Financial institutions are continuously seeking new ways to proactively manage their assets and the risk associated with them. For many institutions, this has meant the introduction of sophisticated risk management tools such as derivatives.
But this approach is still considered by many financial institutions to be in its infancy, excessively complex and potentially of greater risk than that associated with the underlying assets.
We propose a simpler, safer, and extremely flexible alternative that can address specific transactions or the entire loan portfolio.
Financial programs can be tailored to help financial institutions achieve the following goals: shielding quarterly and annual earnings from shock losses; increasing the liquidity and velocity of assets; converting noncash assets into cash; and improving regulatory and credit ratios.
Many of the programs offer the possibility of significant tax advantages. This new generation of financial risk management programs succeeds by combining traditional risk transfer techniques with the innovative risk financing methodologies that are now available.
Here are some specific examples of how financial risk management programs can help financial institutions realize a number of benefits despite limitations imposed by various regulatory, accounting, and rating agency requirements.
Loan-loss-reserve guarantee program. Loan-loss reserves are heavily regulated. As they also encumber capital, they are closely monitored by management, outside auditors, and regulators. Further, while GAAP income is reduced, the tax deductible expense of loan-loss reserves cannot be realized until actual chargeoffs take place.
The alternative now available is an AA or AAA guaranteed financial risk management program that provides a more flexible and controlled method of protecting future earnings against unexpected and/or under-reserved losses.
Designed to address a specific transaction, a portfolio of transactions, or simply 'mirror' the loan-loss reserve account, the program is structured off-balance-sheet and the agreed-upon funding is spread over several years to provide improved balance sheet ratios. The fully identified guaranteed limit of the program is immediately available. Finally, the program is designed to maximize the acceleration of the tax deductibility of the cash flows and to meet all GAAP and IRS accounting requirements.
Asset-backed securitization enhancement. Bond offerings can be securitized by a variety of assets such as credit card, loan or mortgage receivables. To ensure an investment-grade rating on the securitization usually requires some type of collateral account. Alternatively or in addition, rating agencies generally require a nonrated, subordinated "buffer" layer that may be retained by the issuing financial institution.
Individually and collectively, the collateral account and buffer layer can represent a sizable percentage of the entire offering. However, the right financial risk management program can materially change the dynamics by enhancing these two layers with an AA or AAA guarantor.
Under the program, the financial institution immediately receives the cash receipts for the collateral account and "buffer" layer. As the guarantor's cost and recourse can be designed around a determination of the maximum probable loss, the majority of the cash receipts can be available for new loans.
As no new capital is involved, both the institution's velocity of funds and, ultimately, its return on investment, are enhanced. Finally, as with the loan-loss reserve program, the guarantor is able to provide risk transfer to further leverage the benefits to the financial institution.
Residual value guaranty programs. Accounting regulations control how and when lease income is recognized. Generally, sales leases allow for a faster recognition of income than do operating leases. A financial risk management program that provides a third-party guarantee for a portion of the residual value enables the financial institution to comply with the accounting regulations required for sales lease treatment and early income recognition.
Thus, the financial institution benefits not only from faster recognition of income but also from the flexibility of being able to offer its customers a competitive lease agreement. Finally, with a guarantor rated AA or AAA, the opportunity exists to accelerate cash flows by selling the leases via a securitized bond.
These are just some of the ways financial institutions can use financial risk management tools to achieve balance sheet management objectives. Due to the flexible structure and inherent sharing of risk, these programs can be designed to meet almost any risk issue.
Whether addressing commercial exposures such as small-business, middle- market, agricultural, or real estate loans, or consumer financing such as credit cards, mortgages, and home equity, these AA or AAA guaranteed financial risk management programs provide a simpler, more flexible, and certain approach to managing the financial institution's assets and the risks associated with them.
Mr. Anthony is chief executive officer and Mr. Smith is senior vice president of Sequor Group LLC, a specialty brokerage based in New York.
