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Preparing for financial disaster.

http://www.mckinseyquarterly.com/article_page.asp?ar=1198&L2=21&L3=33


Companies can do much to avoid falling victim to sudden national
financial emergencies. Although the tally of such events is rising,
many businesses remain unprepared for them.


Preparing for a Financial Crisis

Dominic Barton, Roberto Newell, and Gregory Wilson The McKinsey
Quarterly, 2002 Number 2 Risk and resilience

One of globalization's most sweeping effects has been to transform
closed, government-controlled financial systems into free markets open
to foreign investors. Over the past two decades, surging capital flows
have reduced funding costs for corporations and enabled investors to
reap higher risk-adjusted returns. But unfettered capital markets have
a downside: increasingly frequent economic breakdowns, particularly in
emerging economies. More than 65 serious financial crises have erupted
over the past ten years-almost one and a half times the number
recorded during the 1980s.1

Last year alone, Argentina suffered a bank shutdown and a severe
devaluation when it defaulted on its government debt, and a
long-smoldering crisis flared in Turkey after one of the country's
largest banks went under, causing confidence to
crumble. Industrialized countries are also vulnerable, as Sweden found
in 1992, when a real-estate-market bubble burst, plunging banks into
the red and causing the value of the krona to plummet.



Yet no matter how real the threat of national financial meltdown might
be, and no matter how devastating the consequences, many companies
seem disinclined to safeguard themselves-even though, in our
experience of dozens of such events over the past 15 years, managers
can take many precautions. Obvious measures include monitoring
potential warning indicators, maximizing cash, and restructuring
debt. To be more thorough still, companies can minimize their key
operational risks, run crisis scenario analyses, and devise explicit
plans for crisis management.

The better prepared a company may be, the more likely it is to survive
a crisis. It might even position itself to prosper from the chaos.
Consider the case of the Ayala Group, one of the oldest conglomerates
in the Philippines. Ayala has traditionally been more fiscally
cautious than its peers, keeping larger amounts of cash on hand and
holding less debt than might seem efficient (exhibit). But this
prudence has enabled the company to withstand numerous difficulties in
its 165 years. During the 1997 crisis that swept through Asia, for
example, while competitors were putting the brakes on their capital
expenditures, Ayala went on aggressively building out the country's
first digital wireless network on the Global System for Mobile
Communication (GSM) standard. The Ayala subsidiary Globe Telecom is
now the top wireless company in the Philippines. In the banking
industry, Ayala acquired one of its major competitors (which was in
distress), thereby boosting its own Bank of the Philippine Islands
from the country's fifth- to second-largest bank in terms of assets.


Readiness has a price, however: management not only must constantly be
ready to engage in battle but also must moderate the usually intense
focus on quarter-to-quarter financial results. In strong economic
times, analysts have chided the Ayala Group for its conservative
balance sheet. But in most cases, careful planning greatly improves
the odds of surviving financial crises, though the worst of them-those
that spark political furors, such as the 1998 crisis in Indonesia and
the 2001-02 crisis in Argentina-can bring down the best-prepared
companies.

See the warning signs

Amid the instantaneous and fickle movements of information and money
in borderless capital markets, corporate executives can rely on no one
but themselves to spot the next crisis welling up. Stanley Fischer,
former first deputy managing director at the International Monetary
Fund, once commented wryly that "The IMF has [privately] predicted 15
of the last 6 crises. If we went out and started predicting
[publicly], we would bring on many crises."2 Indeed, the problem of
self-fulfilling prophecies puts severe constraints on all public
watchdogs, and managers thus cannot depend on the IMF or ratings
agencies to sound the alarm.

The good news, though, is that warning signs can be spotted well in
advance if managers take the time to look. Most observers focus on
macroeconomic variables such as exchange rates and fiscal
deficits. Macroeconomic conditions certainly matter-smart managers
regularly review the country reports put out by bank analysts and
well-informed journals-but these signs are usually the last to flash
red before a crisis breaks. It is in the real economy and the banking
system, where the roots of crises develop, that the first indications
of trouble to come can be seen.3

Indeed, warnings abound: companies fail to earn their cost of capital
or to maintain enough cash flow to cover interest payments
comfortably, for example, while commercial banks go on lending sprees,
often doling out funds to increasingly unstable corporations (see
sidebar, "Signs of crisis"). Ultimately, these problems show up in the
banks' profitability and nonperforming-loan portfolios. Foreign
lenders may add to the credit binge with short-term foreign-currency
loans.4 Asset price bubbles, often in real estate or the stock market,
inflate collateral values and put banks at risk. When several of these
indicators start heading in the wrong direction at once, trouble is
sure to be brewing.

