On Incentives

"Never penalize those who work for us for mistakes or reward them for being right about markets. It will go to their heads, is counterproductive and, in any event, material compensation will not correlate with their ability to predict the future next time."

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Cash Management

I am delighted to talk to you today concerning cash management, liquidity and risk taking, but I must confess that I feel a bit overwhelmed by this sophisticated audience and your expertise.  It is almost as if I were speaking to an audience about the latest floods in Europe and how extensive they were when Noah was in the audience.

But—before I begin—permit me to ask some questions and ask for a show of hands on some points that I believe are relevant to the questions of cash management and profitability.

  • First, let us assume that we buy shares of stock (it could be Phillips) say at 20 euros a share, and in a reasonable period of time—it goes to 40 euros a share—that is, it has doubled in price.  But, we have not sold those shares.  Let’s see a show of hands from how many think we made a profit though the shares have not been sold.  Now, let’s see a show of hands from those who think we have not made a profit until the shares are sold.

    (After the show of hands)  It’s interesting we have divided opinions.
  • Now—another a show of hands—let’s assume we buy shares of stock at 20 euros per share, and the price declines to 10 euros, but we have not yet sold the shares at 10 euros.  Let’s see a show of hands from how many think we have a loss even though the shares have not been sold.  Now, how many think we don’t have a loss until we make the sale.

    (After the show of hands)  Another difference of opinion.
  • Now, for the last hypothetical:  let’s assume that we don’t buy any shares at 20 euros a share, and it rises in price to 40 euros.  Therefore, it never appears on the books since it was not bought.  Have we lost any money?  Let’s see a show of hands from those who think we have lost money.  Now a show of hands from those who think we have not lost money because we never bought the shares.

The relationship between these three examples is at the heart of cash management.  The accountant will argue that there is no profit (or loss) until there is a sale.  The economist/financial return trader will argue that there is a loss whether or not a sale takes place (they mark to market) whatever the rules are with respect to taxation or reported earnings.  They would argue we should know whether we made a wise or unwise decision irrespective of whether we made a sale.

The strategic philosopher responsible for overall decision making believes that even though opportunities lost don’t appear on a balance sheet or a profit and loss statement, they are usually the most devastating to a business or enterprise.  Thus, the company that stands still and does nothing while its competitors are active in developing new products or in making substantial profits from their trading operations over time will make matters quite difficult for those who miss opportunities.

But let me now talk a bit about cash management.  All cash and liquidity management involves risks.  Most instruments that are purchased are liquid, but that does not mean that they are free from risk.  A change of interest rates will produce a devastating effect if liquidity is held in longer dated instruments whether or not the security is sold.  A short-term investment, such as bank CD’s or short-term treasury obligations, may have little principal risk but will involve opportunity losses.  And, irrespective of the maturity of an obligation, we all know about currency risk.  Indeed, there is currency risk even if the cash flows going in and out of the company are matched.

And now the world is filled with instruments (options, futures, derivatives) that are enticing to money managers and they involve risk that did not exist several decades ago.  Let me outline them:

  1. Liquidity Risk.  You think you are precisely hedged, but the product is so esoteric and idiosyncratic that you cannot sell it because there is simply no market for the product.  You may want to either capture a profit or minimize a loss, and you can find no buyers.  This is typical in the derivative market.
  1. Credit Risk.  Our counterparty has lost money and fails.  You were on the right side of the market, unfortunately, your counterparty was on the wrong side.  Or, your counterparty would ordinarily be just fine, but its counterparties, strangers to you, default.
  1. Legal Risk.  The laws in Asia and Western Europe are not as clear as those in the United States.  You believe that you are totally netted with a particular counterparty; that you had a net zero position and, in the event of default and bankruptcy, you would be protected.  It turns out that the netting rules in some countries may not be so clear, and you may have to get in line with other preferred creditors.
  1. Event Risk.  A war takes place; an earthquake occurs; a flood of a magnitude not seen in a hundred years washes over the land; a cartel falls apart; oil prices quadruple; tax laws change, and the market in which you had an open position, or even hedged, moves in a magnitude not only unforeseen, but totally outside past models.  They always do.  We are in trouble.
  1. Basis Risk.  You thought you were hedged.  You believed that investment A hedged instrument B.  You were long in one, short in the other.  They, in fact, moved in the same direction.  The three-year Treasury note in which you were long deteriorated in price, but unhappily, the five-year note, in which you had a short position, increased in price.  You lost both ways.  Rule:  “The only perfect hedge is in a Japanese garden.”
  1. Leverage Risk.  You are so leveraged that even a small market movement will prompt a margin call.  The security which is out of line will move back to its normal position on the yield curve, but someone out there, for one reason or another, has chosen to put pressure on a particular coupon, a particular security, at a particular point on the yield curve, and while over the next week or two it will surely come back into line, in the meantime, you must liquidate.  Worse, liquidation is difficult because the product is idiosyncratic.  Our loss becomes very visible.
  1. Operational Risk.  Back-office systems, yours or someone else’s, fall apart; credit monitoring systems break down; documentation is flawed; transcription and recording mistakes are made; settlements are delayed; systems do not capture fully the nature of the transaction – the computer program doesn’t yet cover that kind of transaction (they are working on it).  And, it is all quite expensive to put in place and keep it up to date.  And, most important, there is no natural constituency to support the financial and resource expenditures that are needed for the back office—particularly if you are not supposed to be a profit center.

Let me conclude by summarizing what one might do.  It is based only upon my own experience and observation of others.  Perhaps, these basic principles may provide some guidelines or foundations for risk management in a competitive and volatile environment.  I will just list them here:

  • Know what the risks are.
  • Know the costs, the premium, the present value outlay for protection.
  • Admit what we don’t know.
  • Ask “what if.”  Quantify “what if.”  Do adverse scenario analyses.
  • Clarify precisely what we are trying to do.  All risk taking must be explicit, no matter how complicated the instrument.
  • Accounting conventions are not useful risk management tools; they too often are designed to make our lives easier and comfortable.
  • Always measure opportunities lost.  Even though we don’t report them.
  • Material compensation does not correlate with ability to predict the future.
  • We are not as smart as we think we are.  Every time we buy, there is a very informed seller on the other side.

Now let me share with you my own sense, my own admission of the kinds of pressures all of us are under when we manage money and try to do what we think is right and wise:

  1. We respond to peer pressure. We try to find that magic zero coupon bond with a perpetual maturity so we need pay neither interest nor principal.
  1. We too often try to capture rewards quickly and visibly.
  1. We often try to share blame or evade responsibility.  We seek not to be identified as the provider of unwisdom.
  1. We do not measure opportunities lost.  Only visible mistakes are punished.  Investments made at 8% when yields rise to 12% are considered a mistake.  Those not made at 12% when yields decline to 8% are not so considered.
  1. There remains a reliance on sympathetic accounting conventions.  Sometimes we need not show losses until we sell.  Performance measures sometimes are designed to cover-up our mistakes.
  1. We look for quantitative support—for charting, for probabilities, for quantitative analysis, to justify, on an objective basis, our views.
  1. Will we be found out?  Discovered?  Identified as the wrongdoer?  The recommender of unwisdom?
  1. Will we be hassled?  By peers, superiors, the bureaucracy.
  1. Have we experienced the pain; made mistakes; seen fortunes or lives damaged by unanticipated moves?  Or, is it referred pain, historical, read about.  Did we actually experience that sinking feeling?  Were we actually on the trading floor when the market went crazy.
  1. The herd instinct.  We act, too often, according to fashion.
  1. Present pleasure – future pain:  let someone else pick up the pieces.

I am sure no one in this room, of course, is subject to these matters.

With all this as background, let me now tell you what our responsibility is.
The nuts and bolts.