Liabilities, Liquidity, and Cash ManagementB alancing Financial Risks phần 8 ppt

212 CASH MANAGEMENT accounts for the cost of money during the farther-out 30 years. This cost typically is included in the pricing equation, as it happens with any other commodity. Yield curves also may be flat or even inverted; the latter condition is known as backwardation. For instance, since the end of the 1980s the yield structure in the German capital market has nearly completed an entire cycle. Starting from a slightly inverse curve, the economic policy uncer- tainties in connection with reunification at the beginning of the 1990s led to an increase in long- term interest rates and therefore to a fairly flat curve. The fact that in Exhibit 11.5 the shape of the 30-year yield curve of U.S. Treasuries and British gilts is not the same reflects the particular economic conditions in each country. Usually a signifi- cant amount of inference about financial and economic conditions can be made by studying the pre- vailing yield curve(s). For this reason, yield curves have been one of the financial industry’s most powerful predictors. If short-term interest rates are expected to rise relative to long-term interest rates, then a curve flattening strategy will involve the selling of short-term interest-rate futures and buying of bond futures on a duration weighted basis. By contrast, if short-term interest rates are expected to fall rel- ative to long-term interest rates, then curve-steepening trades are recommended. These involve the: • Buying of short-term interest rate futures • Selling of bond futures on a duration-weighted basis This is an example of how knowledgeable analysts and traders can use derivatives to fine-tune risk and return trade-offs. Such deals, however, are not free from exposure. Therefore, they should be made within established and accepted risk tolerances. Investors with high risk tolerance could use derivatives to leverage their portfolios for higher returns. In turn, doing this requires them to manage their investment risk very effectively and in real time. For example, some investment banks leverage bond, equity, and currency deals with gearing raised to: Exhibit 11.5 Yield Curve of Treasuries and Gilts (Semilogarithmic Scale) INTEREST RATE IN PERCENT (JUST NOTE DIFFERENCE) 0.25 0.5 1 2 3 30 US UK 510 213 Money Markets, Yield Curves, and Money Rates • 600 percent for the bond module • 300 percent for the currency and equity modules Bankers and investors who take this path usually have a high threshold for market pain. They leverage their bets and also try to hedge them, but with no assurance that the hedge will work as intended when the critical moment comes. Because yields are volatile, they can be both speculative and hedging instruments. One observation we can make from the graph in Exhibit 11.5 is that in normal times, long-term bond yields are higher than short-term interest rates. This fact helps to compensate investors for the higher risk of parting with their money over a longer time period. But just before recessions or sharp slowdowns: • Yield curves flatten out or get inverted. • Short-term rates rise above long-term bond yields. Typically, only listed government securities are used in constructing yield curves. This fact helps to ensure that the financial paper on whose basis the yield pattern is established is homogeneous and that no credit risk effect biases the curve’s shape. Analysts are particularly interested in study- ing this credit-risk-free structure because of its information content. For instance, the inverse shape of the yield curve at the beginning of the 1990s revealed the impact of the Bundesbank’s anti-inflationary policy. This policy was reflected in rising short-term money market rates. Then, from September 1992, the Bundesbank began to relax its interest rate policy, and short-term and long-term capital market rates initially declined in step with each other. Subsequently, starting in February 1994, the German capital market was caught in the wake of an international upsurge in longer-term interest rates, with long-term interest rates distinctly above short-term rates. Since then, the interest differential between the short end and the long end of the market increased. From the beginning of 1996, on the yield differential between German govern- ment debt securities with a maturity of 10 years and of one year became quite large. In conclusion, the shape of the yield curve is never static. It changes continuously, and even one month’s difference may be significant. This is seen in Exhibit 11.6, which maps the yield curves of implied forward euro overnight interest rates as of September 29 and October 30, 2000. The implied forward yield curve in this figure is derived from the term structure of interest rates observed in the euro market. These rates reflect the market’s expectation of future levels of short-term euro interest rates. NOMINAL VERSUS REAL INTEREST RATES One of the metrics used to judge the general interest-rate conditions in the market is the yield on domestic debt securities. This figure is established as the weighted yield on all bearer debt securi- ties outstanding with a residual maturity of more than three years. Such a yardstick shows the aver- age nominal financial costs that arise if direct recourse is taken to the debt securities market. Two observations are in order: 1. This metric correlates with bank interest rate for long-term loans. 