His father had taught him that “A business, like an individual, could remain free only if it keptout of debt.”4 All this is relevant to our discussion because money supply underpins Paul
Trang 1There are different metrics for money supply, from M1to M9 M1is the more limited definition
of money supply, representing the money that can be spent right away; it represents the gross sum
of all currency and demand deposits held by every consumer and business in a country Checkingaccount deposits are about three-quarters of M1; hence M1is much larger than M0
The Fed targeted M1for many years Then it switched to M2, which is equal to M1plus timedeposits in the banking system Like M1, M2varies over time in relation to reserve bank policies,investment policies, propensity to consume, and other factors As Exhibit 8.1 shows, from January
to March 2001 the money supply exploded, rising at a 12 percent annual rate The last time M2surged at a similar pace was in late 1998, in the aftermath of the Russian bond default and the col-lapse of Long Term Capital Management
Other central banks use different metrics For instance, the German Bundesbank tracks M3,which includes: currency in circulation, demand deposits with banks, demand deposits with postalgiro system, time deposits, and savings deposits
No matter which metrics the monetary authorities follow, rapid growth in supply of money canlead to inflation Money supply is increased by increasing either the monetary base or the velocity
of circulation of money, or both Not only the reserve bank but also the banking sector as a wholeimpacts on the money supply The quantity theory of money links money supply to gross nationalproduct (GNP):
Exhibit 8.1 The Rapid Growth of M 2 in a Matter of Three Months (January to March 2001)
P = price level
Q = output of the economy
Trang 2Money supply impacts on the output of the economy as well as on the price level The algorithm
to remember is that credit, and therefore debit, and money supply grow together When added to the monetary base, the banking system’s liabilities make up the basic components of the money supply
at the different Mi(M1, M2, M3, etc.) levels A rapid growth pattern of Mileads to fears it might befollowed by inflation
There is practically no limit to the amount the banking system can expand the money supply,said Marriner Eccles, chairman of the Fed in the Franklin Roosevelt years Eccles was against lever-age His father had taught him that “A business, like an individual, could remain free only if it keptout of debt.”4
All this is relevant to our discussion because money supply underpins Paul Samuelson’s twoclasses: transaction liquidity and general market liquidity The notions presented in the precedingparagraphs also serve to bring attention to the fact that Dr Samuelson’s classification of the demandfor money—transactions and liquidity proper—gives altogether a very simplified picture Shifts indemand for money can be most rapid and unpredictable, therefore altering the overall pattern— andglobalization further promotes pattern changes
The simplification and idealization of a real-world situation is meaningful only when we knowwhat we are after and appreciate the approximations we make Financial analysts should map eco-
nomic and financial relations into models only after they really understand the critical factors
influ-encing the market and its behavior Subsequently, what mathematics can describe computers canbring to life through experimentation
LIQUIDITY RISK, VOLATILITY, AND FINANCIAL STATISTICS
Many knowledgeable financial analysts have suggested that even if the books do not say so, uidity risk is the biggest exposure a financial institution can take because it impacts on the institu-tion’s reserves and on its liabilities in the short, medium, and longer term Drexel failed because itcould not roll its commercial paper Therefore, a Treasury functions properly when it understandsthe liabilities structure of the firm and associates it to projected liquidity This structure can be mod-eled, and it should be kept under perspective with every new commitment and with every examina-tion of current obligations
liq-Liquidity must be measured both in qualitative and quantitative terms—not in a quantitative way
alone Dr Henry Kaufman says that liquidity has to do with the feel of the market Reference has
been already made to the fact that liquidity is no real problem when the market goes up It becomes
a challenge when:
• The banking system gets destabilized, as in Japan from 1990 until today
• Market psychology turns negative with the prices of stocks and the other commodities goingsouth
The regulation of liquidity is so much an art because ways and means we have available areessentially imperfect This has been demonstrated by the brief discussion on money supply metrics
Contrary to what might seem to be the case, overleveraging is an enemy of liquidity—and it could
make the survival of some big banks problematic, as in the case of huge loans to tions companies discussed in Chapter 1
Trang 3telecommunica-Timely and effective liquidity management, therefore, should be a steady preoccupation of
cred-it instcred-itutions After all, they have huge liabilcred-ities made up of financial assets of households, nesses, and governments—and, usually, their own capital is only a small percentage of their totalfootings, as Kaufman aptly suggests
busi-Sometimes interest on liquidity management takes a back seat because of an ill-conceived wealth
effect Its importance depends on absolute value and composition of wealth, on the impact of
mon-etary policy, and on changes in consumption and investment decisions Changes in financial ture toward greater recourse to securities markets are likely to reinforce the importance of wealtheffect, as households and nonfinancial corporations probably will hold a larger share of their wealth
struc-in the form of fstruc-inancial market struc-instruments such as corporate bonds and/or equity However, thismechanism can be weakened by the fact that:
• Credit institutions also hold in their portfolio debt securities, shares, and other equity issued bynonfinancial entities
• The control of exposure of the private sector to price fluctuations in such instruments is notkeeping pace with developments in these markets
This is another reason that making an institution’s financial staying power is so important Tier-1
banks establish liquidity limits based on two levels of reference: (1) liquidity risk, by risk type, risk factor, currency, and market; and (2) liquidity volume, by open position and individual security in
their portfolio or in which they are interested for future investments What do regulators look forwhen they examine a financial institution’s ability to survive? Four questions are topmost:
