Cash in the new post-crisis world
|Stephen Baseby||Associate policy and technical director, ACT|
After more than six years from the start of the financial crisis we have been through a credit and banking crisis, a sovereign debt crisis, the euro crisis and a major process of re-regulation of financial services. While the peaks of turbulence are past, the consequences are still very much with us. And it is not all bad. When times were hard, the benefits of running a well-managed professional treasury department became even more apparent. Efficient cash management and prudent investing became more important than ever.
Larger companies are in the privileged position that bank or bond funding is once again readily available even if more generally the banks’ capacities for making new loans will become more restricted. Private equity owned companies have always been acutely aware of the need for cash generation and tight controls on cash management. That lesson has been learned across the board. Companies revised their cash forecasts, partly to see what levers could be pulled to save cash, and partly because these forecasts needed updating to reflect the continuing downturn in the economy. Reducing gearing was the order of the day, new acquisitions were reined back, working capital was thrown into the spotlight to be managed more tightly and cash was allowed to build up to provide future financial flexibility. The need to diversify sources of funding became apparent and greater concern about counterparty exposure to banks was required. The lessons learned from the financial crisis will have a long lasting benefit in the fields of cash management, forecasting and investing.
Understanding the working capital cycle and taking control of it became a priority; in many companies this had been a neglected area. Making full use of the available accounts receivable and accounts payable technologies, getting on top of reconciliations, reducing admin and errors, tightening Days Sales Outstanding, claiming supplier discounts and improving cash flow and its forecasting will all be a permanent legacy of those critical times.
Spare cash generated may be invested in suitable instruments or may be used to payback debt. Either way, stage one in the process is to revisit the cash forecasts and plans in order to be realistic in the new environment. Old assumptions may not apply. If we have all learned one thing from the credit crisis, it is that you need to plan for the unexpected shock. All forecasts will need to be stress tested with some extreme assumptions.
Whether wanting to reduce debt or to use cash for investing, managing cash flows cannot be neglected. Companies are taking action to chase up debtors (or help debtors and themselves in “supply chain finance” initiatives) and collect the cash. They are looking to make more effective use of any pockets of cash around their group companies. Where small floats are left in subsidiary accounts, these are being reduced. Cash pooling systems are being tightened up with more frequent repatriation of balances, or simply by bringing more companies into the system. For a large group, it is truly amazing what cash can be generated as if from nowhere. The crisis has reminded companies not to take access to funding for granted. If banks are somewhat less inclined to have fully committed credit facilities sitting unused then treasurers have no choice but to pre-fund their needs; this can mean having both borrowings and cash on the balance sheet at the same time. Treasurers and their boards now regard a certain amount of inefficiency in pre funding or over funding, along with the cost of carry, as a cost that has to be borne. In the overall scale of things, it is often thought a cost worth bearing.
Phase three is segmenting the funds, and here the new emphasis is on flexibility and therefore keeping investments more liquid or invested for shorter periods. Now might be the best time to make opportunistic acquisitions so that a company does not want to be locked into long-term and inflexible deposits. Added to this, a shorter maturity presents less risk that the counterparty will get into financial trouble during the investment’s life. The counter argument is that given how low interest rates have been then perhaps it is reasonable to seek a yield pick-up through investing further down the maturity curve. Interestingly, this is not something that has been happening to any great extent. The logic is that flexibility and reducing credit risk trumps any small yield pick-up. This demonstrates that for non-financial companies holding cash and generating income from it is not an end in itself, but rather the cash is there to be used more profitably in the business. Low interest rates are a feature that has prevailed far longer than first expected. To combat recession and encourage economic recovery the authorities in the major economies have provided monetary stimulus using quantitative easing as the key tool to inject cash into the financial system. Central banks have, in a manner of speaking, been printing money in order to purchase government bonds and thus depressing rates, even out to the longer-term maturities. At the short-term end interest rates have, for brief periods, even gone negative, meaning that the banks in effect charge a fee for holding customer deposits safe. When rates are low to start with, banks that are rated relatively safe can be swamped with deposits that they cannot profitably use for on-lending, so instead must discourage via negative rates. Perversely, the very banks that are low risk and attractive to treasurers will very often not wish to gross up their balance sheets through taking deposits. The new Basel III leverage ratio can be a limiting factor on grossing up for some banks, even pushing those banks to consider imposing limits on cash left in operational accounts.
An investment policy encapsulates how a company’s risk appetite translates into practical objectives and rules. Counterparty credit risk is no longer purely theoretical – it is a very real risk. If, pre-crisis, a company was prepared to mark a limit for a single A-rated bank, it is probably still happy to do business with such a counterparty. What has changed is that companies may have reduced the limits per bank so as to force a greater degree of diversification of investments, or have introduced a new rule such as ‘no more than 10% of funds with any one name’, subject to exceptions for modest amounts. But companies operate in the real world and the choice of well-rated banks open to them has diminished. Maybe companies have to accept dealing with lower rated institutions?
