Liabilities liquidity and cash management balancing financial risks phần 5 pptx

116 MANAGING LIABILITIES • Debts that arise from operations directly related to projects they are doing together and servic- es they provide to one another regarding the completion of such projects. Notes payable to banks and trade acceptances are a good example. It is sound accounting practice to show the various note obligations separate in the balance sheet. In the virtual company environment, however, this must be done at a greater level of detail, specifically by business partner and project, including collaterals (if any), but without netting incurred liabilities with those assets that enter into bilateral transactions of the partnership. A distinction that is not uniformly accepted in accounting circles but that can be helpful in transactions of virtual companies is that of loans payable. The term identifies loans from officers, rela- tives, or friends, accepted as a friendly gesture to the creditor and used in place of bank borrowing; such a practice is often used in small companies. Many virtual companies are composed of small entities, and might use this type of financing. What complicates matters is that receivables may not be collected by the borrower but by a business partner who assembles—and who will be in debt to the borrower, not to the party that has advanced the funds. This adds a layer of credit risk. Another example of a virtual company’s more complex accounting is subordinate debentures. These issues are subordinated in principal and interest to senior, or prior, debt. Under typical pro- visions, subordinate debentures are more like preferred stock aspects than they are like debt. Each of the business partners in a virtual company alliance might issue such debentures; some of the companies might be partnerships; and all of the companies might follow accounting systems different from one another. The aspect that is of interest to virtual companies is that subordinate debenture holders will not commence or join any other creditor in commencing a bankruptcy, receivership, dissolution, or similar proceedings. Relationships developing in a virtual company, however, may involve both senior debt regarding money guaranteed in a joint project, and junior debt from current or previous transactions into which each of the real companies had engaged. A virtual organization must handle plenty of basic accounting concepts in a way that leaves no ambiguity regarding its financial obligations (as a whole) and the obligations of each of the organization’s ephemeral partners. Furthermore, each of its activities that must be entered into the alliance’s accounts has to be costed, evaluated in terms of exposure, and subjected to financial planning and control. This approach requires that: • Management makes goals explicit. • Financial obligations taken by different entities are unambiguous. • There is in place an accounting system that tracks everything that moves and everything that does not move. Virtual companies are practicable if the infrastructure, including networks and computer-based models, facilitates the use of complementary resources that exist in cooperating firms. Such resources are left in place but are integrated in an accounting sense to support a particular product effort for as long as doing so is viable. In principle, resources are selectively allocated to the virtual company if: 117 Virtual Balance Sheets and Real-Time Control • They can be utilized more profitably than in the home company. • They can be supported by virtual office systems based on agents to help expand the boundaries of each individual organization. The books must be precise for general accounting reasons; in addition, they must be timely and accurate for management accounting. Financial reporting internal to the virtual company should be done by means of virtual balance sheets and virtual profit and loss statements. These statements must be executed in a way that facilitates interactions between business partners in a depth and breadth greater than is possible under traditional approaches. Because in a dynamic market intra- and intercompany resource availability can change minute to minute, advantages are accruing to parties able to arbitrage available resources rapidly. Virtual organizations must use information technology in a sophisticated way to supplement their cognitive capabilities; doing so will provide them with an advantage, given tight time constraints and the need to reallocate finite resources. NOTES 1. D. N. Chorafas, Implementing and Auditing the Internal Control System (London: Macmillan, 2001). 2. D. N. Chorafas, The 1996 Market Risk Amendment: Understanding the Marking-to-Model and Value-at-Risk (Burr Ridge, IL: McGraw-Hill, 1998). 3. D. N. Chorafas, Reliable Financial Reporting and Internal Control: A Global Implementation Guide (New York: John Wiley & Sons, 2000). 4. Business Week, October 28, 1996. 5. A hypothesis is a tentative statement made to solve a problem or to lead to the investigation of other problems. 6. See D. N. Chorafas, Agent Technology Handbook (New York: McGraw-Hill, 1998). 7. Chorafas, The 1996 Market Risk Amendment. 8. D. N. Chorafas, Managing Credit Risk, Vol. 2: The Lessons of VAR Failures and Imprudent Exposure (London: Euromoney Bank, 2000). 