth monitoring prices all of the time. Even stop-loss systems considered to be a rather conservative approach are geared toward port- folios, not the typical investor. Sell limits can be useful for locking in gains but also may prompt premature selling of equities that have considerable volatility, such as technology stocks. With all these constraints in mind, one may ask the question: Why does market liquidity matter that much? For one thing, investors avoid illiquid markets and illiquid instruments. Also, liquid equity markets allow investors to sell shares easily while permitting firms access to long-term cap- ital through equity issues. Many profitable investments require a long-term commitment of capital. MARKING TO MARKET AND MARKING TO MODEL Liquidity risk and price risk due to volatility are part of market risk. Both are fundamental elements in the business of every financial intermediary. The liquidity risk faced by a credit institution may be its own or that of its major client(s) in some country and in some currency. Clients who are unable to meet their financial commitments are credit risks, but they also create liquidity problems. Price risk affects earnings. It may arise from changes in interest rates, currency rates, equity and commodity prices, and in their implied volatilities. These exposures develop in the normal course of a financial intermediary’s business. Therefore, an efficient risk control process must include the establishment of appropriate market controls, policies, and procedures permitting a rigorous risk oversight by senior management. Exhibit 8.3 Deficit from Trade of Physical Goods and Current Account Deficit of the U.S. Economy 151 Market Liquidity and the Control of Risk Liquidity must be subject to a control process that has upper and lower limits. If low liquidity is a danger signal, for different reasons, so is excess liquidity (see Chapter 5) or liquidity surplus to an institution’s needs. Excess liquidity can be invested in financial markets for better profits than those provided by cash. We can invest excess liquidity without taking inordinate risks only when we are able to monitor our liquidity requirements steadily and prognosticate those that are coming. The able use of advanced technology permits investors to track some of the risks described in the above paragraphs. We can do so through real-time systems and the quantification of changes in value of assets and liabilities. This analysis should be accomplished in absolute terms and as a func- tion of market volatility. There are two ways to do so: 1. Through marking-to market instruments 2. Through marking-to-model instruments Marking-to-market is double for those instruments in our portfolio for which there is an active market. For instance, bid/ask is a dynamic market-driven parameter which makes it possible to gauge the market price for a given product. There are a couple of problems with marking to market. One of them is that quite often the prices are really estimates that prove to be too optimistic or plainly biased. This is the case with the volatil- ity smile, where traders think that volatility will be benign and therefore underprice the instruments they deal with. The second problem is that the majority of over-the-counter trades are esoteric, developed for the counterparty, or too complex to price in an objective manner. Even more involved is their steady repricing. Derivative financial instruments, particularly those which have been personalized, fall into this class. Their valuation can be achieved by marking to model, duly appreciating that models are approximations to reality and frequently contain assumptions that may not always hold. Marking to model also has its limitations. One of them is the lack of skill to do the modeling. Another is that the assumptions we make are not always sound; still another is oversimplification of algorithmic approaches. Few institutions appreciate that it is not enough to model the instrument. We also must study the volatility and liquidity of financial markets through historical analysis. We should take and analyze statistics of market events including both: • Normal market behavior • Squeezes, panics, and crashes The model should work on the premise that liquidity tends to follow different patterns, falling from peak to trough and then increasing again, over a fairly regular time span. The theory under- pinning this approach dates back to the writings of economists Irving Fisher and Friedrich Hayek. The algorithm works on the basis that too much money chasing too few financial assets causes their prices to rise, while tighter liquidity produces the opposite effect. Globalization has seen to it that this concept of volatility in market liquidity became more com- plex, particularly for financial institutions and industrial companies working transborder. Liquidity issues are not only domestic; they are also global. Economists argue which matters more, global liq- uidity or domestic liquidity. TEAMFLY Team-Fly ® 152 MANAGING LIABILITIES Because financial markets of the Group of Ten nations are networked, psychology aside, stock market prices are increasingly being driven by global liquidity. Cross-border investments have left an increasing proportion of shares