Liabilities liquidity and cash management balancing financial risks phần 8 potx

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 ® 222 CASH MANAGEMENT PRACTICAL EXAMPLE ON THE ROLE OF BASIS POINTS IN EXPOSURE A risk point represents the amount of gain or loss that would result from a given movement in inter- est rates. In some cases this is a fixed movement; for instance, 1 percent. In others, a changing esti- mate of likely movements is used, and it is regularly adjusted in light of recent historical data. Several banks have an overall risk point limit, which often is suballocated to different trading desks and portfolio positions. Others find that this is not necessarily the best approach because the planning and control of risk point limits is no exact science. Instead, top management wants to know the change in value in inventoried positions, if and when interest rates increase or decrease by x basis points or 1/100 of 1 percent. This concern is perfectly justified because interest rates are volatile. They vary intraday, daily, weekly, and monthly, often upsetting the most carefully laid out plans, unless an entity exercises utmost vigilance over its portfolio positions. Macroscopically speaking, volatility is shown in Exhibit 12.1 over a 60-year timeframe. The experimental method that has been implemented and applies to all thrifts takes current inter- est rates and changes them 100, 200, 300, and 400 basis points up and down. The adverse condi- tion is the 200-basis-point shock level. For the U.S. banking industry, the Office of the Comptroller of the Currency also has developed models that assist in handling interest-rate risk. The OTS has developed a standard reporting methodology for S&Ls. Prudential financial report- ing by the thrifts now distinguishes between: • Trading, and • Risk management Exhibit 12.1 Volatility in U.S. Prime Interest Rate from 1940 to 2000 PERC ENT 1940 1950 1960 1970 1980 1990 2000 25% 0 15% 10% 5% 20% 223 Mismatched Risk Profiles and Control by the Office of Thrift Supervision The assumptions made by thrifts 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 1988 Annual Report elaborates a hypothetical change in fair value in the financial instruments held by the com- pany at July 25, 1998. While Management said that these instruments were not leveraged and were held for purposes other than trading; still, they have significant sensitivity to changes in interest rates. The method used by Cisco is, to my judgment, an excellent paradigm for financial institutions as well. The modeling technique used measures change in fair values arising from selected potential changes in interest rates. The market changes entering this simulation reflect immediate paral- lel shifts in the yield curve of plus or minus 50 BPs, 100 BPs, and 150 BPs over a 12-month time horizon. • Beginning fair values represent the market principal plus accrued interest, dividends, and cer- tain interest-rate–sensitive securities considered cash and equivalents for financial reporting purposes. • Ending fair values comprises the market principal plus accrued interest, dividends, and rein- vestment income at a 12-month time horizon. Exhibit 12.2 estimates the fair value of the portfolio at a 12-month time horizon. There are rather minor differences in valuation at the 50 BPs, 100 BPs, and 150 BPs level. The importance of this example derives precisely from this fact, which demonstrates a well-balanced portfolio. In its 1998 annual report, Cisco observed that a 50-BPs move in the federal funds rate has occurred in nine of the last 10 years; a 100-BPs move has occurred in six of the last 10 years; and a 150-BPs move has occurred in four of the last 10 years, with the last reference being on September 30, 1998. In other terms: Exhibit 12.2 Estimated Fair Value of a Portfolio (in $Millions) at a 12-Month Time Horizon Valuation of Securities Valuation of Securities Given an Interest Rate No Change Given an Interest Rate Issuer Decrease of X Basis Points in Interest Rates Increase of X Basis Points (150 BPs) (100 BPs) (50 BPs) 50 BPs 100 BPs 150 BPs U.S. Government $1,052 $1,050 $1,047 $1,045 $1,043 $1,040 $1,038 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 810 809 809 807 806 805 804 and bonds Total $5,425 $5,380 $5,336 $5,294 $5,251 $5,208 $5,167 224 CASH MANAGEMENT • Volatilities of 50, 100, and 150 BPs are fairly frequent, and senior management must be always ready to face them. • The 200 BPs volatility, which is an OTS benchmark, is not as frequent but neither is it an outlier. • By contrast, the 300 and 400 BPs volatilities (both plus and minus) used by the OTS model can be seen as outliers; therefore they are benchmarks for stress testing. Notice that 100 BPs is not an extreme event but a reference value. As the Russian meltdown of August 1998 demonstrates, the sky may be the limit. Exhibit 12.3 presents movements of yield spreads in the bond markets and associated risk premiums for Russian, Brazilian, and Argentine bonds. • The risk premium for Russian bonds jumped 5.500 BPs practically overnight. • Argentine debt suffered a yield spread of 700 BPs, while neighboring Brazil saw a 1200 BPs jump. All three are extreme interest-rate events, although the Russian panic beats the Latin American ones by a large margin. As the figures show, this event threatened the Russian economy in its foun- dations at a time when some sort of economic and financial recovery was crucial, because such recovery was the only way to avoid a deep recession. A rigorous analysis of interest-rate risk exposure must consider not only extreme events in yield spread but also risk-adjusted duration. Risk-adjusted duration is a metric in which effective dura- tion is augmented for negative convexity, interest-rate volatility, incremental prepayment risk, spread risk, currency risk, hedging, and gearing. For instance, spread risk estimates reflect percentage change in the portfolio’s market value Exhibit 12.3 Change in Risk Premiums Through Extreme Events Characterizing Spreads in the Bond Market 225 Mismatched Risk Profiles and Control by the Office of Thrift Supervision because of changing yield spreads. A growing yield spread reflects a risk premium demanded by the market for holding securities of a lesser quality than risk-free U.S. Treasuries. Corporates are an example. One of the reasons that led to the near bankruptcy of Long-Term Capital Management (LTCM) in September 1998 was that its partners and Nobel prize–winning rocket scientists misjudged the direction of yield spreads. 