2. It can serve as an indicator of the long-term financing costs of enterprises. 214 CASH MANAGEMENT Nominal interest rates also tend to correlate with inflation rates, but the correlation coefficient is far from being equal to one. The basis for valuation of inflation-indexed securities is the expected real rate of return. This is important both to the issuer and to the buyer. What attracts the issuer is the lower nominal cost on inflation-indexed bonds, reflecting the avoidance of the need to pay an inflation uncertainty risk premium, as the real rate is guaranteed. Also, other things being equal, the longer maturity achievable using inflation-indexed bonds influ- ences investment decisions. Buyers are looking for inflation protection and some other factors. For example, inflation- indexed products can assist investment managers to develop long-term savings and retirement income or provide them with the ability to enter into an inflation swap to convert the funding into either a fixed or a floating rate basis at an acceptable cost. Among the negatives is the fact that the credit risk profile of inflation-indexed debt creates a nat- ural limitation on the type and range of issuers. Credit risk premium demanded for lower credit Exhibit 11.6 Yield Structures of Implied Forward Overnight Euro Interest Rates 2000 2002 2004 2006 2008 20092001 2003 2005 2007 2010 4.0 5.0 5.5 6.0 6.5 DAILY DATA ON ANNUAL INTEREST RATE IN PERCENT 29 SEPTEMBER 2000 30 OCTOBER 2000 4.5 Statistics by the European Central Bank derived from swaps contracts. 215 Money Markets, Yield Curves, and Money Rates quality may be significantly higher than for a conventional bond, with the result that the cost advan- tage of the inflation-indexed financing is reduced or altogether eliminated. One of the major problems is the pricing of inflation-indexed bonds. The theoretical approach is that derivation of a real-rate zero coupon curve is not too different from the construction of a nom- inal interest rate zero coupon curve. This might be true, provided there is a reasonably liquid mar- ket with a sufficient range of inflation-indexed securities characterized by differing maturities. Such an event, however, does not happen frequently. Therefore, in practice either of two solutions is used: 1. A term structure is chosen to derive the real-rate yield curve assuming forward inflation rates. 2. Assumptions are made about the shape of the real-rate curve able to approximate its zero coupon equivalent. The first approach permits the valuation of options. The implied inflation term structure is com- puted by solving simultaneous equations of price as a function of the nominal discount factor, through interpolation. However, the relatively small size of this market presents the challenge that investor participation is restricted. This restriction leads to: • Lack of liquidity in these securities • Computational results that are not statistically significant To simplify the model, in many cases a trend in inflation is assumed based on past statistics. Nominal interest rates are adjusted by simple or weighted averages of past inflation rates, and this helps to obtain an approximation of the expected real interest rate. On a longer-term average, this type of adjustment can be acceptable, but it is rather difficult to estimate the trend in real interest rates for short periods. This reference is particularly true: • In periods of decidedly low or high inflation rates • During a fundamental reorientation of monetary policy by the central bank Still another problem has to do with transparency in accounting and with tax treatment. There is a continuing debate about whether inflation-indexed securities constitute a separate asset class, even if inflation-indexed instruments have been in existence since the mid-1980s. These problems see to it that nominal rather than real interest rates are the dominant ones in the market, even if investors think in terms of real interest rates expected over the maturity of an instru- ment. Because inflation may escape the control of governments and central banks, there are risks involved in estimating inflation expectations, as they are not directly observable. CHALLENGES ARISING FROM THE USE OF ELECTRONIC MONEY Electronic money, or virtual money, is an electronic store of monetary value on a technological device that may be widely used for making payments to entities other than the issuer, without nec- essarily involving the intermediation of bank accounts in the transaction. Electronic money usually acts as a prepaid bearer instrument representing monetary value through a claim on the issuer. 