Corporates may need to look through the borrower risk, look to the bank's home government to decide what degree of support can be expected to be provided. Reducing risk through diversification has become less simple. Tradeable instruments open capital risk. The composition of money market funds needs monitoring to avoid concentrating risk by counterparty or region, and their evolving regulation will focus on their liquidity exposure. The counterparty limit set for a bank (which covers all forms of credit exposure, not just liquid funds investments) will usually be derived from an approach that starts with the credit ratings of the banks, supplemented by other information. Limits are set so that the expected loss from a credit event, while regrettable, is not disastrous, since no policy can be designed to be event-free under all circumstances. An important step is to ensure that you know which legal entity within a bank group you are dealing with and which has a rating. If you are dealing with more than one entity in a banking group, set an overall bank group credit limit as well as limits for individual legal entities (and even branches – see next section). But bank risk is about to become a lot more complicated and highly dependent on the structure of the banking group involved.
Bank recovery, resolution and bail-in
The crucial role of banks in keeping any economy alive has meant that in recent times there has always been some sort of implied state support for banks, particularly if those banks are large and systemically important for the jurisdiction concerned. This has been borne out in practice as states stepped in to support or rescue their banking sectors. But sentiment has changed. It is no longer politically acceptable for governments just to pick up the bill for rescuing a bank. In some cases the sheer size of the banking sector as compared to its host state means it is not practical either.
A failing bank can traditionally survive if it is recapitalised with new capital from its own shareholders or in extremis from the government. The theme being explored now, and indeed beginning to be implemented, is to create a legal regime that will allow the cost of rescuing and recapitalising a failing bank or shutting it down to be placed back with the creditors of that bank. There needs to be a mechanism to share the pain so as to allow the bank to survive and to protect retail depositors. If, for example, bond investors have lent the bank £100 then if the bond-holders’ claim is written down to £70 this creates £30 of new capital in the bank balance sheet. This is termed “bail-in”. It contributes to restoring solvency of the bank but of course does not generate any new liquidity. It must be hoped that with the bank’s stronger capital position, the market or central bank will be prepared to give access to liquidity.
The problem is to devise a fair set of rules around bail-in and the starting point is an assumption that retail depositors should not suffer bail-in, or at least not up to certain limits. A bank that is funded heavily by retail deposits was normally regarded as safer than one heavily funded from the wholesale markets, on the presumption that retail deposits are stickier. In the event of a problem, wholesale funding will quickly be withdrawn and dry up whereas retail money is slow to be withdrawn. In the new world of bail-in, the perverse result is that a bank with most of its funding from retail deposits will have to bail in its few bond-holders and wholesale depositors to a far larger extent – so a disproportionate risk falls on wholesale depositors, making them even more like “hot money”, withdrawn at the first signs of trouble. This is aggravated if retail deposits or the guarantee scheme they benefit from are ranked above wholesale deposits in bank resolution.
Then, in a bank group there are further complications and risks from bail-in. Will the creditors being bailed in be at the parent or holding company level or at the operating subsidiary level? And will a problem with a sister subsidiary in a banking group, if it cannot be resolved within that subsidiary, trigger a bail-in in a solvent member of the group.
Foreign branches of banks raise particular problems. Will depositors be treated similarly to those at the home country branches? The home-country’s retail depositor insurance does not usually apply but the host-country’s scheme may. Will the head office support wholesale depositors? Is the branch required by the host country to be “ring fenced” from the rest of its legal entity with local capital and liquidity demanded? Enquiry has to be made individually for each foreign branch. Branch credit ratings (e.g. Fitch National Ratings) are only occasionally available.
Ring fencing of activities within a bank group will also need to be monitored. Regulators seek to return to segregate types of risk within the banks which have globalised: to separate retail from wholesale; investment from corporate; lending form trading. Conflict may emerge between the bank entity the investor prefers to fund and the entity from which the bank can lend.
The implications for investing corporate cash with banks, be that directly through deposits or indirectly via a money market fund, are very significant. Any credit assessment will need to build in consideration of the exact entity you are dealing with, the make-up of its funding mix, the hierarchy of preference for the different funding providers, any ring fencing and the entity’s relationship with and risk from other businesses in the same group, and any applicable local regulations.
If counterparty risk is a big concern then mitigating this through taking collateral is a possibility. It sounds rather self-defeating for the bank to take a deposit and then give back an equivalent amount of collateral, but the point is that the collateral can be a longer-term asset that the bank wants to continue to hold and that can be put to good use supporting immediate liquidity. This form of secured deposit is known as a repo or repurchase agreement (strictly speaking a reverse repo) and is beginning to be used by some larger companies, and is set to become more usual.
Everyone, right down to the private investor with money in his/her bank account, is now acutely aware of the risk of default. The heightened risks and awareness mean that the monitoring and reporting of counterparty exposures has become a more frequent exercise for company treasury departments. Although most companies already keep track in real time as part of the dealing process, new end-of-day reports are being created for senior management along with other related information, and treasury systems become more integrated into dealing and accounting systems to shorten the time delay to confirm and report trades.
Experienced treasurers have always maintained that when it comes to investing temporary company cash, the priorities are Security, Liquidity and Yield (SLY) in that order of importance. They have been proved right again and again and this will continue to be the treasurer’s mantra, even if the practicalities of achieving it have become a lot more complicated.