9. D. N. Chorafas, Setting Limits for Market Risk (London: Euromoney Books, 1999). 10. See D. N. Chorafas, Rocket Scientists in Banking (London: Lafferty Publications, 1995). 119 CHAPTER 7 Liquidity Management and the Risk of Default Liquidity is the quality or state of being liquid. In finance, this term is used in respect to securities and other assets that can be converted into cash at fair market price without loss associated to fire sale or other stress conditions. A good liquidity depends on the ability to instantly and easily trade assets. In general, and with only a few exceptions, it is wise to stay liquid, although it is not necessary to hold the assets in cash (see Chapters 9 and 10). Liquidity is ammunition, permitting quick mobilization of monetary resources, whether for defensive reasons or to take advantage of business opportunities. Every market, every company, and every financial instrument has liquidity characteristics of its own. While futures markets are usually liquid, very large orders might have to be broken down into smaller units to prevent an adverse price change, which often happens when transactions overwhelm the available store of value. In their seminal book Money and Banking, 1 Dr. W. H. Steiner and Dr. Eli Shapiro say that the character, amount, and distribution of its assets conditions a bank’s capacity to meet its liabilities and extend credit—thereby answering the community’s financing needs. “A critical problem for bank managements as well as the monetary control authorities is the need for resolving the conflict between liquidity, solvency, and yield,” say Steiner and Shapiro. “A bank is liquid when it is able to exchange its assets for cash rapidly enough to meet the demands made upon it for cash payments.” “We have a flat, flexible, decentralized organization, with unity of direction,” says Manuel Martin of Banco Popular. “The focus is on profitability, enforcing strict liquidity and solvency criteria, and concentrating on areas of business that we know about—sticking to the knitting.” 2 Solvency and profitability are two concepts that often conflict with one another. A bank is solvent when the realizable value of its assets is at least sufficient to cover all of its liabilities. The solvency of the bank depends on the size of the capital accounts, the size of its reserves, and the stability of value of its assets. Adequacy of reserves is a central issue in terms of current and coming capital requirements. • If banks held only currency, which over short time periods is a fixed-price asset, • Then there would be little or no need for capital accounts to serve as a guarantee fund. 120 MANAGING LIABILITIES The currency itself would be used for liquidity purposes, an asset sold at the fixed price at which it was acquired. But this is not rewarding in profitability terms. Also, over the medium to longer term, no currency or other financial assets have a fixed price. “They fluctuate,” as J. P. Morgan wise- ly advised a young man who asked about prices and investments in the stock market. Given this fluctuation, if the need arises to liquidate, there must be a settlement by agreement or legal process of an amount corresponding to that of indebtedness or other obligation. Maintaining a good liquidity enables one to avoid the necessity of a fire sale. Good liquidity makes it easier to clear up the liabilities side of the business, settling the accounts by matching assets and debts. An orderly procedure is not possible, however, when a bank faces liquidity problems. Another crucial issue connected to the same concept is market liquidity and its associated opportunities and risks. (See Chapter 8.) Financial institutions tend to define market liquidity with reference to the extent to which prices move as a result of the institutions’ own transactions. Normally, market liquidity is affected by many factors: money supply, velocity of circulation of money, market psychology, and others. Due to increased transaction size and more aggressive short-term trading, market makers sometimes are swamped by one-way market moves. LIQUID ASSETS AND THE CONCEPT OF LIQUIDITY ANALYSIS Liquidity analysis is the process of measuring a company’s ability to meet its maturing obligations. Companies usually position themselves against such obligations by holding liquid assets and assets that can be liquefied easily without loss of value. Liquid assets include cash on hand, cash generated from operations (accounts receivable), balances due from banks, and short-term lines of credit. Assets easy to liquefy are typically short-term investments, usually in high-grade securities. In general, • liquid assets mature within the next three months, and • they should be presented in the balance sheet at fair value. The more liquid assets a company has, the more liquid it is; the less liquid assets it has, the more the amount of overdrafts in its banking account. Overdrafts can get out of hand. It is therefore wise that top management follows very closely current liquidity and ensures that carefully established limits are always observed. Exhibit 7.1 shows that this can be done effectively on an intraday basis through statistical quality control charts. 