Symptoms of Argentina's crisis, for example, were visible long before
it erupted in December 2001. The economy of Argentina had been
shrinking for the past four years, and its companies' return on
invested capital for some time had been lower than the cost of
capital. Depositors had been moving funds offshore for more than a
year and stepped up the pace sharply in the six months before the
crisis erupted. Meanwhile, Argentina's fiscal deficit had ballooned,
placing the country on an unsustainable borrowing binge. The writing
was on the wall.

Conserve cash and restructure debt

When the storm breaks, revenue streams and credit lines dry up and
interest rates skyrocket. After Brazil's sharp devaluation in 1998,
interest rates soared to 65 percent and stayed there for more than
three months. In Argentina, interest rates rose to 74 percent in
November 2001-just before the government froze deposits and banks
stopped lending money altogether. Under such circumstances, companies
that lack adequate cash flows or bear a heavy burden of indebtedness
soon develop liquidity problems and often descend rapidly into
insolvency.

To protect against this kind of shock, companies must put their
balance sheets and income statements in order as early as they can,
before it becomes impossible to find creditors and revamp cash
flows. Two important indicators of a company's ability to withstand a
storm are the amount of free cash flow5 it generates and its interest
coverage ratio, or ICR (the ratio of cash flow to debt payments over a
specified period). Our experience of working with companies in
emerging markets suggests that many such organizations don't fully
understand their cash flows and are liable to make the fundamental
mistake of believing that profits equal cash flow. It is also not
uncommon for companies to have an ICR of less than 1, meaning that
they stay afloat only by using new loans to repay old ones. In South
Korea in 1999-well after the chaos of the region's 1997 crisis had
subsided-40 percent of listed companies were in this acutely unstable
situation, and a further 20 percent were only slightly less at risk.
Fortunately, the situation in South Korea has improved significantly
over the past three years.

Companies blessed with more farsighted management will maximize their
cash flows by divesting cash-consuming business units and optimizing
their working capital. Aurrerá, a Mexican supermarket chain, honed its
cash-management skills after the country's 1982 economic breakdown. It
negotiated special terms with suppliers that granted it 60 to 90 days
on accounts payable and shortened accounts receivable, thereby
producing a negative working-capital position. This spread enabled
Aurrerá to finance its own growth during the remainder of the 1980s,
when the rest of the Mexican economy stagnated, and into the 1990s. In
1996 Wal-Mart acquired the chain in a deal that was highly lucrative
for its private owners.

Samsung Corporation, a business within the Samsung Group, also learned
a valuable debt lesson during hard times. Just before South Korea's
economy nose-dived in 1997, the company had almost two-thirds of its
$2.1 billion total debt due for repayment in less than a year. About
20 percent was denominated in foreign currencies. When corporate bond
rates leapt from 12.6 percent at the beginning of November 1997 to
more than 30 percent by the end of the year, Samsung Corporation's
debt payments took off too. The company survived and within two years
had brought the level of its short-term loans down to less than 20
percent of its total debt.

Of course, reducing debt levels (to no more than 50 percent of equity,
for example) and lengthening loan maturities will increase the cost of
borrowing. But the premium can be regarded as insurance for stable
funding through thick and thin. Companies should also hedge their
currency risk on foreign loans even if the exchange rates of their
countries are supposed to be fixed; in every crisis over the past
decade, fixed or managed exchange rates collapsed. But hedging
currency risk is expensive (if not impossible) when currency forwards
and derivatives markets are lacking. In this case, companies can, for
example, establish a natural currency hedge or try to earn
dollar-based revenues to offset dollar-based interest payments.
Companies that lack a natural hedge or access to currency forwards
shouldn't borrow foreign currencies, no matter how tempting it may be
to do so, and may even want to prepay foreign-currency
liabilities. Currency depreciation may average more than 100 percent
during the first two quarters of a crisis.

Finally, chief financial officers can diversify and strengthen their
funding sources. While times are good, backup lines of credit must be
established. When they are in place, companies-even large
conglomerates with as many as 100 different lending sources-should
continue to monitor the health of each lender. To maintain a solid
funding base, Doosan, one of the oldest conglomerates in South Korea,
rates the financial health of each of its lenders by examining their
quarterly reports. Any lenders that show signs of weakness are
identified early and replaced by stronger banks.

Minimize operational risks

Contingency planning should extend to suppliers, wholesalers, and
retailers as well as transportation. In a crisis, domestic suppliers
could file for bankruptcy or stop shipments to conserve cash, while
foreign suppliers might worry about a buyer's creditworthiness or find
themselves hamstrung by interruptions in the international payments
system. Sudden consumer demand shifts that occur when people lose
their jobs and savings could damage wholesalers and retailers, and
liquidity problems among shippers could make transportation grind to a
halt.

Understanding these risks and planning for them can make the
difference between surviving a crisis and succumbing to it. In 1997,
one South Korean automaker saw many of its parts suppliers go
under. Without backup suppliers, it couldn't increase production for
export when the won was devalued. While foreign distributors begged
for more cars to sell, production lines were idle back at home for
lack of critical parts. The company weathered the storm but never
fully recovered its market position and was eventually acquired by
another domestic automaker.