1 Does it have risk limits of a type appropriate to our business?
2 Do its policies constrain the trading to the risk/reward ratio desired by top management?
3 Does it have real-time monitoring of all transactions? of tick-by-tick exposure?
4 Is top management sensitive to deviations and the breaking of limits?
The component elements underpinning these queries form, so to speak, the infrastructure onwhich a control model operates Beyond this, a valid internal control model needs an input from
every operating department It also requires building a modular capital code to permit flexible risk
control, splitting financial exposure according to counterparty, instruments being handled, and theirvolatility As far as the control structure is concerned:
• Liquidity and volatility are those prevailing in the market.
• Cash flow has to be carefully calculated by channel of activity.
• Interest-rate risk must be tractable intraday (See Chapters 11 and 13.)
The input from regulators must include a great deal of clear definitions and guidelines Forinstance, how many degrees of freedom do we have in handling commercial mortgages? Validapproaches will invariably involve taking a look at securitized products and working by analogy:
Can we manage the loan book as if it were a bond book?
We can develop securitization models that reflect policies and practices with house mortgagesbut embed a stronger credit risk factor for corporates A similar type of prudence should prevail in
Trang 4connection with cash flow estimates (see Chapter 9) as well as with cash holdings It is wrong to
place the cash book into the banking book, a practice followed because of cash management sons The cash book is part of the trading book.
rea-In the absence of clear regulatory directives, it may be wise to look at what some of the managed financial institutions are doing: How do they massage and mine market data, and what dothey get out of their models? In short, how do they increase their business acuity in performing indifferent environments? Said Brandon Davies, of Barclays Bank: “As we get more sophisticated wefind we consume time and thought trying to develop solutions other banks do already.”
best-The economic turnover ratio is a model that can extend what has been discussed about ratios in
Chapter 7 It addresses market liquidity by measuring the total value of all trades divided by a try’s market capitalization A thorough analysis also looks at stock market volatility and the open-ness of a country’s capital market
coun-Current account information is also important Based on U.S Department of Commerce tics, Exhibit 8.2 shows the pattern of physical goods imports over three decades: 1970 to 2000 Theexponential growth shown in this figure finds its counterpart in trade deficit connected to physicalgoods and the U.S current account deficit Both are shown in Exhibit 8.3 The careful reader willappreciate the similitude of these two patterns
statis-It is also wise to examine how closely different indicators are correlated with economic growth
In principle, countries with the most liquid stock markets tend to grow fastest Stock market uidity is a convenience, but price changes can distract attention from the need to assess corporatevalue regularly and to evaluate the way corporate governance behaves
liq-Exhibit 8.2 Statistics on Three Decades of Imports of Physical Goods in the United States
$ BILLIONS
1,200
0
600 1,000
400
200 800
1,400
Exhibit 8.2 Statistics on Three Decades of Imports of Physical Goods in the United States
$ BILLIONS
1,200
0
600 1,000
400
200 800 1,400
Trang 5Mathematical models and simulation provide a great deal of assistance in studying currentaccount deficits and the analysis of factors characteristic of corporate governance Investing in equi-ties demands the ability to analyze an entity’s intrinsic value (see Chapter 9) and ignore emotionwhen stocks become volatile The best strategy is to follow a company, its products, and its instru-ments closely and make a long-term commitment Only when fundamentals change is it wise to sell;but it is worth monitoring prices all of the time.
