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 neces- sary 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,1Dr. 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 liquidityandsolvencycri- teria, 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 solventwhen the realizable value of its assets is at least sufficient to cover all of its lia- bilities. 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.
• Ifbanks held only currency, which over short time periods is a fixed-price asset,
• Thenthere would be little or no need for capital accounts to serve as a guarantee fund.
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 oppor- tunities and risks. (See Chapter 8.) Financial institutions tend to define market liquidity with refer- ence 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, mar- ket psychology, and others. Due to increased transaction size and more aggressive short-term trad- ing, 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
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
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®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 termfunding related to its nonfinancing busi- nesses 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 expo- sure 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 termmust 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 institu- tions 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 ID ITY BASIC
EXPO SU R E
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 nec- essary to estimate concentration or spread of holdings. Criteria for liquidity associated with securi- ties 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 secu- rities? 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 com- pany 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 liq- uidity and funding risk, but differences in opinion and in approach also exist between similar insti- tutions 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 char- acter 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:
• 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 identi- fied four different measures of liquidity that need to be taken into account simultaneously, as shown in Exhibit 7.3.
1. General money market liquidityis practically equal to liquidity in central bank money.
2. Special money market liquidity, in an intercommercial bank sense, is based on the credit insti- tution’s own money.
3. Capital market liquidityhas to do with the ability to buy and sell securities in established exchanges.
4. Swaps market liquidityis 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 prin- ciple. 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 CE N TRA L B A N K PO LICIES
LIQU ID ITY
C APITAL M AR KET BU YIN G AND SELLING
M O NEY M AR KET IN INTERC O N TIN EN TAL
BAN KING SW AP S M AR KE T
A N D O T HER O TC CO NTR ACT S
Liquidity Management and the Risk of Default
These are also the players in markets that are growing exponentially and therefore require increas- ing 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 bor- rowings, 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 con- tracts 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.
Excluding amounts that are not available because the customer has not yet satisfied the condi- tions for borrowing, at that date approximately $3.3 billion in loan commitments was undrawn and available for borrowing; approximately $1.3 billion had been advanced and was outstanding. In addition, as of September 30, 2000, Lucent had made commitments to guarantee customer debt of about $1.4 billion.
Excluding amounts not available for guarantee because preconditions had not been satisfied, approximately $600 million of guarantees was undrawn and available and about $770 million was outstanding at the aforementioned date.
These examples are revealing because they show that the ability of a manufacturing company to arrange or provide financing for its customers is crucial to its day-to-day and longer-term marketing operations. Such facility depends on a number of factors, including the manufacturing company’s:
• Capital structure
• Credit rating
• Level of available credit
• Continued ability to sell or transfer commitments and drawn-down borrowing on acceptable terms
In its annual report, Lucent emphasized that it believed it would be able to access the capital markets on terms and in amounts that are satisfactory to its business activity and that it could obtain bid and performance bonds; arrange or provide customer financing as necessary; and engage in hedging transactions on commercially acceptable terms.
Of course, there can be no assurance that what a company believes to be true will actually be the case, but senior management must exercise diligence in its forecasts and pay due attention to risk control. Credit risk, however, is not the only exposure. The company is also exposed to market risk from changes in foreign currency exchange rates and interest rates that could impact results from operations and financial condition. Lucent manages its exposure to these market risks through:
• Its regular operating and financing activities
• The use of derivative financial instruments
Lucent stated in its 2000 annual report that it uses derivatives as risk control tools and not for trading reasons. It also enters into bilateral agreements with a diversified group of financial institu- tions to manage exposure to nonperformance on derivatives products. (See Chapter 4 on reputa- tional risk.)
Regarding equity risk, the annual report states that Lucent generally does not hedge its equity price risk, but on occasion it may use equity derivative instruments to complement its investment strategies. In contrast, like all other manufacturing firms with multinational operations, Lucent uses foreign exchange forward and options contracts to reduce its exposure to the risk of net cash inflows and outflows resulting from the sale of products to non-U.S. customers and adverse affects by changes in exhange rates on purchases from non-U.S. suppliers.
Foreign exchange forward contracts, entered into in connection with recorded, firmly committed, or anticipated purchases and sales, permit the company to reduce its overall exposure to exchange rate movements. As of September 30, 2000, Lucent’s primary net foreign currency market exposures
Liquidity Management and the Risk of Default
report estimated that as of September 30, 2000, a 10 percent depreciation (appreciation) in these currencies from the prevailing market rates would result in an incremental net unrealized gain (loss) of approximately $59 million.
An important reference also has been how Lucent manages its ratio of fixed to floating rate debt with the objective of achieving an appropriate mix. The company enters into interest-rate swap agreements through which it exchanges various patterns of fixed and variable interest rates, in recognition of the fact that the fair value of its fixed rate long-term debt is sensitive to changes in interest rates.
Interest-rate changes would result in gains or losses in the market value of outstanding debt due to differences between the market interest rates and rates at the inception of the obligation. Based on a hypothetical immediate 150-basis-point increase in interest rates at September 30, 2000, the market value of Lucent’s fixed-rate long-term debt would be reduced by approximately $317 mil- lion. Conversely, 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 liquid- ity and the need to mobilize money quickly. But because cash usually earns less than other invest- ments, it is necessary to strike a balance between return and the risk of being illiquid at a given point of time. We have seen how this can be done.
In nervous markets, liquidity helps to guard against financial ruptures. This is as true at compa- ny level as it is at the national and international levels of money management. Robert E. Rubin, the former U.S. Treasury secretary, found that out when confronting economic flash fires in spots rang- ing from Mexico, to East Asia and South America. Putting out several spontaneous fires and avoid- ing a possible devastating aftermath has become an increasingly important part of the Treasury Department’s job.
Liquidity and fair value of instruments correlate. When a financial instrument is traded in active and liquid markets, its quoted market price provides the best evidence of fair value. In adjusting fac- tors for the determination of fair value, any limitation on market liquidity should be considered as negative. To establish reliable fair value estimates, it is therefore appropriate to distinguish between:
• Instruments with a quoted market price
• Unquoted instruments, including those of bilateral agreements
Who should be responsible for liquidity management at the corporate level? Bernt Gyllenswärd, of Scandinaviska Enskilda Banken, said that the treasury function is responsible for liquidity manage- ment and that liquidity positions always must be subject to risk control. The liquidity threshold of the bank should be dynamically adjusted for market conditions of high volatility and/or low liquidity.
In my practice I advise a hedging strategy, which is explained in graphic form in Exhibit 7.4. It is based on two axes of reference: compliance to strategic plan (and 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.