The message for managers is that they should identify their most
important suppliers before trouble starts. For specialized,
noncommodity inputs, companies would be well-advised to establish
reserve suppliers and to keep an eye on the financial situation of
each. For more general inputs, it makes sense to diversify a supply
base a bit more than usual from the outset. Increased purchasing costs
and some management inefficiencies are a price worth paying to ensure
continued operation at all times.

A similarly watchful eye should be kept on the profitability and
financial stability of wholesalers and retailers. During Russia's 1998
financial crash, Roust, a large consumer goods distribution company,
was particularly effective at limiting losses, because it kept tabs on
its distributors' health. Within days, the company retrieved 90
percent of its stock of alcoholic beverages from wholesalers. Although
Roust suffered losses on inventory, the company then resupplied goods
in limited quantities on a prepaid basis to its most solvent
distributors, thereby preempting defaults on accounts receivable.

Furthermore, in the midst of chaos, transportation can't be taken for
granted. For one thing, companies can find their just-in-time supply
chains disrupted. In Mexico in 1982, for instance, the
cash-distribution logistics chain of Banamex, a leading bank, became
so strained that executives feared that branches would run out of
cash, sparking a bank run. The ingenious response was to hire off-duty
ambulances to help the company's armored cars distribute cash, thus
averting chaos. Other banks were less successful.

Conduct scenario planning

Minimizing financial and operational risks can vastly improve a
company's chances of survival. The use of scenario analyses and
contingency planning can put a company on an even higher level of
alertness. Thus many consumer goods companies now routinely study
Johnson & Johnson's classic, speedy, and successful response to the
1982 Tylenol crisis, in which seven people died after swallowing
tablets laced with cyanide. Anticipation and familiarity with crisis
situations-even simulated ones-pay off when the real thing erupts.

Scenario planning typically centers on a financial model that shows
how a company's cash flow and balance sheet change in response to key
variables. At the very least, changes in the following variables
should be tested: demand (both volume and price), supply chain
disruptions, external funding conditions (including interest rates,
stock prices, and a liquidity crunch), macroeconomic conditions
(exchange rates), and the competitive landscape (the health of
competitors or the possible arrival of global ones). For each
variable, companies must consider a broad-and perhaps previously
unthinkable-range of outcomes. In the crises we studied, we have seen
exchange rates plunge by 50 percent in weeks, interest rates triple,
lines of credit and new loans dry up completely, and demand for
consumer durable goods fall by up to 70 percent almost overnight.

Simply conducting such an exercise helps to prepare management
mentally for an actual crisis. But the real value of the exercise lies
in following it up with contingency planning. Which assets could a
company most easily divest to raise cash, for example? Which plants or
offices, if closed, would cut costs most sharply or preserve the
largest amount of cash? Which products or services are least
profitable and could be jettisoned? Conversely, what critical
business lines and customer relationships must be preserved at any
cost?

Again, earlier is better. It takes time to compile data and run
analyses, but in a crisis, decisions must be made within hours or
days, not weeks. By putting contingency plans in place, senior
executives will be able to delegate responsibility for specific
actions quickly, freeing up their own time to think about strategy; to
communicate with customers, suppliers, and creditors; and to monitor
operations.

Prepare crisis leadership

Most companies fail to act decisively, though the initial days of an
emergency are critical. The postcrisis landscape is littered with the
corpses of survival programs that weren't implemented in time. Almost
as important as what to do is how to do it. Planning specific
management responses ahead of time can prevent crippling paralysis and
delays.

The first step is to plan who does what when a crisis erupts. For a
large conglomerate with many business units, it would not be
unreasonable for the CFO and CEO to spend all of their time monitoring
the situation and making decisions in real time. Fifty or more junior
people might be needed to do the legwork. Knowing in advance who is
going to serve on the crisis-management team and how responsibilities
will be divided can save time and enable a company to stop the
bleeding quickly.

One approach that we have found useful is the creation of specialized
teams to lead key activities. A cash team might measure and report on
the company's cash flow every day and maximize working capital. A
funding team would monitor upcoming debt payments and the health of
creditors. And a divesture team would sell noncore assets to raise
cash. These teams would typically report to the CFO every day and
update the CEO at least several times a week.