216 CASH MANAGEMENT • Electronic money is issued on receipt of funds or through account debits. • Its amount is stored on an electronic device. • The corresponding credit is accepted as means of payment by parties other than the issuer. Such funds must be able to be handled by third parties who accept them by debiting the amount stored on the device and crediting the third parties’ accounts. Such an operation should be done in a secure way (which is not always the case) and at low cost. This and similar definitions recognize that single-purpose electronic payment instruments, which are accepted as payment only by their issuers, do not fall under the concept of electronic money. Single-purpose payments, such as smart cards or chip-in-card devices issued by telephone compa- nies, are essentially down payments for goods or services that the issuer is expected to deliver at a later time. Chip-in-card solutions are used with credit cards, but do not make them safer. On the contrary, in 2000, after credit cards with chips were introduced in France, their theft increased by 50 percent. Such distinction between prepayments for services stored in electronic form and electronic money proper is important, even if both use—for instance—chip-in-card. The term electronic money is reserved for products used to make payments to entities other than the issuer, implicitly incorporating within this definition two different concepts: 1. Multipurpose electronic money 2. Limited-purpose electronic payment instruments Under the multipurpose classification, the stored purchasing power can be used widely in mak- ing payments. Limited-purpose instruments confine the purchasing power to a small number of clearly identified points of sale within a well-defined location—for instance, electronic payments accepted only for public transportation that is provided by several different companies within the same city or adjacent cities. A subcategory of multipurpose electronic payments is those solutions connected to the Internet. Whenever electronic money is transferred via telecommunications networks, the term network money is employed, regardless of whether the electronic money is software-based or hardware- based (i.e., smart cards). As Exhibit 11.7 suggests, electronic money can be seen as the end—but by no means as the ulti- mate development—of an evolutionary cycle that started at the dawn of civilization with barter agreements and was followed by silver and gold coins as fiduciary money. In terms of support, elec- tronic money may be stored in smart cards or transit through networks. • It can extend all the way into what some expect to become a wealth card carrying information on personal assets and liabilities. • It benefits its user by facilitating payments but involves security risks because money cards can be stolen or lost. The issuers of electronic money benefit because they capitalized on float, gaining on the inter- est rate—a practice well known with travelers’ checks. They also can use electronic money to hold their client base. At the same time, however, they too suffer from security lapses, which may 217 Money Markets, Yield Curves, and Money Rates become quite costly as courts tend to side with consumers who suffer from the insecurity of elec- tronic money. (This topic is discussed in more detail later.) Security issues aside, among the currently existing limitations that differentiate electronic money from greenbucks (paper money) is the fact that, in the majority of cases, electronic money received by the beneficiary cannot be used again. It has to be forwarded to the issuer for redemption. This process is known as closed circulation of electronic money. The opposite is open circulation of electronic money, which functions in a similar way as bank- notes and coins, allowing a number of transactions to be carried out without the involvement of the issuer. In terms of practical implementation, open circulation would be more cost effective than closed circulation, but it poses many challenges, the most important being that of needing security solutions. Another characteristic of electronic money is the need for journaling the transactions. Theoretically, electronic money can provide varying degrees of anonymity, from total anonymity to full disclosure of the identity of the user, depending on the technical features of the individual Exhibit 11.7 Transition in the Form of Money Over 3,000 Years 218 CASH MANAGEMENT system. Security reasons, however, necessitate the identification of both parties to a transaction and that the keeping of a record of every transaction for auditing. Because electronic money offers both advantages and limitations, its development and wider implementation will depend on whether consumers and merchants like it as a payment instrument. So far, from the early test of smart cards in Norway in the late 1980s, to the intensive tests in the United States in the late 1990s, the answer has been negative. It is appropriate to examine security connected to electronic money, because its absence is a major roadblock to the acceptance of new forms of payments. Theoretically, but only theoretically, smart cards provide a higher level of security. Practically, however, this is not so. If it were, smart card crime would not have increased more than 25 percent in