3 Because primary sources of liquidity are cash generated from operations and borrowings, it is appropriate to watch these chapters in detail and have their values available ad hoc, interactively in real time. A consolidated statement of cash flows addresses cash inflows, cash outflows, and changes in cash balances. (See Chapter 9 for information on the concept underpinning cash flows.) The following text outlines the most pertinent issues: 1. Cash Flows from Operational Activities 1.1 Income from continuing operations 1.2 Adjustments required to reconcile income to cash flows from operations: • Change in inventories • Change in accounts receivable • Change in accounts payable and accrued compensation 121 Liquidity Management and the Risk of Default • Depreciation and amortization • Provision for doubtful accounts • Provision for postretirement medical benefits, net of payments • Undistributed equity in income of affiliated companies • Net change in current and deferred income taxes • Other, net charges 2. Cash Flows from Investment Activities 2.1 Cost of additions to: • Land • Buildings • Equipment • Subsidiaries 2.2 Proceeds from sales of: • Land • Buildings • Equipment • Subsidiaries 2.3 Net change for discontinued operations 2.4 Purchase of interest in other firms 2.5 Other, net charges 3. Cash Flows from Financing Activities 3.1 Net change in loans from the banking industry 3.2 Net change in commercial paper and bonds Exhibit 7.1 Using Statistical Quality Control to Intraday Overdrafts or Any Other Variable Whose Limits Must Be Controlled TEAMFLY Team-Fly ® 122 MANAGING LIABILITIES 3.3 Net change in other debt 3.4 Dividends on common and preferred stock 3.5 Proceeds from sale of common and preferred stock 3.6 Repurchase of common and preferred stock 3.7 Proceeds from issuance of different redeemable securities 4. Effect of Exchange Rate Changes on Cash 4.1 Net change from exchange rate volatility in countries/currencies with stable establishments 4.2 Net change from exchange rate volatility in major export markets 4.3 Net change from exchange rate volatility in major import markets 4.4 Net change from exchange rate volatility in secondary export/import markets Every well-managed company sees to it that any term funding related to its nonfinancing businesses is based on the prevailing interest-rate environment and overall capital market conditions. A sound underlying strategy is to continue to extend funding duration while balancing the typical yield curve of floating rates and reduced volatility obtained from fixed-rate financing. Basic exposure always must be counted in a coordinate system of volatility, liquidity, and assumed credit risk, as shown in Exhibit 7.2. The reference to any term must be qualified. The discussion so far mainly concerned the one- to three-month period. The liquidity of assets maturing in the next short-term timeframes, four to six months and seven to 12 months, is often assured through diversification. Several financial institutions studied commented that it is very difficult to define the correlation between liquidity and diversification in a sufficiently crisp manner—that is, in a way that can be used for establishing a common base of reference. But they do try to do so. Exhibit 7.2 A Coordinate System for Measuring Basic Exposure in Connection to a Bank’s Solvency CR ED IT R ISK LIQU IDITY V O L A TILIT Y BASIC EXPOSU RE 123 Liquidity Management and the Risk of Default Diversification can be established by the portfolio methodology adopted, based on some simpler or more complex rule; the simpler rules usually reflect stratification by threshold. A model is necessary to estimate concentration or spread of holdings. Criteria for liquidity associated with securities typically include: • Business turnover, and • Number of market makers. Market characteristics are crucial in fine-tuning the distribution that comes with diversification. This fact makes the rule more complex. The same is true of policies the board is adopting. For instance, what really makes a company kick in terms of liquidity? How can we establish dynamic thresholds? Dynamically adjusted limits? What are the signals leading to the revision of thresholds? Other critical queries relate to the market(s) a company addresses itself to and the part of the pie it wishes to have in each market by instrument class. What is our primary target: fixed income securities? equities? derivatives? other vehicles? What is the expected cash flow in each class? What is the prevailing liquidity? Which factors directly and indirectly affect this liquidity? No financial institution and no industrial company can afford to ignore these subjects. Two sets of answers are necessary. • One is specific to a company’s own trading book and banking book. • The other concerns the global liquidity pie chart and that of the main markets to which the company addresses itself. The company’s business characteristics impact on its trading book and banking book. Generally, banks have a different approach from securities firms and industrial outfits in regard to cash liquidity and funding risk, but differences in opinion and in approach also exist between similar institutions of different credit standing and different management policies. Cash liquidity risk appears to be more of a concern in situations