Even stop-loss systems considered to be a rather conservative approach are geared toward folios, not the typical investor Sell limits can be useful for locking in gains but also may promptpremature selling of equities that have considerable volatility, such as technology stocks
port-With all these constraints in mind, one may ask the question: Why does market liquidity matterthat much? For one thing, investors avoid illiquid markets and illiquid instruments Also, liquidequity markets allow investors to sell shares easily while permitting firms access to long-term cap-ital through equity issues Many profitable investments require a long-term commitment of capital
MARKING TO MARKET AND MARKING TO MODEL
Liquidity risk and price risk due to volatility are part of market risk Both are fundamental elements
in the business of every financial intermediary The liquidity risk faced by a credit institution may
be its own or that of its major client(s) in some country and in some currency Clients who areunable to meet their financial commitments are credit risks, but they also create liquidity problems.Price risk affects earnings It may arise from changes in interest rates, currency rates, equity andcommodity prices, and in their implied volatilities These exposures develop in the normal course
of a financial intermediary’s business Therefore, an efficient risk control process must include theestablishment of appropriate market controls, policies, and procedures permitting a rigorous riskoversight by senior management
Exhibit 8.3 Deficit from Trade of Physical Goods and Current Account Deficit of the U.S Economy
Trang 6Market Liquidity and the Control of Risk
Liquidity must be subject to a control process that has upper and lower limits If low liquidity is
a danger signal, for different reasons, so is excess liquidity (see Chapter 5) or liquidity surplus to an
institution’s needs Excess liquidity can be invested in financial markets for better profits than thoseprovided by cash We can invest excess liquidity without taking inordinate risks only when we areable to monitor our liquidity requirements steadily and prognosticate those that are coming.The able use of advanced technology permits investors to track some of the risks described inthe above paragraphs We can do so through real-time systems and the quantification of changes invalue of assets and liabilities This analysis should be accomplished in absolute terms and as a func-tion of market volatility There are two ways to do so:
1 Through marking-to market instruments
2 Through marking-to-model instruments
Marking-to-market is double for those instruments in our portfolio for which there is an active
market For instance, bid/ask is a dynamic market-driven parameter which makes it possible togauge the market price for a given product
There are a couple of problems with marking to market One of them is that quite often the prices
are really estimates that prove to be too optimistic or plainly biased This is the case with the
volatil-ity smile, where traders think that volatilvolatil-ity will be benign and therefore underprice the instruments
they deal with
The second problem is that the majority of over-the-counter trades are esoteric, developed for thecounterparty, or too complex to price in an objective manner Even more involved is their steadyrepricing Derivative financial instruments, particularly those which have been personalized, fall into
this class Their valuation can be achieved by marking to model, duly appreciating that models are
approximations to reality and frequently contain assumptions that may not always hold Marking tomodel also has its limitations One of them is the lack of skill to do the modeling Another is thatthe assumptions we make are not always sound; still another is oversimplification of algorithmicapproaches
Few institutions appreciate that it is not enough to model the instrument We also must study thevolatility and liquidity of financial markets through historical analysis We should take and analyzestatistics of market events including both:
• Normal market behavior
• Squeezes, panics, and crashesThe model should work on the premise that liquidity tends to follow different patterns, fallingfrom peak to trough and then increasing again, over a fairly regular time span The theory under-pinning this approach dates back to the writings of economists Irving Fisher and Friedrich Hayek.The algorithm works on the basis that too much money chasing too few financial assets causes theirprices to rise, while tighter liquidity produces the opposite effect
Globalization has seen to it that this concept of volatility in market liquidity became more plex, particularly for financial institutions and industrial companies working transborder Liquidityissues are not only domestic; they are also global Economists argue which matters more, global liq-uidity or domestic liquidity
Trang 7Because financial markets of the Group of Ten nations are networked, psychology aside, stockmarket prices are increasingly being driven by global liquidity Cross-border investments have left
an increasing proportion of shares in foreign hands But that does not mean that domestic factorsplay only a minor role Among other reasons why domestic liquidity remains a key player is thateconomies around the world are at different stages of the business cycle It is also good to noticethat:
• The real economy lags nine months or so behind the liquidity cycle
