Active Balance Sheet Management: A Treasury & Investment Perspective

Copyright © 2021 by Maulik N. Parekh.

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CONTENTS

Foreword

Preface

For the Readers

Chapter I Background and Motivation

-   Reminiscence of a Money Market Dealer

-   Journey of a Stock Market Investor

Chapter II Three Biggest Financial Innovations in the Past Three Decades

-   History of Finance

-   Game Changers in Finance

-   Innovation No. 1: Derivatives Are Here to Stay

-   Innovation No. 2: Leverage Finance Boost Returns

Innovation No. 3: Securitization Adds Value

Chapter III Historical Backdrop and Lessons from the Past

-   Bubbles, Crisis, and Scandals

Chapter IV Introduction to Balance Sheet Management

-   Definition of Balance Sheet Management (BSM)

-   Objective of BSM

-   Key Risks and Challenges of BSM

-   Organizational Context for BSM

-   Advantages of BSM

-   Next-Generation BSM

Chapter V Market-Driven Balance Sheet Management

Understanding the Economic and Market Cycles

-   Interrelationships between Markets

-   Anatomy of the Economic and Business Cycle

-   Stages of the Economic and Market Cycle

-   Contraction Cycle Explained

-   Balance Sheet Management to the Rhythm of Markets

-   Early-Warning Indicators (EWI) for BSM

-   EWIs for Sovereign Risk

-   EWI and Supply Chain Finance

-   An Introduction to Z-Score and relevance for EWI in BSM

Chapter VI Investment Strategy and Portfolio Management

-   Investment Philosophy

-   Steps Involved in Investment Philosophy formulation

-   Extrospection (Exploration)

-   Institutional Investment Management

-   Purpose of the Committee

-   Composition of the Committee

-   Investment Philosophy and Strategy

-   Asset Liability and Portfolio Management (ALM)

-   Portfolio Performance Management

-   Portfolio Performance

-   Performance Measurement

-   Manager Performance

-   Modern Portfolio Theory (MPT)

-   Strategic and Tactical Asset Allocation

-   Conclusion

Chapter VII Implications for Corporate CFOs

-   Corporate Credit Cycles of Boom, Downgrades, and Defaults

-   Key Learning for Corporate CFOs from Banking and Financial Services Industry (BFSI)

-   Strategic Asset Liability Management (ALM)

Chapter VIII GM A Case Study

-   Step 1: Background Analysis of GM

-   Step 2: Stress Testing

-   Step 3: Capital Management

-   Step 4: Liquidity Management

-   Step 5: Conclusion

Chapter IX Active Balance Sheet Management – An Integrated Approach

-   (I)   Integrated Approach:

-   (II)   Technical Skills:

-   (III)   Tactical Execution:

Concluding Remarks

Notes

References

Acronyms

Diagrams, Charts, and Tables Summary

Acknowledgments

About the Author

Book Reviews

Foreword

The ongoing Covid-19 pandemic has created disruptions that have challenged the skills and ability of corporate professionals on how to address such a crisis. Past lessons have shown us that although each crisis is unique, the age-old principles of sound balance sheet management remain the same. That is why Maulik Parekh’s latest offering is extremely topical. What makes this book unique is that the author has a deep understanding of the world of finance and is able to dissect complex financial products into easily understandable concepts.

Maulik is not averse to financial innovations that have come about over the years such as derivatives, leverage finance, and securitization. These are worthy of due attention for every balance sheet manager. However, the temptation of excessive greed and not paying heed to the underlying risks have led to the downward spiral of renowned financial institutions. The global financial crisis of 2007 to 2008 was an apt example of greed getting out of control. The book cites a cautionary tale of how risks were completely ignored when investment banks’derivative exposure had a leverage ratio of 100:1 during the 2004 to 2007 periods, which meant that a small change in the market price of an asset had devastating effects.

Leverage helps scale up businesses and enhances returns, but it is this very tool that has been the cause of the downfall of many. The movement from leverage to overleverage is a very fine one. Past experiences have shown that it is important to manage debt and keep costs under control, irrespective of the business cycle.

This book is a must-read for CFOs who need to keep abreast with the disruptive financial and technological changes taking place while also taking cognizance of identifying new risks and unprecedented scenarios. As the book suggests, treasurers need to be agile and always plan for contingencies. Bubbles will never go away despite having burned many fingers. Recent trends reveal that money is pouring into the U.S. stock market at the fastest pace since 2015 even as valuations are close to all-time highs. Possible tapering and interest rate hikes could create higher volatility should markets selloff. Financial speculation clearly pervades, which may be tell-tale signs of a bubble.

I highly recommend this very well-written, hands-on book with pragmatic guidance. I am confident that finance professionals will lap it up with relish.

—Mr. Deepak Parekh

Chairman, Housing Development and Finance

Corporation, HDFC Ltd. (India)

Preface

The word Agile has its origins in the Latin word agilis, meaning nimble or mentally aware. The intellectual acuity and ability to think and draw conclusions quickly define the word agile. We believe these are the key characteristics that will differentiate the winners and the next generation of treasurers and CFOs.