where: • A firm’s involvement in derivatives is more pronounced. • Its reliance on short-term funding is higher. • Its credit rating in the financial market is lower. • Its access to central bank discount or borrowing facilities is more restricted. Provided access to central bank repo or borrowing facilities is not handicapped for any reason, in spite of the shrinkage of the deposits market and the increase in their derivatives business, many banks seem less concerned about liquidity risk than do banks without such a direct link to the central bank. Among the latter, uncertainty with respect to day-to-day cash flow causes continual concern. By contrast, securities firms find less challenging the management of cash requirements arising from a large derivatives portfolio. This fact has much to do with the traditionally short-term character of their funding. Cash liquidity requirements can arise suddenly and in large amounts when changes in market conditions or in perceptions of credit rating necessitate: 124 MANAGING LIABILITIES • Significant margin payments, or • Adjustment of hedges and positions. The issues connected to bank liquidity, particularly for universal banks, are, as the Bundesbank suggested during interviews, far more complex than it may seem at first sight. “Everybody uses the word ‘liquidity’ but very few people really know what it means,” said Eckhard Oechler. He identified four different measures of liquidity that need to be taken into account simultaneously, as shown in Exhibit 7.3. 1. General money market liquidity is practically equal to liquidity in central bank money. 2. Special money market liquidity, in an intercommercial bank sense, is based on the credit institution’s own money. 3. Capital market liquidity has to do with the ability to buy and sell securities in established exchanges. 4. Swaps market liquidity is necessary to buy or sell off–balance sheet contracts, usually over the counter. The crucial question in swaps market liquidity is whether the bank in need really can find a new partner to pull it out of a hole. This is very difficult to assess a priori or as a matter of general principle. Every situation has its own characteristics. Therefore, a prudent management would be very sensitive to swaps liquidity and its aftermath. Swaps market liquidity is relatively novel. As the German Bundesbank explained, not only is the notion of swaps liquidity not found in textbooks, but it is also alien to many bankers. Yet these are the people who every day have to deal with swaps liquidity in different trades they are executing. Exhibit 7.3 Four Dimensions of Liquidity That Should Be Taken Into Account in Financial Planning M O NEY M AR KET INFLUENCED BY CENTRALBANK PO LICIES LIQU IDITY CAPITALMARKET BU YING AND SELLING SE CUR ITIES M O NEY M AR KET ININTERC ONTINENTAL BANKING SW APS MARKET AND OT HER OTC CO NTRACTS 125 Liquidity Management and the Risk of Default These are also the players in markets that are growing exponentially and therefore require increasing amounts of swaps and other derivatives products in bilateral deals that may be illiquid. LIQUIDITY AND CAPITAL RESOURCES: THE VIEW FROM LUCENT TECHNOLOGIES As detailed in the Lucent Technologies 2000 annual report, the company expected that, from time to time, outstanding commercial paper balances would be replaced with short- or long-term borrowings, as market conditions permit. On September 30, 2000, Lucent maintained approximately $4.7 billion in credit facilities, of which a small portion was used to support its commercial paper program, while $4.5 billion was unused. Like any other entity, Lucent expects that future financing will be arranged to meet liquidity requirements. Management policy sees to it that the timing, amount, and form of the liquidity issue depends on prevailing market perspectives and general economic conditions. The company antici- pated that the solution of liquidity problems will be straightforward because of: • Borrowings under its banks’ credit facilities • Issuance of additional commercial paper • Cash generated from operations • Short- and long-term debt financing • Securitization of receivables • Expected proceeds from sale of business assets • Planned initial public offering (IPO) of Agere Systems These proceeds were projected to be adequate to satisfy future cash requirements. Management, however, noted in its annual report to shareholders that there can be no assurance that this would always be the case. This reservation is typical with all industrial companies and financial institutions. An integral part of a manufacturing company’s liquidity is that its customers worldwide require their suppliers to arrange or provide long-term financing for them, as a condition of obtaining contracts or bidding on infrastructural projects. Often such projects call for financing in amounts rang- ing up to $1 billion, although some projects may call only for modest funds. To face this challenge, Lucent has increasingly provided or arranged long-term financing for its customers. This financing provision obliges Lucent management to continually monitor and review the creditworthiness of such customers. The 2000 annual report notes that as market conditions permit, Lucent’s intention is to sell or transfer long-term financing arrangements, which may include both commitments and drawn-down borrowing, to financial institutions and other investors. Doing this will enable the company to reduce the amount of its commitments and free up financing capacity for new transactions. As part of the revenue recognition process, Lucent had to determine whether notes receivable under these contracts are reasonably assured of collection based on various factors, among which is the ability of Lucent to sell these notes. • As of September 30, 2000, Lucent had made commitments, or entered into agreements, to extend credit to certain customers for an aggregate of approximately $6.7 billion. [...]