France in the year 2000. From time to time, some new approaches are adopted to improve security. The latest is biomet- ric identification, which can be incorporated into a smart card. One of the features in biometrics is the fingerprint. It can be stored as a binary data string or as a template. Another biometric is the reti- na. Smart cards also can store signatures and voice. None of these approaches is fool-proof. Visa and Mastercard, among others, have done trials in the United States using smart cards with fingerprint biometrics. Other firms examined solutions for rewriting information with smart cards in a way that cannot be read by unauthorized persons. Any cryptographic code can be broken. All these security measures, however, fail to consider the fact that smart cards can get easily lost or stolen. When this happens, all biometrics information of the legitimate user is wide open to thieves. Protection through the now-substandard personal identification number (PIN) is most unreliable, because these numbers easily fall into the hands of third parties. On the positive side, PINs can be changed easily, but fingerprints cannot be. Once the smart card is in the hands of a gang, the true owner of the new smart card—and his or her account—cannot be safe at any time, in any place. Security is a truly major challenge with electronic money, including network money. Thus far no solution available solves the security problem. When asked “What does one do with virtual money?” Walter Wriston, the former CEO of Citibank, suggested: “One pays his bills.” But then he added: “The problem with this kind of money is the security of the networks. There exist too many 16-year-olds with gold chains around the neck, who break into the data system.” Wriston pointed out that it is possible to work on more secure solutions through an ingenious use of hardware and software. But technology changes so fast that it would be impossible to say which system is really secure in the longer term. The world today has become so transparent in an infor- mation sense that nothing can be properly secured anymore, much less secured in a lasting way. 219 CHAPTER 12 Mismatched Risk Profiles and Control by the Office of Thrift Supervision The events that led to the meltdown of the savings and loan (S&L) industry in the United States in the late 1980s/early 1990s are recent enough that they do not need to be retold. What is important in connection with the salvage of the thrifts industry is the action that followed its restructuring— and, most particularly, ways and means established for controlling its interest-rate profile. Wise people learn from their mistakes, and the wisest people are able to capitalize on the mis- takes of others to help them face challenges presented in the future. Here is, as an example, how chroniclers described the way Romans reacted in the aftermath of their defeat in the third century B.C. at the hands of the Gauls: “The ascendancy acquired by Rome in 100 years was lost in a sin- gle campaign. But the Romans with characteristic doggedness set to work to retrieve their losses. With equally characteristic sagacity they studied their own failure and drew profitable lessons from it. A great disaster was the prelude to far-reaching victories. 1 This quotation applies to the action taken by the regulators of the S&L industry right after the disastrous events of the late 1980s. Guidelines set by the Office of Thrift Supervision (OTS) see to it that senior management ensures the bank’s exposure to the volatility of interest rates is maintained within self-imposed limits. A system of interest-rate risk controls elaborated by OTS: • Helps in setting prudent boundaries for the level of interest-rate risk chosen by the institution • Provides the capability to set and control limits for individual portfolios, activities, and business units The financial reporting system examined in this chapter ensures that positions exceeding limits, or other predetermined levels, receive prompt management attention and are directly communicat- ed to regulators. Established procedures ensure that senior executives of the institution are notified immediately of any breaches of limits. The OTS also has been instrumental in promoting clear poli- cies as to how the board and top management of a thrift must be informed so that timely and appro- priate corrective action is taken. To keep exposure under control, the OTS steadily monitors the entire S&L industry—and this monitoring is proactive. When supervisory authorities follow this policy, they help the banks they control to confront their problems. It is no coincidence that the best-managed financial institutions are way ahead of all other banks in solving their challenges before they become too big and too risky. 