• An institution’s liquidity may be, up to a point, uncoupled from that of the economy as a whole.Many reasons are behind the bifurcation in these statements A few examples are excessiveleverage, imprudent management, and poorly followed-up commitments A more thorough exami-nation of the behavior of the bank in the market requires understanding of its trading mandate andrisks being taken at all levels of transacting business There are a great deal of other critical ques-tions as well, such as clear levels of authority, not only in normal times but also in times of crisislike escalation events:
• Level of sophistication of internal auditing
• Existence of funding/liquidity limits
• Experience of management and trading staff
Models are not supposed to solve these problems In times of crisis, much will depend on thematurity of the whole system of management and its ability to perform steady review and monitor-ing using rapid-response feedback loops Discovery action by senior management greatly depends
on critical analysis of what is working and what is not working as it should
Some of the cases I have seen involved potential loss not constrained in a rigorous manner ormeasured at an acceptable level of accuracy; lax management supervision of liquidity issues; andthe “feeling” that if matters are left to their own devices, they will take care of themselves For amoney center bank, a liquidity crisis could happen anywhere in the world because large financialinstitutions typically have:
• A global book
• Complex portfolios
• Overseas traders who are not well controlled
• A universal asset base that is not always thoroughly analyzed
In general, when the analytical part is wanting, the results of marking to model will be abysmal
I have seen cases where the modeling constructs were so sloppy and untested that the resultsobtained ranged from chaos to uncertainty Also the data being used were neither accurate norobtained in real time.5
Those institutions whose operations are characterized by overnight trading, long communicationlines, incompatible information technology systems, and a great deal of internal politics have to be themost careful with their models—and with their management These are usually big banks Smallbanks also have constraints, such as the limited number and skills of personnel, lack of specialists in
Trang 8some of the areas they operate, small budgets for information technology, and the fact that because thesenior people actually do much of the business, controlling the resulting exposure is more difficult.
LIQUIDITY PREMIUM AND THE CONTROL OF EXCESS LIQUIDITY
Whether debt or equities, financial instruments are liquid if they can be easily sold at a fair marketprice Traders would consider a liquid security, bought or sold, as one characterized by little or noliquidity premium A problem, however, arises when we try to describe liquidity risk in terms ofthresholds in liquidity premium, which often are used to explain different price effects
Liquidity premium exists because a given change in interest rates will have a greater effect on the
price of long-term bonds than on short-term debt With long-term bonds, there is more of an tunity for gains if interest rates fall and greater risk for losses if interest rates rise At the same time,even if a certain premium were solely a function of market liquidity, it could at best measure theperceived value of liquidity but not other factors, such as transaction size
oppor-Transactions in small amounts and in large blocks trigger the inclusion of an extra liquidity mium in the price, which does not necessarily occur with the classic notion of a liquidity premium.This extra premium suggests that the risk of a transaction should not be measured independentlyfrom its size, because doing so would be equivalent to assuming constant market liquidity regard-less of fundamentals
pre-In academic circles and among some investment bankers, the liquidity premium theory often isused as an explanation of the term structure of interest rates By supplementing investors’ expecta-tions with a liquidity premium, the theory aims to explain the prevalence of upward- and downward-sloping yield curves Investor uncertainty is behind such movement, as shown in Exhibit 8.4, withtwo 30-year Treasury yield curves in consecutive months at the end of 1997 Analysts try to explain:
• Why the yield curve is generally downward-sloping when interest rates are high
• Why the opposite is generally true when interest rates are low
• Which fundamentals underpin a flat yield curve
A good deal of challenge lies in the fact the liquidity preference theory makes no significant tribution to the influence of forward rates on the existing term structure To do so requires the abil-ity to estimate relevant liquidity premiums accurately, which is not easy, especially in a dynamicmarket
con-To make matters more complex, the magnitude of the risk premium is itself variable, and it candepend on existing and projected economic conditions and investor psychology For this reason, itsstudy requires much more than a textbook sort of algorithm, which, for instance, states that theinterest rate on a long-term bond will be equal to:
• The average of the short-term interest rates that are expected to prevail over the life of the bond
• Plus a liquidity premium that investors must be paid to convince them to hold the bond in thelonger term
These two points express a simplification that is used quite often Based on this algorithm,the liquidity premium theory argues that investors are not indifferent to investments of different
Trang 9maturities; they have a preference for short-term instruments because of their superior liquidity.(See also Chapter 7 on the advantages of liquid instruments.)
