June 2007 Capital Adequacy Extension © Copyright 2007, CCRO. All rights reserved. Page 8 of 92 For example, this graphic illustrates how earnings may enhance or degrade a company’s equity. The earnings expectations for a company are displayed for time periods T+0 through T+7, the lower chart indicates how those earnings affect equity. Assume for the moment that T+8 through T+30 have positive earnings expectations, resulting in a significantly positive NPV. Relying exclusively on an NPV analysis to determine the economic capital required for market risk, could result in overlooking some time periods where negative equity can result(T+5). These periods represent poor financial condition possibly leading to financial failure, preventing the firm from realizing its full economic value. A standard NPV based Monte Carlo simulation approach may not reveal the time periods where the firm can be financially distressed., such as T+3 through T+5. 1.6. Adequacy for Financial Liquidity The term financial “liquidity” refers to a company’s ability to create access to liquid capital in the amount and in the timeframe needed to meet all the current cash obligations. These include cash demands resulting from the day today operations and financing activities (such as maturing financial liabilities) of the corporation’s business. We can assess liquidity adequacy by determining internal funding requirements from all expected internal and external financial resources under normal and adverse market conditions taking into account market, credit, and operative contingencies. To the extent possible, the same price modeling process used in market and credit risk assessments can be combined with financial relationships to construct a pro forma financial cash flow statements. It is also necessary to account for conditional events such as trigger events that can cause credit rating down grades, probability of counterparty defaults, material adverse changes, adequate assurances, and debt to equity triggers. Modeling liquidity is a complex but necessary effort in measuring liquidity adequacy. The framework for determining Cash Flow at Risk (CFaR) is comprised of the same elements that made up the framework for assessing Economic Earnings Equity T+0 T+1 T+2 T+3 T+4 T+5 T+6 T+7 Equity Depleted Possible Bankruptcy Equity Growth