220 CASH MANAGEMENT Timothy J. Stier, the chief accountant of the OTS, explained in a factual and documented man- ner why proactive information and experimentation is so important to the proper conduct of the thrifts’ business. With the world of the mortgage loans changing and with interest-rate risk being under the spotlight more than ever before, the S&L (and all other credit institutions) always must watch out both for generalized exposure and for specific risks of individual investments. INTEREST-RATE RISK MEASUREMENT AND OFFICE OF THRIFT SUPERVISION GUIDELINES After the events of the late 1980s, the Office of Thrift Supervision paid a great amount of attention to interest-rate risk. Ninety percent of the regulated 1,119 S&Ls, specifically the larger thrifts, file a report providing the OTC with interest-rate risk information. This report uses a regulatory com- pliance model. The concept behind this model is important to every financial institution. It integrates what-if hypotheses on the movement of interest rates and integrates maturity ladders. The OTS runs the sub- mitted results through Monte Carlo simulation. Over the years, the thrifts have learned how to perform: • Worst-case scenarios • Sensitivity measurements • Capital-before-shock calculations • Capital-after-shock calculations As a matter of policy, the OTS strongly recommends that institutions have in place interest-rate risk measurement systems able to capture all material sources of interest-rate risk. Such measure- ment systems should incorporate sound assumptions and parameters, which are both understood by senior management and followed by the operating units. The following paragraphs describe in a nutshell what an interest-rate risk measurement system must assess. First and foremost is the amount of interest-rate risk that has been assumed by type of loan and interest-rate bracket. The next most important issue is the effect of interest-rate changes on both earnings and economic value. Financial reporting required by the OTS addresses all mate- rial sources of interest-rate risk including: • Repricing • Yield curve • Basis risk • Option risk exposures While all of a bank’s holdings should receive appropriate treatment, financial instruments whose interest-rate sensitivity may significantly affect the institution’s overall results must be subject to special attention. For an S&L, for example, this is true of mortgages. The same concept is valid with other instruments whose embedded options may have major effects on final results. The thesis of the OTS is absolutely correct: The usefulness of any interest-rate risk measurement system depends on the validity of the underlying assumptions. Management assumptions have sig- nificant impact on accuracy; therefore they must follow a prudent methodology, and they should be 221 Mismatched Risk Profiles and Control by the Office of Thrift Supervision validated through real-life data. In designing interest-rate risk measurement solutions, banks must ensure that: • The degree of detail regarding the nature of their interest-sensitive positions is commensurate with the complexity and risk inherent in those positions, and • Senior management assesses the potential loss of precision by determining the extent of aggre- gation and simplification used by the measurements and in hypotheses. Senior management, the OTS suggests, should see to it that all material positions and cash flows, including off–balance sheet positions, are incorporated into the interest-rate measurement system. Where applicable, this data must include information on coupon rates and cash flows of associated instruments and contracts. Few thrifts—only 76 out of 1,119—have entered the derivatives market. “Once in a while we find a thrift who bought a reverse floater, but the majority of the savings and loans keep out of this market,” said Timothy Stier. Regulators insist that management pay special attention to those positions with uncertain matu- rities. Examples include savings and time deposits, which provide depositors with the option to make withdrawals at any time. To increase sensitivity to factors of timing, basic assumptions used to measure interest-rate risk exposure should be re-evaluated at least annually: • Hypotheses made in assessing interest-rate sensitivity of complex instruments should be explained properly and reviewed periodically. • Any adjustments to underlying data should be documented, and the nature and reason(s) for the adjustments should be explicit. The OTS believes that all these basic policy steps are necessary for rigorous interest-rate risk management. For a commercial bank—and even more for a thrift—interest-rate risk significantly increases the vulnerability of the institution’s financial condition to market liquidity and volatility. 2 Savings and loans, as well as practically all commercial banks, have experience with deposits and loans, but senior management does not always appreciate that while interest-rate risk is a part of financial intermediation, an excessive amount of such risk poses a significant threat to an institu- tion’s earnings and capital: • Changes in interest rates affect a bank’s earnings by altering interest-sensitive income and expenses. • Such changes also impact on the underlying value of the bank’s assets, liabilities, and off–bal- ance sheet instruments. Future cash flows change when interest rates change, and the interest-rate risk banks are con- fronted with comes from several sources: repricing, yield curve, basis risk, and options risk. All these are factors affecting the level of exposure and must be confronted in an able manner. Both the guidelines and the models developed by the OTS are, in their basics, quality control measures. They both complement and are complemented by the statistical quality control principles and charts 3 as well as by approaches based on behavioral science. TEAMFLY Team-Fly ® [...]