in foreign hands. But that does not mean that domestic factors play only a minor role. Among other reasons why domestic liquidity remains a key player is that economies around the world are at different stages of the business cycle. It is also good to notice that: • The real economy lags nine months or so behind the liquidity cycle. • An institution’s liquidity may be, up to a point, uncoupled from that of the economy as a whole. Many reasons are behind the bifurcation in these statements. A few examples are excessive leverage, imprudent management, and poorly followed-up commitments. A more thorough exami- nation of the behavior of the bank in the market requires understanding of its trading mandate and risks being taken at all levels of transacting business. There are a great deal of other critical ques- tions as well, such as clear levels of authority, not only in normal times but also in times of crisis like escalation events: • Level of sophistication of internal auditing • Existence of funding/liquidity limits • Experience of management and trading staff Models are not supposed to solve these problems. In times of crisis, much will depend on the maturity of the whole system of management and its ability to perform steady review and monitor- ing using rapid-response feedback loops. Discovery action by senior management greatly depends on critical analysis of what is working and what is not working as it should. Some of the cases I have seen involved potential loss not constrained in a rigorous manner or measured at an acceptable level of accuracy; lax management supervision of liquidity issues; and the “feeling” that if matters are left to their own devices, they will take care of themselves. For a money center bank, a liquidity crisis could happen anywhere in the world because large financial institutions typically have: • A global book • Complex portfolios • Overseas traders who are not well controlled • A universal asset base that is not always thoroughly analyzed In general, when the analytical part is wanting, the results of marking to model will be abysmal. I have seen cases where the modeling constructs were so sloppy and untested that the results obtained ranged from chaos to uncertainty. Also the data being used were neither accurate nor obtained in real time. 5 Those institutions whose operations are characterized by overnight trading, long communication lines, incompatible information technology systems, and a great deal of internal politics have to be the most careful with their models—and with their management. These are usually big banks. Small banks also have constraints, such as the limited number and skills of personnel, lack of specialists in 153 Market Liquidity and the Control of Risk some of the areas they operate, small budgets for information technology, and the fact that because the senior people actually do much of the business, controlling the resulting exposure is more difficult. LIQUIDITY PREMIUM AND THE CONTROL OF EXCESS LIQUIDITY Whether debt or equities, financial instruments are liquid if they can be easily sold at a fair market price. Traders would consider a liquid security, bought or sold, as one characterized by little or no liquidity premium. A problem, however, arises when we try to describe liquidity risk in terms of thresholds in liquidity premium, which often are used to explain different price effects. Liquidity premium exists because a given change in interest rates will have a greater effect on the price of long-term bonds than on short-term debt. With long-term bonds, there is more of an oppor- tunity for gains if interest rates fall and greater risk for losses if interest rates rise. At the same time, even if a certain premium were solely a function of market liquidity, it could at best measure the perceived value of liquidity but not other factors, such as transaction size. Transactions in small amounts and in large blocks trigger the inclusion of an extra liquidity pre- mium in the price, which does not necessarily occur with the classic notion of a liquidity premium. This extra premium suggests that the risk of a transaction should not be measured independently from its size, because doing so would be equivalent to assuming constant market liquidity regard- less of fundamentals. In academic circles and among some investment bankers, the liquidity premium theory often is used as an explanation of the term structure of interest rates. By supplementing investors’ expecta- tions with a liquidity premium, the theory aims to explain the prevalence of upward- and downward- sloping yield curves. Investor uncertainty is behind such movement, as shown in Exhibit 8.4, with two 30-year Treasury yield curves in consecutive months at the end of 1997. Analysts try to explain: • Why the yield curve is generally downward-sloping when interest rates are high • Why the opposite is generally true when interest rates are low • Which fundamentals underpin a flat yield curve A good deal of challenge lies in the fact the liquidity preference theory makes no significant con- tribution to the influence of forward rates on the existing term structure. To do so requires the abil- ity to estimate relevant liquidity premiums accurately, which is not easy, especially in a