Other things being equal, short-term instruments have less interest-rate risk because their priceschange more slowly for a given change in interest-rate levels Therefore, investors may be willing toaccept a lower return on short-term securities Again, everything else being equal, investors wouldlike to be paid something extra for holding long-term securities, but this liquidity premium must beestimated carefully, accounting for the fact that “other things” may not be equal
Even if future spot rates are expected to be equal to current spot rates, there may be an sloping yield curve because of a liquidity premium At the same time, liquidity has a cost associat-
upward-ed with it, which means that price liquidity is not a one-way street Therefore, we neupward-ed methods,procedures, and models that permit:
require-To help themselves in optimization studies, financial institutions use indices of national data onmoney supply growth and the evolution of interest rates in all the countries where they operate, as
Exhibit 8.4 Within a Month, Investor Uncertainty Changes the Yield Curve of U.S Treasury Bonds
Trang 10well as on indices weighting heavily on the global market The metrics employed attempt to ure volatility in liquidity as well as excess liquidity, where it exists In this case, excess liquidity isdefined as:
meas-• Money that is not spent directly on goods and services
• Therefore, it can be plowed into financial assets, propelling market activity
For instance, in 1995 and the years immediately thereafter, the sharp rise in this index signaled
a significant increase in the amount of excess money available This increased availability was mostlikely due to the fact that central banks in the United States and Europe were cutting their interestrates, while the Bank of Japan was pumping money into the Japanese economy in a bid to revive it.One way of looking at the liquidity cycle is that it follows a pattern whereby, at different points,different types of assets tend to outperform others When there has been a surge in liquidity in theUnited States and other developed countries, their stock markets have been the first to benefit
In general, less developed countries and their financial assets also benefited From 1995 to 1997,emerging markets tended to lag behind the G-10 ones in the investment cycle, even when theyabsorbed inordinate amounts of money, which led to the crash of East Asian countries of August toDecember 1997—as the latter were overloaded with foreign funds in search of quick profits Quickbucks are not what companies and investors should look for, because invariably such a policy leads
to disaster
MATURITY LADDER FOR LIQUIDITY MANAGEMENT
Today there exists no global supervisory authority that can look into international monetary flow.This breach in the supervisory armory, as far as global markets are concerned, risks bringing them
to the breaking point The International Monetary Fund (IMF) usually acts after the fact, usually in
a fire department’s role While there has been a great deal of discussion regarding giving the IMFnew powers, with a preventive authority associated with it (the so-called New Bretton Woods agree-ments), this has not happened yet.6
The fact that there is no global gatekeeper for international money flows and liquidity increasesthe scope of focused liquidity management systems and procedures within every financial institu-tion Better management usually happens through the institution of maturity ladders, which permitthe study of net funding requirements, including excess or deficit of liquidity at selected maturitybrackets
A study of maturity ladder can address a coarse or a much finer grid I personally advise the ter In each bucket, the study is typically based on assumptions of future behavior of cash inflowsand outflows—the latter due to liabilities, including off–balance sheet items By dividing futurecommitments into a finite maturity ladder, we are able to look more clearly into future positive andnegative cash flows (See Chapter 9.)
lat-• Positive cash flows arise from maturing assets, nonmaturing assets that can be sold at fair value,and established credit lines available to be used
• Negative cash flows include liabilities falling due, contingent liabilities that can be drawn down,maturing derivative instruments, and so on
Trang 11A maturity ladder is dynamic and needs to be updated intraday as new trades are executed Indeveloping it, we must allocate each cash inflow or outflow to specific calendar date(s), preferablystarting the first day in the bracket, but also accounting for clearing and settlement conventions weare using that help to determine the initial point The best policy is to use conservative estimates forboth cash inflows and outflows—for instance, accounts receivables, other money due, liabilitiesfalling due, repayment options, possible contingencies, and so on In each period, this calculationleads to an excess or deficit of future liquidity.