4 Corporate bonds always feature a premium over credit-risk-free Treasuries. As shown in Exhibit 12.4: • The premium demanded by investors is much higher for BBB-rated corporates than for AAA ones. • In the second half of 1998, market nervousness saw to it that all premiums increased, and with them the spread. Yield spreads are volatile. 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 PORTFOLIO VALUE The primary form of interest-rate risk to a 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 com- mercial banking, and they can expose the institution’s income and economic value. If interest rates change, a credit institution that funded a long-term fixed rate loan with a short-term deposit is liable to face a decline in both: • Its future income arising from loans and investments • Its capital position, which is of value to shareholders and society Exhibit 12.4 Risk Premiums for American Enterprises with AAA and BBB Ratings 226 CASH MANAGEMENT Repricing mismatches also can expose a bank to changes in both the slope and the shape of the yield curve. Yield curve risk arises when unexpected shifts of the yield curve have adverse effects on an institution’s income. “Unexpected risks” is of course a misnomer. Management should never be taken by surprise when the yield curve changes significantly. It should attack the issue head on through experimentation. Short-term and long-term bond yields may rise or plunge significantly at short notice. As an example of yield changes on U.S., German, and Japanese bonds, Exhibit 12.5 presents statistics for 10-year government securities. Bond yields have plunged over 1998, reflecting: Exhibit 12.5 Yield Curves for 10-year Government Bonds 227 Mismatched Risk Profiles and Control by the Office of Thrift Supervision • Lower inflation expectations • Investors’ flight from risky equities Over the same timeframe, short-term yields also were generally lower because interest-rate cuts were in the offing. Another source of interest-rate risk comes from imperfect correlation in the adjustment of the rates earned and paid on different financial instruments with otherwise similar repricing characteristics. When interest rates change, these differences can cause changes in the cash flows and earnings spread among assets, liabilities, and off–balance sheet instruments of similar maturities or repric- ing frequencies. For instance, funding a five-year loan that reprices quarterly based on the three- month U.S. Treasury bill rate with a four-year deposit that reprices quarterly based on three-month LIBOR exposes the institution to the risk that: • The spread between the two index rates may change unexpectedly, and • Without appropriate tools and real-time systems, management does not have time to hedge. Volatility has always been a characteristic of the financial markets, and the yield curve against which interest-rate exposure is measured can change fairly rapidly before a bank is able to reposi- tion itself. Exhibit 12.6 dramatizes how investor uncertainty alters the yield curve of U.S. Treasury bonds within one day, one week, two weeks, and one month. Interest-rate risk also arises from options embedded in many financial instruments. Products with embedded options include bonds and notes with call or put provisions, loans that give bor- rowers the right to prepay balances, and adjustable rate loans with interest-rate caps or floors that limit the amount by which the rate may adjust. Exhibit 12.6 Yield Curves of Treasury Bonds at Different Time Intervals [...]... 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. .. Chorafas, 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... 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. .. know how to gear their assets and liabilities are both clever and skillful Then comes the day of reckoning, as with LTCM in 19 98 and with Daewoo in 2000 Chapter 3 discussed credit risk in connection with derivative financial instruments Leveraging and flagrant mismanagement are by no means its only reasons It may be that a business downturn catches a company off-guard Its cash flow is impaired, while... its part, senior management must: • • • • Manage the institution’s investments on a daily basis—or, even better, 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,... control process “Failure to understand and adequately manage the risks in these areas constitutes an unsafe and unsound practice,” states the OTS’s Supervisory Policy Statement on Investment Securities and End-User Derivatives Activities This strong wording reflects the belief that both the board and senior management should provide oversight to an effective risk management program The board of directors... 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... establish risk limits, and make sure that management has the skills to control the risks taken by the institution The board also should: • • • Review portfolio activity and risk levels at fairly frequent intervals Require that management is complying with approved risk limits Understand the institution’s overall loans, investments, and derivatives activities 236 Mismatched Risk Profiles and Control by the... to focus their resources on thrifts and banks that present the most immediate supervisory concerns To guide the board and senior management toward sound banking practices, the OTS and the other U.S regulators have spelled out the six deadly sins of investment and trading decisions The supervisory agencies believe the practices identified by these managerial and financial misbehaviors should not occur... of banking, financial institutions no longer know the counter- Exhibit 13.2 Marking Loans Positions to Market is a Complex Task That Must Account for Volatility and Liquidity VOL ATILI TY LIQU I I D TY M ARK E T PR I E C 243 CREDIT RISK, MARKET RISK, LEVERAGE, AND THE REGULATORS party as well as in the past, when operations were local and a financial institution knew, quite often first hand, the different . 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 management. $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. Team-Fly ® 232 CASH MANAGEMENT and derivatives financial instruments. The board and senior management also should understand and appreciate the metrics of exposure, associated sensitivities, and the