... $1,045 $1,043 $1,040 $1,0 38 State, municipal, and county government notes and bonds 3,530 3, 488 3, 488 3,409 3,369 3,330 3,292 33 33 33 33 33 33 33 81 0 80 9 80 9 80 7 80 6 80 5 80 4 $5,425 $5, 380 $5,336 $5,294 $5,251 $5,2 08 $5,167 Foreign government notes and bonds Corporate notes and bonds Total 223 CASH MANAGEMENT • • • Volatilities of 50, 100, and 150 BPs are fairly frequent, and senior management must... quality of management of a financial institution SENSITIVITY MEASURES AND LIMITS ON DEALING WITH COMPLEX SECURITIES It should be absolutely evident—even if it is not common practice—that the board and senior management of a bank must understand the various risks associated with loans, investment securities, Team-Fly® 231 CASH MANAGEMENT and derivatives financial instruments The board and senior management... They narrow and widen in response to a number of factors, including liquidity, changes in credit quality, market volatility, supply and demand pressures, perceived future conditions, and investor sentiment The bank that plans its loans and investments without paying attention to these factors prepares itself for major disappointments and eventually for bankruptcy SENSITIVITY TO MARKET RISK AND POST-SHOCK... Understanding Volatility and Liquidity in Financial Markets (London: Euromoney Books, 19 98) D N Chorafas, Reliable Financial Reporting and Internal Control: A Global Implementation Guide (New York: John Wiley, 2000) D N Chorafas, Credit Risk Management, Vol 2: The Lessons of VAR Failures and Imprudent Exposure (London: Euromoney Books, 2000) D N Chorafas, Reliable Financial Reporting and Internal Control... institution knew, quite often first hand, the different players in its market and their standing The three major intentional rating agencies are: Standard and Poor’s (S&P), Moody’s Investors Service, and Fitch IBCA Both lenders and investors in credit instruments must decide what credit risk profile they are after and how much financial pain they can afford if credits turn sour or there is a panic in... intraday Establish and enforce policies and procedures on both a longer-range and a day-to-day operational basis Understand the nature and level of various risks Segregate the responsibilities for managing investment activities to maintain operational integrity From a senior management perspective, this is synonymous with ensuring that the people responsible for backoffice, settlement, and transaction... institution expands The size of the institution increases The complexity of its assets, liabilities, and derivatives grows Quality of management criteria include awareness of market risk and credit risk at all management levels; establishment of and adherence to limits; a rigorous methodology for measuring net portfolio value sensitivity; and a system for earnings sensitivity based on database mining Financial. .. regarding the impact of interest-rate volatility on earnings and cash flow is not public knowledge, but basis points provide a good example Cisco’s 1 988 Annual Report elaborates a hypothetical change in fair value in the financial instruments held by the company at July 25, 19 98 While Management said that these instruments were not leveraged and were held for purposes other than trading; still, they... deposit-taking bank that gives loans arises from timing differences in the maturity and repricing of assets, liabilities, and off–balance sheet positions Down to the fundamentals, this is structural risk, or mismatch risk Mismatches are part and parcel of commercial banking, and they can expose the institution’s income and economic value If interest rates change, a credit institution that funded a long-term... management also should understand and appreciate the metrics of exposure, associated sensitivities, and the testing procedures A sound policy requires that prior to taking an investment position or initiating a derivatives transaction, managers and traders ensure in a factual and documented manner that: • • • The projected transaction is legally permissible The terms and conditions of the security . bonds Corporate notes 81 0 80 9 80 9 80 7 80 6 80 5 80 4 and bonds Total $5,425 $5, 380 $5,336 $5,294 $5,251 $5,2 08 $5,167 224 CASH MANAGEMENT • Volatilities of 50, 100, and 150 BPs are fairly frequent, and senior. $1,0 38 notes and bonds State, municipal, 3,530 3, 488 3, 488 3,409 3,369 3,330 3,292 and county government notes and bonds Foreign government 33 33 33 33 33 33 33 notes and bonds Corporate notes 81 0. volatility on earnings and cash flow is not public knowledge, but basis points provide a good example. Cisco’s 1 988 Annual Report elaborates a hypothetical change in fair value in the financial instruments