dynamic market. To make matters more complex, the magnitude of the risk premium is itself variable, and it can depend on existing and projected economic conditions and investor psychology. For this reason, its study requires much more than a textbook sort of algorithm, which, for instance, states that the interest rate on a long-term bond will be equal to: • The average of the short-term interest rates that are expected to prevail over the life of the bond • Plus a liquidity premium that investors must be paid to convince them to hold the bond in the longer term These two points express a simplification that is used quite often. Based on this algorithm, the liquidity premium theory argues that investors are not indifferent to investments of different 154 MANAGING LIABILITIES maturities; they have a preference for short-term instruments because of their superior liquidity. (See also Chapter 7 on the advantages of liquid instruments.) Other things being equal, short-term instruments have less interest-rate risk because their prices change more slowly for a given change in interest-rate levels. Therefore, investors may be willing to accept a lower return on short-term securities. Again, everything else being equal, investors would like to be paid something extra for holding long-term securities, but this liquidity premium must be estimated carefully, accounting for the fact that “other things” may not be equal. Even if future spot rates are expected to be equal to current spot rates, there may be an upward- sloping yield curve because of a liquidity premium. At the same time, liquidity has a cost associat- ed with it, which means that price liquidity is not a one-way street. Therefore, we need methods, procedures, and models that permit: • Experimentation • Optimization • Control of results For every financial institution and industrial company, optimization decisions must be based on policies established by the board and on internal tools that can be used for analysis and evaluation of alternatives. Typically, such an approach requires the study of the company’s liquidity require- ments along a maturity ladder and national economic data that are steadily updated to reflect liq- uidity conditions, as well as a view of the global market. To help themselves in optimization studies, financial institutions use indices of national data on money supply growth and the evolution of interest rates in all the countries where they operate, as Exhibit 8.4 Within a Month, Investor Uncertainty Changes the Yield Curve of U.S. Treasury Bonds 155 Market Liquidity and the Control of Risk well as on indices weighting heavily on the global market. The metrics employed attempt to meas- ure volatility in liquidity as well as excess liquidity, where it exists. In this case, excess liquidity is defined as: • Money that is not spent directly on goods and services. • Therefore, it can be plowed into financial assets, propelling market activity. For instance, in 1995 and the years immediately thereafter, the sharp rise in this index signaled a significant increase in the amount of excess money available. This increased availability was most likely due to the fact that central banks in the United States and Europe were cutting their interest rates, while the Bank of Japan was pumping money into the Japanese economy in a bid to revive it. One way of looking at the liquidity cycle is that it follows a pattern whereby, at different points, different types of assets tend to outperform others. When there has been a surge in liquidity in the United States and other developed countries, their stock markets have been the first to benefit. In general, less developed countries and their financial assets also benefited. From 1995 to 1997, emerging markets tended to lag behind the G-10 ones in the investment cycle, even when they absorbed inordinate amounts of money, which led to the crash of East Asian countries of August to December 1997—as the latter were overloaded with foreign funds in search of quick profits. Quick bucks are not what companies and investors should look for, because invariably such a policy leads to disaster. MATURITY LADDER FOR LIQUIDITY MANAGEMENT Today there exists no global supervisory authority that can look into international monetary flow. This breach in the supervisory armory, as far as global markets are concerned, risks bringing them to the breaking point. The International Monetary Fund (IMF) usually acts after the fact, usually in a fire department’s role. While there has been a great deal of discussion regarding giving the IMF new powers, with a preventive authority associated with it (the so-called New Bretton Woods agree- ments), this has not happened yet. 6 The fact that there is no global gatekeeper for international money flows and liquidity increases the scope of focused liquidity management systems and procedures within every financial institu- tion. Better management usually happens through the institution of maturity ladders, which permit the study of net funding requirements, including excess or deficit of liquidity at selected maturity brackets. A study of maturity ladder can address a coarse or a much finer grid. I personally advise the lat- ter. In each bucket, the study is typically based on assumptions of future behavior of cash inflows and outflows—the latter due to liabilities, including off–balance sheet items. By dividing future commitments into a finite maturity ladder, we are able to look more clearly into future positive and negative cash flows. (See Chapter 9.) • Positive cash flows arise from maturing assets, nonmaturing assets that can be sold at fair value, and established credit lines available to be used. • Negative cash flows include liabilities falling due, contingent liabilities that can be drawn down, maturing derivative instruments, and so on. [...]