Published: January 01, 2000
A strengthening macro-economic backdrop and the introduction of Basel III, which reduces the value of some types of corporations’ cash to banks, are prompting corporations to rethink how they optimise cash and manage the challenges resulting from the changing environment.
After the long cold winter of the credit crisis when corporates hoarded cash, a thaw has begun to take place. Companies want to do more with their cash as the global economy gradually improves and the threat of financial unrest recedes. Cash is once again being redeployed in traditional ways to take advantage of an evolving global economy.
For example, some companies are using cash for mergers and acquisitions (M&A): activity globally is expected to rise in 2013. Other firms are increasing dividends, with some beginning payouts for the first time. Additionally, corporations are seeking a better return on their cash from non-strategic investments. Options including bank deposits or cash equivalents, such as money market funds (MMFs), offer diversification and liquidity; however, there may be disappointment in store.
First, the record-low interest rate environment in the US is now expected to continue as long as the unemployment rate is above 6.5%. Meanwhile, rates in the Eurozone reached a new record low of 0.5% in May this year. Only a few countries worldwide, such as Chile, have raised interest rates since the financial crisis – and even they have done so slowly – with most still holding at historically low levels. Such low rates mean that cash runs the risk of being eroded by inflation.
Second – and more importantly – Basel III, a global regulation designed to improve the stability of the global financial system by requiring banks to hold more capital, is changing banks’ practices toward corporate deposits. Historically, if a corporate client placed a large cash deposit in the bank for an extended period of time, a favorable rate of return was expected. Basel III challenges that assumption, and now banks are becoming more selective about accepting certain types of cash deposits.
Under Basel III, banks will be required to set aside liquid assets for long-term cash deposits according to a prescribed liquidity coverage ratio (LCR). Since the December 2010 draft of Basel III was written, a number of changes have been made in response to criticisms levied by government officials and industry groups.
For example, required LCR percentages have been relaxed so that banks will only have to set aside capital/assets on corporate reserve cash amounting to 40% of its value for un-insured and 20% for insured balances compared to the previously anticipated 75%. Additionally, draw/outflow assumptions on corporations’ liquidity facilities (covering an acute, short-term stress event) have been reduced from 100% to 30%. The timetable for the introduction of the LCR has also been lengthened. While still becoming effective in 2015, it now requires banks to be 60% compliant by that date, with incremental increases of 10 percentage points per year until 2019.
Other changes include an amended definition of high quality liquid assets, which is the numerator of the LCR equation, and describes the assets that banks are required to keep against certain types of deposits. In addition to cash, sovereign bonds and mortgage backed securities (with a haircut), high quality liquid assets now include residential mortgage backed securities, A+ to BBB- rated corporate debt and unencumbered securities. The new instruments all have haircuts and are capped at 15% of total high quality liquid assets.
While these changes are welcome for both banks and corporates, they nevertheless represent a significant change when compared to existing requirements under Basel II. Moreover, it is possible US regulators could unilaterally act to introduce a more onerous capital adequacy regime for banks in the future. Even based on the revised version of Basel III, banks will be more selective in the future in terms of accepting certain types of cash deposits and will differentiate between operating cash (which will be relatively attractive to banks) and reserve cash (which will be comparatively less attractive). For example, deposits linked to the provision of transaction services will have a lower capital requirement for working capital deposits. This will result in banks competing for the same type of corporate activity because they will not want only one-off deposits from a client’s strategic cash – they will be eyeing the balances that are linked to underlying transactional activity.
Given the repercussions from the introduction of Basel III, corporates with a reserve cash deposit may seek to move their cash balances into cash equivalents, such as MMFs. However, MMFs have not escaped regulatory reform. Examples of this are the amendments to Rule 2a-7, approved by the Securities and Exchange Commission (SEC) in January 2010, to manage the quality, maturity and diversity of investments. To improve the quality of MMFs, the SEC amendments include:
More recent reform options, published by the Security and Exchange Commission, include changing from a stable $1.00 net asset value (NAV) to a floating NAV. Another option is to create a redemption gate that would require participants to pay a 2% fee if redemptions exceed 15% of the fund’s value within a specific time period. Both provisions are aimed at Prime Money Market Funds, but do not target Government or US Treasury Funds.
As a result of these proposed reforms, MMF families will experience further product commoditisation effects, which may fuel industry consolidation. For example, it is likely that the reforms are going to put pressure on the fund families that are smaller and/or not bank-sponsored.
In the next two years – as banks feel the effects of Basel III – there may be increased pressure for organiations to move reserve cash to off-balance sheet instruments, but there may also be fewer fund families available to take that cash because the reforms to Rule 2a-7 may accelerate consolidation in the MMF market. Many small MMF providers have sold out to larger organisations because new regulations make it uneconomical for them to carry on.[[[PAGE]]]
As with other regulations, there are good reasons for implementing Basel III. Regulators are trying to reduce the chances of another colossal financial crisis. For that reason, their emphasis on liquidity risk management within banks is absolutely pivotal.
However, the consequent reduction in the range of investment options for corporations’ reserve cash will drive down the rate of return. It is important that corporates continue to look for opportunities to maximise value for this type of cash in the new LCR environment. The moral of the story is clear: cash is still vitally important, but not all cash will be created equal.
Corporates may be using some of their cash for M&A and dividend payments, but the lessons learned from the recent financial crisis mean that the value of cash is acutely recognised, and access to cash remains important. Treasurers have re-examined their cash deployment methods given the much-changed credit environment since 2008. Now they must look to optimise cash in new ways, taking into account the changing regulatory environment and the impact on product availability and returns.
As a result of this new environment, treasurers will need to look further ahead than they are accustomed to doing, and deal with a greater variety of investment instruments than before. With the introduction of Basel III, organisations should continue to review their cash position, so that they are able to weather stress events. They should look at enhancing their cash flow forecasting – an area in which all companies could improve. They will also need to review their investment policies, processes and procedures.
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