Dedicated to the practice of active

balance sheet management

across financial institutions and corporations

For the Readers

This script is addressed as a guiding framework to the following audience as they navigate the complexities of global markets with the goal of growing their businesses under risk-reward scenarios:

1. Aspiring CFOs, treasurers, and chartered accountants across the industry sectors and market capitalization spectrum

2. Engagement managers in management consulting firms wanting an inside flavor of the dealings and decision-making in the context of corporate finance and global markets

3. Nonfinancial managers, engineers, and business students wanting to develop insight into the world of finance

Chapter I

Background and Motivation

Reminiscence of a Money Market Dealer

Mine US$ 200 mio@ 0.5% O/n and S/B 100 mio EUR/$ @ par O/n are a few of the standardized money market nomenclatures, ticket sizes, and instruments utilized by any ALM desk in the dealing rooms of banks worldwide. The amounts that a dealer takes for granted during business-as-usual (BAU) market conditions prove to be the same amounts that cause the entire institution to burst during liquidity stress driven by run on the bank. This proved to be the case for Lehman Brothers during Q1/Q2 2008. How could a globally recognized bank of the stature of Lehman Brothers with a balance sheet of US$600 billion and the market cap of $60 billion scramble for $200 million funding in wholesale interbank repo markets? Lehman’s U.S., Asia, and Europe units got selectively liquidated to Barclays and Nomura for a total sum not greater than $2 billion, according to media reports. During the period of unprecedented financial market crisis at the peak of the liquidity crunch, Lehman choked for a few hundred million while good names like JPMorgan and Barclays had tens of billions deposited by lenders queuing up as a result of flight to quality and perception of high credit ratings.

It was this experience of coming to the office every morning from 2008 to 2009 and looking at the banks’ funding gap with hopes of borrowing in the interbank market and bridging the liquidity risk which provided the basis for publishing my experiences. Why won’t anyone lend even three months’ money and instead prefer to place cash overnight with safe-haven banks? This complete breach of trust in wholesale interbank markets—living through the experience of day-to-day fear of survival of the bank and hoping there are no major outflows of cash or that some big depositor does not pull out money based on market rumors of stress on the bank’s balance sheet—triggered my inquisitiveness in global market psychology.

A look at the USD Libor from 2007 to 2008 shows the volatility in rates during the tumultuous times of credit crisis and chaotic money markets trying to cope with economic and market uncertainties. It was during these trying times in money markets when central banks and commercial banks were grappling with day-to-day survival that more than four hundred U.S. banks failed and more than fifty mortgage lenders were acquired and folded. These chaotic times also led to the creation of the Libor scandal where there was alleged collusion by member banks connected to the rate submissions, leading to manipulation.

Figure 1: Effective fed funds rate 1990–2020

The reality is that the market lends to the wealthy and liquidity chases the few good names. On the other hand, the lesser mortals get caught in the liquidity trap. Credit ratings are key to the survival of any financial institution during these times of liquidity-drained markets. This shallowness of market behavior and lessons learned had to be passed on to the next generation of finance professionals.

It was this insider view of the dichotomy in markets that served as the key motivation to document my experiences. After the tsunami of bankruptcies that swept past the global financial services industry from 2008 to 2009, I felt the timing was right to publish a framework for thinking through the challenges of balance sheet management and to formulate a framework on the remedies for the effective financial management of companies. It is this endeavor to explain how businesses can steer through the downward spiral, which can encircle a balance sheet of any size when market conditions deteriorate and when the company is caught up on the wrong side of the market.

Banks make money on credit risk and

banks go burst on liquidity risk.

Journey of a Stock Market Investor

Equity Cycle I: 1997–2000 (Dot-com Bubble)

Although I was exposed to equity asset class since childhood, my first personal equity investing happened in the U.S. while in graduate school at the University of Michigan. I made initial investments in individual stocks and mutual fund schemes in 1998. The results were positive, and by the time it was calendar year 2000, the U.S. markets were on an all-time high riding on more than five years of expansionary economic cycle and political stability of the Bill Clinton era.

Valuations of start-up Internet-based companies without an ounce of a track record sold on nonfinancial metrics like clicks to eyeballs and created an unsustainable and unrealistic hype in markets. Merchant bankers’ greed in capital markets created financial projections for IPOs, which were rosier than thou without any execution history. They presented lived happily ever after scenarios of companies with one-way trajectory and high terminal valuations.

Figure 2: Nasdaq 100 Chartover 25 Years

In FY 2000, Nasdaq 100 Composite, which comprised of predominantly technology stocks, was seen kissing 5,000 levels and markets looked like no going back. The U.S. was the technological innovation hub, and global economic powerhouse and global markets followed the direction of U.S. indices. Surprisingly for gullible investors, Nasdaq touched a low of 1,000 within twenty-four months.

Equity Cycle II: 2000–2004 (Dot-com Burst)

The last leg of the steep climb in Nasdaq 100 and fad-based investing peaked in March 2000. While the market started losing steam with investors pulling out of get big fast capital guzzling dot-coms, the reality check had set in by end of 2000. Global events like the Severe Acute Respiratory Syndrome (SARS) and 9/11 terror attacks in the U.S. proved to be the decisive devastating blow to the economy. Markets would never be the same again for e-commerce firms. From 2000 to 2002, the bubble collapsed. Companies such as Pets.com and Webvan failed completely and shut down. The stocks of other credible large tech firms like Cisco and Qualcomm declined by more than 50 percent. They lost a large portion of their market capitalization but survived. Some companies, such as eBay and Amazon.com, would later recover and surpass their dot-com-bubble stock price peaks.

Figure 3: Nasdaq 100 chart 2000-2004

Equity Cycle III: 2004–2007 - Emerging Markets (EM) rising and U.S. credit bubble

Since I lived in the U.S. during the Internet bubble of 1999 to 2000 and luckily having exited investments to finance the business school education, the desire to understand business cycles grew strong in my mind. On moving to India in 2004 when stock market Indian Sensex (EM) was at the rock bottom 3,000, it was a joyride to see it more than quadruple and peak in 2007 at 20,000. Similar was the China EM story with HangSeng Index (HK 50) clocking 4X returns over the same time with the EM story shining brighter than ever.

Figure 4 (A) : China EM 2002–2008 chart

Figure 4 (B): India (EM) 2002–2008 chart

Equity Cycle IV: 2007–2011 (U.S. sub-prime-led credit crisis)