... the difference between 1 76 Cash, Cash Flow, and the Cash Budget what they paid for a firm and the lower book value Goodwill is amortized over a long period, usually 40 years, and requires no cash outlay Based on this definition of cash flow, the algorithm for net cash flow yield is: Net Cash Flow Yield = Cash Flow + Interest Expense Interest expense is added back to the simple cash flow to get the broadest... used by credit institutions and corporate treasuries use this segregation Cash in banks is more easily verified than cash on hand Any situation where the amount of cash in bank(s) as shown on the balance sheet is greater or less than the sum actually on deposit calls for an immediate explanation 172 Cash, Cash Flow, and the Cash Budget On a number of occasions cash on hand is easily misrepresented,... regular and ad hoc intervals Clearly stated policies serving this purpose of performance evaluation are a must CASH FLOW, OPERATING CASH FLOW, AND FREE CASH FLOW This chapter has referred frequently to cash flow But which cash flow? There is not one but several types, which must be examined prior to discussing discounted cash flow, intrinsic value, and their use for managerial evaluations and decisions Cash. .. Chorafas, The 19 96 Market Risk Amendment Understanding the Marking-to-Model and Value-at-Risk (Burr Ridge, IL: McGraw-Hill, 1998) D N Chorafas, Chaos Theory in the Financial Markets (Chicago: Probus, 1994) 159 PART THREE TE AM FL Y Cash Management Team-Fly® CHAPTER 9 Cash, Cash Flow, and the Cash Budget Cash is any free credit balance in an account(s) or owed by a counterparty payable upon demand, to be... asset, evidently including cash Another important issue to keep in mind is that: • Current assets must be financed, just as fixed assets must be 164 Cash, Cash Flow, and the Cash Budget • How this financing is done can be determined by examining the flow of cash in the operations of a company This is an integral part of cash management based on the notion of the cash cycle and its effects on balance... facing its financial obligations As such, cash flow and discounted cash flow studies constitute some of the best tools available in modern finance Every financial manager should be interested in the influence of the cash cycle and price level changes on financing requirements He or she should be aware that financing needs follow sales and trades with a lag As sales rise and decline, so do cash inflows;... have learned how to: • • Implement flexible budgeting Develop alternative financial plans 170 Cash, Cash Flow, and the Cash Budget Fixed, Variable, and Semivariable Costs and the Breakeven Point TE AM FL Y Exhibit 9.4 Because of requirements underpinning the implementation of flexible budgeting and the development of alternative financial plans, the yearly budget should profit from Monte Carlo simulation... management purposes, risk premium income and write-offs in connection with default risks, among other items, are often booked via the cash account • • Premiums due are credited to the cash account, and Default payments are debited to the cash account Cash flow from assets and operations defines a company’s liquidity as well as its ability to service its debt Properly done, cash flow analysis succeeds in exposing... adverse conditions in financial markets Typically, such hypotheses must address assets, liabilities, derivatives, and some other issues specific to the particular bank and its operations, including: • • • Cash inflows Cash outflows Discounted cash flows by maturity ladder Concepts underpinning these items and the tools necessary are discussed in more detail in Chapter 9 in conjunction with cash management... a cash debit and ends with a cash credit Such debits and credits 175 CASH MANAGEMENT Exhibit 9 .6 Components of Profitability create the basis of a company’s cash flow and its computation • • Productive resources are acquired by bargaining transactions They are used to create products that are sold to the market through other transactions Within this cyclical perspective of financing, production, and . 163 CHAPTER 9 Cash, Cash Flow, and the Cash Budget Cash is any free credit balance in an account(s) or owed by a counterparty payable upon demand, to be used in the conduct of business. Cash. demand and standard costs reporting production and distribution. Expert systems can be instrumental assistants 2 to both: • The cash budget, which forecasts direct and indirect cost outlays, balancing. these changes are reflected in cash outflows. 164 CASH MANAGEMENT Therefore, the cash budget is a basic tool in financial analysis. It assists users in distinguishing between temporary and permanent financing