The full list of recognized managers and organizations that participated in this research is shown in the Acknowledgments. Associate Chief Accountant Office of the Chief Accountant Securities and Exchange Commission 450 Fifth Street NW.
Contents
The consequences of operational risk affect both the fund and the intermediary. 70 Scandals become part of reputational risk when. Sensitivity analysis, value-added solutions and gap analysis 84 Correct recognition of assets and liabilities and the concept of stress testing 88 Balance sheet resizing with asset disposal 91.
PART ONE
Challenges of Liabilities Management
Market Bubble of Telecoms Stocks
Making the liability side of the balance sheet the heavyweight is akin to specializing in the creation of debt. In the 1990s, 70 years later, the telecommunications and dot-coms of the United States and Europe repeated this tradition.
Downfall of Lucent Technologies, Xerox, and Dot-Coms
At first, during the mid to late 1990s, we saw the bright side of the New Economy: One should never forget that services are at the core of the New Economy.
Liabilities and Derivatives Risk
Figure 3.1 and Figure 3.2 show the evolution of the on-balance sheet and off-balance sheet portfolio of a large financial institution over five consecutive years. Each of the world's 30 largest banks – American, European and Japanese – will have the equivalent of $3 to $4 trillion in off-balance sheet exposure on average. Brent crude and West Texas crude form the basis on which more than 90 percent of the world's oil is valued.
A similar statement is valid about the use of the derivatives market for profit by some of the better known companies. They are still in this hole despite the Japanese government's efforts to jumpstart the economy. The effects of the bubble bursting can be that much more severe as off-balance sheet financial instruments produce fantastic growth statistics.
The sophisticated person on the street, who is generally the average investor, understands that technology is the engine of the new economy and wants to be part of the action. Many experts assume that what we experienced in the 1990s is only the tip of the iceberg in technological developments. This reference is best appreciated if the polyvalence of the debt challenge is kept in mind.
Reputational and Operational Risk
This criticism has become quite vocal due to the frequency and scale of IMF bailouts. These cases, which emerged after the bankruptcy of Baring and BCCI, are not the only ones involving reputational risk for CPAs. Most of the operational risk literature still deals with problems that occur further down the food chain.
An example is the twelfth hour bailout of the savings and loan institutions in the United States in the late 1980s. This applies not only to the cosmos, but also to the life of an organization. Paying off more of the debt early sent a positive signal to the bond markets.
Eventually, time erased the memory of the 1994 debacle and proved that the bankruptcy court-approved debt repayment plan worked. Many of the executives I asked felt that the Orange County affair was not just a matter of a lack of internal control, but also a lack of internal discipline. To recover some of the money that went down the drain, Orange County got involved in a lawsuit against Merrill Lynch.
PART TWO
Managing Liabilities
Assets, Liabilities, and the Balance Sheet
Interest paid on debt securities reflects prevailing market rates (see Chapter 11) as well as differences in the creditworthiness of the respective issuers. As in the case of the two insurance companies, it can weaken the assets in the portfolio and therefore give an unwanted boost to the liabilities on the balance sheet. One of the more difficult forms of interest rate risk management is structural risk.
In most cases, senior management is only informed that the balance sheet is upside down when something catastrophic happens. The results are aggregated to show the cumulative interest rate sensitivity gap between the asset and liability sides of the balance sheet. It can be misleading unless all the instruments in the analysis are denominated in one currency.
It may seem superfluous to talk about the need for correct recognition of assets and liabilities in the balance sheet, but it is nevertheless important. When it comes to assets and liabilities on the balance sheet, no one—from board members and the CEO to other levels of oversight—has the ability to change the situation on their own. In the case of gap analysis, this means a constant simulation up and down the interest rate scale of the portfolio of assets and liabilities and of the covenants and other variables attached to them.
Virtual Balance Sheets and Real-Time Control
Johnson & Johnson is one of the companies whose senior management has been revolutionized by modern financial information technology. The strategic aspect of A&L modeling is a direct result of the fact that a company's balance sheets represent its successive financial statements. An example of the implementation of real-time reporting with the State Street Bank of Boston will also be provided.).
First-class information technology can produce virtual financial statements in a matter of minutes, providing their recipient with an order-of-magnitude appreciation of the current status of assets and liabilities. Optimization offers plenty of room to protect foreign currency earnings against fluctuations in the value of the dollar. An outgrowth of the algorithms underlying the value-to-risk presentation was Morgan's RiskMetrics.
RiskMetrics is the background algorithm of value at risk, which was generalized in the wake of the 1996 Market Risk Amendment by the Basel Committee.7. One of the reporting objectives should be high-frequency financial data that is interactively available intraday at an acceptable level of accuracy. The reader is well advised to avoid clichés such as "the virtual office means you never have to commute" or "the virtual market means you never have to waste time waiting in line at the mall." To its fundamentals, business and technology need a base to be applied to - and this base is the real world.
Liquidity Management and the Risk of Default
Changes in interest rates would result in gains or losses in the market value of outstanding debt due to differences between the market interest rates and the rates at the time of the obligation. Conversely, a decrease in interest rates of 150 basis points would result in a net increase in the market value of the company's long-term fixed rate debt outstanding on that same date of approximately 150 basis points. In the telecom sector, a number of operators were expected to fail to comply with self-imposed deleveraging procedures.
A different algorithm should be used regarding short-term and long-term profitability. The ratio of sales to total assets was developed by du Pont and is still a central metric in the du Pont system of financial control. It represents the daily profit and loss resulting from derivative financial instruments in the trading book of a major financial institution.
Note that what has been outlined in the previous paragraphs can be nicely expressed in a soft engineering diagram, as shown in Exhibit 7.8. In the insurance industry, liquidity risk arises from the possibility that the insurance company will have insufficient liquid assets to service the needs of its guarantees. Then, in the early hours of the morning, its board experimented with various alternatives online, prompting Bankers Trust to move with its UK branch.
Market Liquidity and the Control of Risk
The money supply affects the output of the economy as well as the price level. When added to the monetary base, the liabilities of the banking system constitute the basic components of the monetary supply at different levels Mi (M1, M2, M3, etc.). There is virtually no limit to how much the banking system can expand the money supply, said Marriner Eccles, Fed chairman during the Franklin Roosevelt years.
Samuelson's classification of the demand for money – transactions and actual liquidity – gives a very simplified picture on the whole. The skillful use of advanced technology allows investors to track some of the risks described in the above section. An institution's liquidity can be decoupled from the economy as a whole up to a certain point.
A more thorough examination of the bank's behavior in the market requires an understanding of its trading mandate and risks taken at all levels of transactions. The average of the short-term interest rates that are expected to prevail over the bond's maturity. Much of the inertia in living with one's time comes from lack of experience in the processes discussed here and in Chapter 7.
PART THREE
Cash Management
Cash, Cash Flow, and the Cash Budget
In the long run, cash flow is a function of products and services and their marketing. In the very short and short term (90 to 180 days), cash flow makes the difference between liquidation and survival. One of the models developed for monetary flow follows a process with two states of transitional probabilities (Markov chains),4 with positive or negative values.
A new product or new company typically experiences an initial period of cash flow deficits, Exhibit 9.5 Noninterest Budgeting. Net income is both the bottom line and the starting point when determining a company's cash flow. Interest expense is added back to the simple cash flow to get the broadest possible measure.
The free cash flow can be used to increase dividends, buy back shares, redeem shares or pay off debt. Some companies that look pricey based on earnings can be bargains when measured by free cash flow. One of the principles of good management is that no one should lose sight of cash flow estimates or the allocation of resources and wealth.