For the CEO, a crucial task in the first few days is to lead a
communications team that maintains the trust of key shareholders,
suppliers, and customers by reaching out to them frequently and
straightforwardly. A company will have to issue broad announcements
about the status of its business and key assets, and top executives
will probably have to supply a few crucial investors, creditors,
suppliers, and customers with more (or more detailed)
information. Contradictions, obfuscations, and partial disclosures are
almost always judged negatively and can compound the crisis.
------------------------------------------------------------------------

National financial crises are becoming a permanent fixture of the
global economic landscape. Companies that ignore this truth and carry
on with business as usual are likely to be part of the wreckage left
after the event. Those that plan for any contingency raise their
chances of survival and might even turn adversity into advantage.
Signs of crisis It takes a blend of art and science to see the warning
signs of a financial crisis. Listed here are eight key indicators that
managers should monitor; both the level and the trend are
important. When several of these indicators start heading in the wrong
direction at once, a crisis could be brewing.

* Value destruction by the private sector: In every crisis we
* have witnessed, the private sector's aggregate return on
* invested capital (ROIC) had been less than its weighted
* average cost of capital (WACC) for several years before the
* crisis. Example: In Colombia, 90 percent of the 500 largest
* companies failed to earn their cost of capital during the two
* years preceding the 1998 crisis. Interest coverage ratio: The
* ICR of a company is the ratio of its cash flow to its interest
* payments. When ICRs are decreasing and fall below 2 for many
* companies, the economy is vulnerable to widespread
* bankruptcies. Example: In 1999, 40 percent of the listed
* companies in South Korea had an ICR below 1. Profitability of
* banks: If the banks' return on assets (ROA) falls below 1
* percent and net interest margins below 2 percent, a crisis may
* well be coming. Similarly, an increase in the rates of
* interbank loans could indicate profitability
* problems. Example: The ROA of Colombia's banking sector was
* -1.03 percent before its 1998 crisis. Rapid growth in the
* lending portfolio: We have found that when the loan portfolios
* of banks grow by upward of 20 percent annually for more than
* one year, many of those loans turn out to be bad, which can
* fuel a financial crisis. Example: In Colombia, commercial
* loans grew by 25 percent a year before its 1998 crisis.
* Shrinking deposits: Beware when depositors start pulling their
* money out of local banks. Shrinking deposits for more than two
* quarters mean trouble. Central banks and bank balance sheets
* report data on deposits. Example: Last year in Argentina,
* depositors moved 22 percent of the banking system's deposits
* offshore to protect their value from further erosion after the
* new government abandoned the 1:1 peso-to-dollar conversion
* rate that had been in place previously. Nonperforming loans:
* A crisis could be on its way when nonperforming loans exceed 5
* percent of total bank assets. The reports of private analysts
* are often the best source of information on nonperforming
* loans, since banks can be tardy in acknowledging the true
* extent of the problem. Example: In Thailand, nonperforming
* loans rose as high as 22.5 percent of bank assets in 1997 but
* then soared following the crisis, reaching a peak of 54
* percent in 1998.1 The growth and term structure of loans from
* foreign banks: Borrowers should beware when loans from foreign
* institutions are on the rise and the majority of these loans
* have maturities of less than one year or are denominated in
* foreign currencies. The Bank for International Settlements
* (BIS) provides such data. Example: In Thailand, foreign
* liabilities increased by 45 percent annually for three and a
* half years before the 1997 crisis, and 37 percent had
* maturities of one year or less. The percentage of short-term
* maturities reached a high of 50 percent in 1995.2 Asset price
* bubbles: Several years of more than 20 percent annual growth
* in asset prices can indicate a bubble that is waiting to
* burst. Watch the real-estate and stock markets closely, since
* assets of this kind are used as bank collateral. Example: In
* Thailand, property prices rose by no less than 395 percent
* from 1993 to 1996.



Notes: 1Thailand: Selected Issues, International Monetary Fund,
Country Report Number 01/147, 2000, August 20, 2001. 2Bank of
Thailand.

Return to reference


Notes: Dominic Barton is a director in McKinsey's Seoul office;
Roberto Newell, formerly a director in the Miami office, serves on the
McKinsey Advisory Council; Greg Wilson is a principal in the
Washington, DC, office. This article is adapted from their upcoming
book, Dangerous Markets: Managing in Financial Crises, New York: John
Wiley, 2002. 1Gerard Caprio and Daniela Klingebiel, Episodes of
Systemic and Borderline Financial Crises, The World Bank, October
1999. In this article, 45 crises during the 1980s are identified.
2"IMF splits over plan for global warning," Washington Times, May 2,
1998, p. A11. 3For more on the causes of financial crises, see
Dominic Barton, George Nast, Roberto Newell, and Gregory Wilson,
"Surviving an economic crisis," The McKinsey Quarterly, 2000 Number 4
special edition: Asia revalued, pp. 48-63. 4For more on the
volatility of foreign funding, see Martin N. Baily, Diana Farrell, and
Susan Lund, "Hot money," The McKinsey Quarterly, 2000 Number 2,
pp. 108-19. 5Free cash flow is defined as net operating profit less
adjusted taxes (NOPLAT) less the net change in invested capital. It
also equals gross cash flow minus gross investment.
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