... and many other commercial banks, liquidity management is done by the treasury, in close collaboration with collateral management Bank Leu said that liquidity control does not directly affect trading limits, because senior management depends on the professionalism of line management to tighten them In another financial institution, liquidity management is handled by the group’s asset and liability management. .. 128 Liquidity Management and the Risk of Default In another major brokerage house, liquidity management is done by the treasury Treasury operations are responsible for assets and liabilities management as well as for funding As documented through my research, this policy is characteristic of an increasing number of institutions that tend to formalize their liquidity management procedures To help in liquidity. .. during the year In principle, high cash velocity suggests that cash is being used effectively But if the liquidity ratios are weak, then a high cash velocity may be an indication of liquidity problems faced by the company The family of cash flow ratios discussed in Chapter 9 both compete with and complement cash velocity as a criterion of cash management I chose to include cash velocity in this list because,... of market liquidity and its sustenance For this reason, measures of market liquidity must consider the spread, depth, and price impact of trades in addition to liquidity s implications for trading and the management of risk It is also important to examine the role of: • • • • Transaction time Number of transactions made Transaction volume Volatility in liquidity and liquidity predictions Liquidity. .. 1 147 MANAGING LIABILITIES Timely and effective liquidity management, therefore, should be a steady preoccupation of credit institutions After all, they have huge liabilities made up of financial assets of households, businesses, 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... 130 Liquidity Management and the Risk of Default Yet, in spite of resting on the aforementioned list of unrealistic assumptions, the ModiglianiMiller model has taken academia by storm It also has followers at Wall Street and in the city By contrast, the liquidity, assets /liabilities, and other financial ratios used by analysts in their evaluation of an entity’s health have both a longer history and. .. a 150 -basis-point decrease in interest rates would result in a net increase in the market value of the company’s fixed-rate long-term debt outstanding, at that same date, of about $397 million (See also in Chapter 12 the case study on savings and loans.) WHO IS RESPONSIBLE FOR LIQUIDITY MANAGEMENT? Well-managed companies and regulators pay a great deal of attention to the management of liquidity and. .. done in association with contingency planning CONTINGENCY PLANNING FOR LIQUIDITY MANAGEMENT The liquidity of a financial institution must be measured and managed to ensure that it is able to meet liabilities as they come due Fundamentally, liquidity management aims to reduce the probability of an irreversible adverse situation and its aftermath Even in cases where a crisis develops because of a problem... prevailing regulations) and steady assessment of effectiveness The results of a focused analysis typically tend to cluster around one of four key points identified in this reference system 127 MANAGING LIABILITIES Exhibit 7.4 Liquidity Hedges and Practices Must Be Subject to Steady Evaluation and Control Liquidity management is the responsibility of the global asset and liability committee, and is carried... profile of any entity and of every one of its positions The problem is that the method by which financial institutions and industrial companies address the issue of liquidity produces many unreliable responses because of their tendency to mix different distinct factors addressing liquidity, such as market liquidity and transaction liquidity In principle, it is wise to differentiate between liquidity in a . senior management depends on the professionalism of line management to tighten them. In another financial institution, liquidity management is handled by the group’s asset and liability management. formal procedures. Exhibit 7.4 Liquidity Hedges and Practices Must Be Subject to Steady Evaluation and Control 129 Liquidity Management and the Risk of Default In another major brokerage house, liquidity management. consolidated statement of cash flows addresses cash inflows, cash outflows, and changes in cash balances. (See Chapter 9 for information on the concept underpinning cash flows.) The following

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