The computation of positive and negative excess liquidity is by no means the end point Theresulting funding requirements require senior management to decide how they can be met effective-
ly It is always wise to account for a margin of error Such analysis might reveal substantial fundinggaps in distant periods, and solutions must be found to fill these gaps This can be accomplished by:
• Generating additional cash flows
• Influencing the maturity of transactions to offset the gap(s)
It is always wise to act in time to close the gap(s) before it (they) get too close or too wide Doing
so requires a more rigorous analysis of liabilities and assets, because having sufficient liquiditydepends in large measure on the behavior of positive and negative cash flows under different con-
ditions Hence the need to do what-if scenarios and to employ real-time financial reporting (See
Chapter 6.)
Going from the more general to the more specific, one of the scenarios being used is based on
general market crisis, where liquidity is affected at all credit institutions, in one or more markets.
The basic hypothesis is that perceived credit quality would be king, so that differences in fundingaccess among classes of financial institutions would widen, as will the interest rate of their debtagainst benchmark Treasuries
A more limited version of this scenario, in terms of a spreading liquidity crisis, is one that siders that liquidity problems remain confined to one bank or a specific group of banks This sce-nario also provides a worst-case benchmark, but one of more confined aftermath Depending on theextent of such an event, it could be that some of a bank’s liabilities are not rolled over or replacedand have to be repaid at maturity This obliges the bank to wind down its books to some extent; or
con-it might bring up specific problems not related to liquidcon-ity proper
A more favorable scenario is one that establishes a benchmark for what is assumed as basicallynormal behavior of balance cash flows in the ordinary course of business, with only some minorexceptions that oblige a closer look at debt markets In this case, the goal is to manage net fundingrequirements in the most economical way while avoiding being faced with large needs for extracash on a given day A sound strategy is that of countermeasures designed to smooth the impact oftemporary constraints on the ability to roll over liabilities
Theoretically, all banks should be doing maturity ladder computations and scenario analyses Infact, however, very few—only the best-managed ones—are doing so The others either lack skillsfor such exercise or even fail to appreciate the need to control their liabilities exposure If the con-cept of closing their liabilities gaps was not alien to them, they would not fail at the rate they dobecause of the combined effect of assumed risks with loans and derivatives losses—as was the casewith the Bank of New England (BNE) among others At the end of 1989, when the Massachusettsreal estate bubble burst, BNE had $32 billion in assets and $36 billion in derivatives exposure (innotional principal)
Trang 12To keep systemic risk under lock and key, the Federal Reserve Bank of Boston took hold of theBank of New England, replaced the chairman, and pumped in billions in public money Contrarianssaid this was like throwing good money after bad money, but most financial analysts saw this sal-vage as necessary because the risk was too great that a BNE collapse might lead to a panic On $36billion in notional principal amount, BNE had $6 billion in derivatives losses, a ratio of 1:6.The Bank of New England was clogged by regulators in January 1991—at a cost of $2.3 billion.
At that time its derivatives portfolio was down to $6.7 billion in notional amount—or roughly
$1 billion in toxic waste, which represented pure counterparty risk for those institutions and othercompanies that traded in derivatives with BNE
This is a good case study because it demonstrates how imprudent management may be in ing risks Because a credit institution’s future liquidity position is affected by factors that cannotalways be forecast with precision, assumptions need to be made about overcoming adverse condi-tions in financial markets Typically, such hypotheses must address assets, liabilities, derivatives,and some other issues specific to the particular bank and its operations, including:
assum-• Cash inflows
• Cash outflows
• Discounted cash flows by maturity ladder
Concepts underpinning these items and the tools necessary are discussed in more detail inChapter 9 in conjunction with cash management Here, I wish to stress the importance of estab-lishing in a factual and documented manner the evolution of a bank’s liquidity profile under differ-ent scenarios, including the balance of expected cash inflows and cash outflows in every maturitybracket and at selected sensitive time points
Both short-term and long-term perspectives must be considered Most credit institutions do notmanage in an active way their funding requirement over a period longer than a month or so, espe-cially in banks active in markets for longer-term assets and liabilities These banks absolutely need
to use a longer time frame The methodology we choose and apply always must correspond to thebusiness we make
ROLE OF VALUATION RULES ON AN INSTITUTION’S LIQUIDITY POSITIONS
