Unified Financial Analysis

The Missing Links of Finance

Willi Brammertz, Ioannis Akkizidis, Wolfgang Breymann, Rami Entin, Marco Rustmann

• Publisher: Wiley
• Year: 2011
• Print ISBN: 9780470697153
• eBook ISBN: 9781119991106
• Edition: 1
• Topic: Negocios y empresa
• Subtopic: Contabilidad gerencial

Unified Financial Analysis arrives at the right time, in the midst of the current financial crisis where the call for better and more efficient financial control cannot be overstated. The book argues that from a technical perspective, there is no need for more, but for better and more efficiently organized information.

The title demonstrates that it is possible with a single but well organized set of information and algorithms to derive all types of financial analysis. This reaches far beyond classical risk and return or profitability management, spanning all risk categories, all valuation techniques (local GAAP, IFRS, full mark-to-market and so on) and static, historic and dynamic analysis, just to name the most important dimensions.

The dedication of a complete section to dynamic analysis, which is based on a going concern view, is unique, contrasting with the static, liquidation-based view prevalent today in banks. The commonly applied arbitrage-free paradigm, which is too narrow, is expanded to real world market models. The title starts with a brief history of the evolution of financial analysis to create the current industry structure, with the organisation of many banks following a strict silo structure, and finishes with suggestions for the way forward from the current financial turmoil.

Throughout the book, the authors advocate the adoption of a 'unified financial language' that could also be the basis for a new regulatory approach. They argue that such a language is indispensable, if the next regulatory wave – which is surely to come – should not end in an expensive regulatory chaos.

Unified Financial Analysis will be of value to CEOs and CFOs in banking and insurance, risk and asset and liability managers, regulators and compliance officers, students of Finance or Economics, or anyone with a stake in the finance industry.

Part I

Introduction

Chapter 1

The Evolution of Financial Analysis

The financial industry is from an analytical viewpoint in a bad state, dominated by analytical silos and lack of a unified approach. How did this come about? Only up to a few decades ago, financial analysis was roughly synonymous with bookkeeping. This state of affairs has changed with the advent of modern finance, a change that was further accelerated by increasing regulation. In what follows we give a brief and eclectic history of financial analysis, explaining its evolution into its current state and focusing only on developments that are relevant to our purpose. The next chapter is an outline of what a solution to these problems should be.

1.1 BOOKKEEPING

Many of the early cuneiform clay tablets found in Mesopotamia were records linked to economic activity registering transactions, debts and so on, which suggests that the invention of writing is closely linked to bookkeeping.1 Early bookkeeping systems were single-entry systems whose purpose was generally to keep records of transactions and of cash. The focus of such systems was realized cash flows and consequently there was no real notion of assets, liability, expense and revenue except in memorandum form. Any investment or even a loan had to be registered as a strain on cash, giving a negative impression of these activities.

Given the constant lack of cash before the advent of paper money, the preoccupation with cash flows is not astonishing. Even today many people think in terms of cash when thinking of wealth. Another reason for this fixation on cash is its tangibility, which is after all the only observable fact of finance.

In the banking area it first became apparent that simple recording of cash was not sufficient. The pure cash flow view made it impossible to account for value. Lending someone, for example, 1000 denars for two years led to a registration of an outflow of 1000 denars from the cash box. Against this outflow the banker had a paper at hand which reminded him of the fact that he was entitled to receive the 1000 denars back with possible periodic interest. This, however, was not recorded in the book.

By the same token, it was not possible to account for continuous income. If, for example, the 1000 denars had a rate of 12% payable annually, then only after the first and second year would a cash payment have been registered of 120 denars. In the months in between, nothing was visible.

The breakthrough took place sometime in the 13th or 14th century in Florence when the double-entry bookkeeping system was invented, probably by the Medici family. The system was formalized by the monk Luca Pacioli, a collaborator of Leonardo da Vinci in 1494. Although Pacioli only formalized the system, he is generally regarded as the father of accounting. He described the use of journals and ledgers. His ledger had accounts for assets (including receivables and inventories), liabilities, capital, income and expenses. Pacioli warned every person not to go to sleep at night until the debits equaled the credits.2

Following the above example, a credit entry of 1000 denars in the loans account could now be registered and balanced by a debit entry in the cash account without changing the equity position. However, the equity position would increase over time via the income statement. If subyearly income statements were made, it was now possible to attribute to each month an income of 10 denars reflecting the accrued interest income.

Thanks to Pacioli, accounting became a generally accepted and known art which spread through Europe and finally conquered the whole world. Accounting made it possible to think in terms of investments with delayed but very profitable revenue streams turning the focus to value and away from a pure cash register view. It has been convincingly argued that bookkeeping was one of the essential innovations leading to the European take-off.3, What was really new was the focus on value and income or expense that generates net value. As a side effect, the preoccupation with value meant that cash fell into disrepute. This state of affairs applies by and large to bookkeeping today. Most students of economics and finance are introduced to the profession via the balance sheet and the P&L statement. Even when mathematical finance is taught, it is purely centered on value concepts.

The focus on value has remained. The evolution of the position of cash flow within the system should be noticed with interest. This is especially striking given the importance of liquidity and liquidity risk in banks, especially for the early banks. After all, liquidity risk is the primal risk of banking after credit risk because the liabilities have to be much higher than available cash in order to be profitable.

Liquidity risk can only be properly managed if represented as a flow. However, instead of representing it in this way, liquidity was treated like a simple investment account and liquidity risk was approximated with liquidity ratios. Was it because fixation on cash flow was still viewed as primitive or because it is more difficult to register a flow than a stock? Whatever the case, liquidity ratios stayed state of the art for a long time. Early regulation demanded that the amount of cash could not be lower than a certain fraction of the short-term liabilities. So it was managed similarly like credit risk – the second important risk faced by banks – where equity ratios were introduced. Equity ratios describe a relationship between loans of a certain type and the amount of available equity. For example, the largest single debtor to a bank cannot be bigger than x % of the bank’s equity.

The next relevant attempt to improve cash flow measurement was the introduction of the cash flow statement. Bookkeepers – in line with the fixation on value and antipathy to cash – derived liquidity from the balance sheet. This was putting the cart before the horse! The remarkable fact here is that bookkeepers derived cash flow from the balance sheet and P&L, which itself is derived from cash flow, a classical tail biter! Is it this inherent contradiction that makes it so difficult to teach cash flow statements in finance classes? Who doesn’t remember the bewildering classes where a despairing teacher tries to teach cash flow statements! Marx would have said that bookkeeping stood on its head from where it had to be put back on its feet.4 The cash flow statement had an additional disadvantage: it was past oriented.

This was roughly the state of financial analysis regulation before the FASB 1335 and the Basel II regulations and before the advent of modern finance. The change came with the US savings and loans crises in the 1970s and 1980s. These institutions have been tightly regulated since the 1930s: they could offer long-term mortgages (up to 30 years) and were financed by short-term deposits (about six months). As a joke goes, a manager of a savings and loans only had to know the 3-6-3 rule: pay 3% for the deposits, receive 6% for the mortgages and be at the golf course at 3 o’clock.

During the 1970s the 3-6-3 rule broke down. The US government had to finance the unpopular Vietnam war with the money press. The ensuing inflation could first be exported to other countries via the Bretton Woods system. The international strain brought Bretton Woods down, and the inflation hit at home frontally. To curb inflation short-term rates had to be raised to 20% and more. In such an environment nobody would save in deposits paying a 3% rate, and the saving and loans lost their liabilities, causing a dire liquidity crisis. The crisis had to be overcome by a law allowing the savings and loans to refinance themselves on the money market. At the same time – because the situation of the savings and loans was already known to the public – the governmental guarantees for the savings and loans had to be raised. Although the refinancing was now settled, the income perspectives were disastrous. The liabilities were towering somewhere near 20%, and the assets only very slowly could be adjusted from the 6% level to the higher environment due to the long-term and fixed rate character of the existing business. Many banks went bankrupt. The government was finally left with uncovered guarantees of $500 billion, an incredible sum which had negative effects on the economy for years.

This incident brought market risk, more specifically interest rate risk, into the picture. The notion of interest rate risk for a bank did not exist before. The focus had been on liquidity and credit risk as mentioned above. The tremendous cost to the US tax payer triggered regulation, and Thrift Bulletin 136 was the first reaction.

Thrift Bulletin 13 required an interest rate gap analysis representing the repricing mismatches between assets and liabilities. As we will see, interest rate risk arises due to a mismatch of the interest rate adjustment cycles. In the savings and loans industry, this mismatch arose from the 30-year fixed mortgages financed by short-term deposits which became a problem during the interest rate hikes in the 1980s. The short-term liabilities adjusted rapidly to the higher rate environment, increasing the expense, whereas the fixed long-term mortgages on the asset side did not allow significant adjustments.

Gap analysis introduced the future time line into the daily bank management. Introducing the time line also brought a renewed interest in the “flow nature” of the business. The new techniques allowed not only a correct representation of interest rate risk but also of liquidity risk. However, the time line was not easy to introduce into bookkeeping. The notion of “value” is almost the opposite of the time line. Value means combining all future cash flows to one point in time. Valuation was invented to overcome the time aspect of finance. The notion of net present value, for example, was introduced to overcome the difficulties with cash flows which are irregularly spread over time. It allowed comparing two entirely different cash flow patterns on a value basis. In other words, bookkeeping was not fit for the task. The neglect of cash and cash flow started to hurt.

Asset and liability management (ALM) was introduced to model the time line. Although ALM is not a well-defined term today, it meant at that time the management of the interest rate risk within the banking book.7 Why only the banking book? Because of the rising dichotomy between the “trading guys” who managed the trading book on mark to market terms and the “bookkeepers” who stayed with the more old-fashioned bookkeeping. We will hear more about this in the next section.

ALM meant in practice gap analysis and net interest income simulation (NII). Gap analysis was further split into interest rate gap and liquidity gap. A further development was the introduction of the duration concept for the management interest rate risk.

The methods will be explained in more detail later in the book. At this point we only intend to show the representation of an interest rate gap and a net interest income report because this introduced the time line. Figure 1.1 shows a classical representation of net cash flow with some outflow in the first period, a big inflow in the second period and so on. Net interest income demanded even dynamic simulation techniques. In short, it is possible to state expected future market scenarios and future planned strategies (what kind of business is planned) and to see the combined effect on value and income. Figure 1.2 shows, for example, the evolution of projected income under different scenario/strategy mixes.

Figure 1.1 Cash flows proj...

Table of contents

• Cover
• Half Title page
• Title page
• Copyright page
• List of Figures
• List of Tables
• Acknowledgements
• Preface
• Part I: Introduction
• Part II: Input Elements
• Part III: Analysis – Liquidation View
• Part IV: Analysis – Going-Concern View
• Part V: Outlook and Conclusions
• Index