At the beginning of the twenty-first century, banking and financial services have become a key
glob-al battleground, with the most important financiglob-al battles fought off-exchange This globglob-alized ronment develops by involving banks, nonbanks, and corporate treasuries in bilateral agreementsthat, for the most part, lack a secondary market Increasingly more powerful tools are used for:
envi-• Rapid development of new instruments
• Optimization of trades
• Online execution of complex transactions and their confirmation
What (regrettably) is often lacking is the a priori risk analysis and, in many cases, the a ori reevaluation of exposure Yet, to be able to survive in an increasingly competitive market, let
Trang 13posteri-alone to make a profit, we must not only follow a risk and return approach but also develop and testdifferent scenarios Old-style approaches that do not provide for experimentation can:
• Give false signals about the soundness of transactions
• Create perverse incentives for banks to take on disproportionate and/or concentrated risks.Much of the inertia in living with one’s time comes from lack of experience in the processes dis-cussed here and in Chapter 7 Back in 1996, critics of the BIS Market Risk Amendment7contend-
ed that the costs to banks of implementing its clauses, including the value-at-risk (VAR) model,would be out of proportion to any benefit they, or the system, might receive The Amendment, theysaid, “would engender inefficiency in financial institutions” and would “encourage disintermedia-tion.” In the years since, all these negative arguments proved to be false
Contrary to what its critics were saying, the 1996 Market Risk Amendment by BIS allowedbanks to use superior methods of risk measurement in many circumstances In 1999 the new CapitalAdequacy Framework by BIS set novel, more sophisticated capital adequacy standards Based onthis framework, banks should not only establish minimum prudential levels of liquidity but alsoexperiment on a band of fluctuation within which each institution can:
• Adapt itself and its operations
• Receive warning signals and act on them
Both the amount of capital a bank needs and its liquidity position should be related to the value
it has at risk Algorithmic and heuristic solutions8 must incorporate the uncertainty about futureassets and liability values and cash added (or subtracted) on each side of the balance sheet because
of projected events
Such a value-added approach to risk management can be served by disaggregating risks by typeacross all positions and activities and by evaluating the likelihood of spikes in exposure and reag-gregating risk factors by taking into account reasonable estimates of correlations among events Incontrast to a static approach, the suggested methodology requires:
• Appropriate definition of dynamic parameters
• The ability to validate the output of models being used
Critical to a successful control of exposure is the adoption of accounting, financial accounting,and disclosure practices that reflect the economic reality of a bank’s business and provide sufficientinformation to manage assumed responsibilities in an able manner Due attention should be paid tothe fact that:
• Risk management feeds into capital allocation by way of management decisions about ing risk and return,
balanc-• Capital adequacy is calculated in a way able to provide a buffer against losses that may be pected, and
unex-• Adequate liquidity is available within each time bracket of the maturity ladder for all expectedevents, with a reserve for unexpected events
Trang 14This process can be helped if control limits applied to the trading book and banking book are
tracked in real time, covering current positions and new transactions as they happen, and ing all items—both on-balance sheet and off-balance sheet The technology solution we adopt mustreflect the fact that the trading book is typically characterized by the objective of obtaining short-term profits from price fluctuations
address-For both internal and regulatory financial reporting purposes, instruments in the trading lio must be stated at fair value According to the definition given by the Financial AccountingStandards Board (FASB) and International Accounting Standard (IAS) 32, fair value is the amount
portfo-at which a financial instrument could be exchanged in a transaction entered into under normal market conditions between independent, informed, and willing parties, other than in a forced or liquidation sale
NOTES
1 Henry Kaufman, On Money and Markets (New York: McGraw-Hill, 2000).
2 Paul A Samuelson, Economics An Introductory Analysis (New York: McGraw-Hill, 1951).
3 For a detailed discussion on monetary base and money supply, see D N Chorafas,
The Money Magnet Regulating International Finance and Analyzing Money Flows (London:
Euromoney Books, 1997)
4 William Greider, Secrets of the Temple (New York: Touchstone/Simon and Schuster, 1989).
5 For real-life modeling failures, see D N Chorafas, Managing Risk in the New Economy (New York:
New York Institute of Finance, 2001)
6 D N Chorafas, New Regulation of the Financial Industry (London: Macmillan, 2000).
7 D N Chorafas, The 1996 Market Risk Amendment Understanding the Marking-to-Model and
Value-at-Risk (Burr Ridge, IL: McGraw-Hill, 1998).
8 D N Chorafas, Chaos Theory in the Financial Markets (Chicago: Probus, 1994).
Trang 16PART THREE Cash Management