Keeping the Liquidity Tap On

by Helen Sanders, Editor

The liquidity crisis, which indeed it has been, has seen the liquidity tap (faucet) gradually turned off since the summer of 2007. Not only has the flow been reduced, but the cost of liquidity has increased dramatically. September 2008 saw a sharp reduction in flow, leaving just a dripping tap into an empty sink. Nearly a year on since Lehmans, where are we now? There have been signs of recovery and the elusive hand of the markets (and to some extent governments) may gradually be turning the tap back on, but costs remain high and firms are jostling to fill their cups from the trickle and there is not enough to go around. Where are firms today from a liquidity perspective, and what should their focus now be? While the free flow of liquidity could, with hindsight, perhaps not have continued indefinitely, treasurers today are far more aware of the need to manage their liquidity risk closely, perhaps the most considerable change in treasurers’ approach to liquidity in the past twelve months.

Cash and liquidity management has always been an important consideration for treasurers, but this has been more operational than strategic in approach. The squeeze on credit has made treasurers starkly aware of the need to identify, measure and manage liquidity risk, which has changed many behaviours, not least the focus on accessing liquidity internally where possible, as opposed to relying on external lenders. Steve Everett, Director of Balance Sheet and Operating Assets at Northern Trust summarises the key liquidity concerns over the past year,

"We would identify three key issues for corporate treasurers from the perspective of liquidity management: firstly, financing and diversification of funding sources; cash forecasting and treasury management infrastructure efficiency; and cash investment/risk management practices."

He continues,

"The most significant impact of the crisis on corporates is in the area of financing. Over the period from July 2007 onwards, liquidity dried up in financial markets, accelerated by the events of September 2008. Over this period, capital markets have become constrained in a variety of ways. Consequently, firms that historically relied solely on cost in driving their financing decisions came to realise that diversification and stability of their funding sources is of greater priority."

Lisa Rossi, Head of Liquidity Management, Global Transaction Banking, Deutsche Bank agrees,

“Credit is the number one challenge at the moment for all of our clients, whether letters of credit, loans etc. as financing has become more expensive and/or difficult to secure.”

So what has this meant in practice? Large multinational companies are generally suffering least, and indeed the first quarter of this year saw a large volume of bond issuance, albeit often at a very high rate. Steve Everett, Northern Trust explains,

“Companies raised capital during good times because it was relatively easy and cheap to do so, even when they did not necessarily need the cash short-term. Corporations with solid balance sheets or issuers with government support were able to issue bonds during Q1, 2009, however, oftentimes paid more than their secondary debt levels in the market, showing that market conditions are improving but not yet fully repaired.”

The most  significant impact of the crisis on corporates is in the area of financing. STEVE EVERETT

There are various reasons for doing this. In some cases, they simply needed the cash, of course. In others however, companies sought to maintain relationships with potential investors so that they could continue to be assured of buyers for their debt in the future. Smaller companies are finding the situation more difficult. Orlando Lyomu, Finance Director of Kenyan firm Gulf Energy explains,

“As a growing company without a strong international brand, we are finding big differences in our situation compared with that of multinational firms. Capital is very difficult to access, and very expensive.”

He continues by explaining how Gulf Energy has addressed this,

“We have continued to work closely with our primary bank, BNP Paribas, with whom we have a very strong relationship. It is important to maintain a long-term outlook when forming and maintaining bank relationships, so that they understand our business in detail, making it easier to weather the storm.” [[[PAGE]]]

Defensive borrowing where appropriate, particularly during the first part of 2009, and cementing bank relationships to increase confidence in ongoing access to capital have therefore been part of treasurers’ liquidity risk management strategy. In addition, treasurers have been focusing on both external and internal cash management and liquidity structures to find new ways of sourcing liquidity. While to some extent there is nothing new in this, the internal (as well as external) climate for doing so is quite different. As Bart Ivens, Global Head of Sales, Payments and Cash Management, ING explains, treasury has never been more visible or important to the organisation. This attention brings certain opportunities - and challenges,

"Corporate treasury is now attracting greater interest from company bosses than in the past. Any major structuring or restructuring of cash or liquidity management is seen as a major event and directly attributable to the crisis, which may not always be the case. Treasurers therefore need to take care to be seen to be acting conservatively and in the long-term interests of the company.

However, as well as being more visible, the process of deciding and implementing liquidity management strategies is also accelerating as pressure from senior management to optimise corporate liquidity increases. Companies recognise the value of liquidity and are trying to leverage as much as cash as possible.”

Lisa Rossi, Deutsche Bank crystallises treasurers’ objectives,

“Treasurers want more information and increased visibility over their cash position. Having achieved visibility, they can then mobilise and best utilise their cash.”

As treasurers with cash held with many banks, in many accounts, currencies and locations, these can be challenging. However, as Bart Ivens, ING outlines, treasurers are adopting a pragmatic approach,

“Treasurers are less interested in highly complex, structured solutions to manage liquidity than they may have been in the past. Instead, they are seeking reliable, cost-effective solutions with benefits that are easy to articulate. For example, if they can centralise 80% of cash with a less sophisticated solution, they will probably do so rather than going the extra mile to find an extra 5% or so.

This actually makes the design and implementation of liquidity management solutions more straightforward and with a very high opportunity for success. Rather than defining every detail of a solution, treasurers are working more closely with their banks to apply a pragmatic solution which takes into account the structure of the organisation and then builds on the strengths that the bank provides.”

But what does this mean in practice? As Lisa Rossi, Deutsche Bank explains,

“Liquidity management issues, including bank relationships, bank account structures, etc. have been discussed many times, but only now are treasurers truly prioritising them. These concerns are linked to credit, but also the need to use cash wisely. Companies with growth strategies prior to the crisis now have the time to analyse liquidity structures so they can consolidate acquisitions within a centralised structure.”

It is important to maintain a long-term outlook when forming and maintaining bank relationships, so that they understand our business in detail, making it easier to weather the storm. ORLANDO LYOMU

To achieve corporate liquidity objectives, we see treasurers focusing on the following:

Banking Relationships. The crisis has highlighted those banking partners who are prepared to go the course with a company, through its various ups and downs, and those who are not. As Gulf Energy illustrated, working with a few cash management banks, with whom a strong relationship can be formed, can help in ensuring reliable funding and cash management structures. In some respects, limiting cash management banking relationships may seem counter-intuitive at a time when treasurers have become more conscious of liquidity and counterparty risk. The benefits of having access to as much of the company’s cash as possible cannot be under-estimated; furthermore, the risk to a cash management bank is limited to intra-day and settlement risk if efficient investment strategies are in place. If cash is distributed across multiple banks, with little ability to access or invest, the risk may be higher.

Bank Connectivity. The right bank connectivity, with strong integration with internal systems, can be extremely valuable in an effective liquidity management solution. Firstly, this can ensure the secure, reliable exchange of information, such as bank statements and payments, enabling greater visibility and control over cash balances and transactions; secondly, by adopting a bank-independent connectivity solution, such as SWIFTNet, or a limited number of proprietary banking tools, so that payments can be routed through an alternative bank if necessary.

Cash Management Structures. Centralising cash to ensure greater visibility and access to cash has been a trend for a number of years, but the crisis has helped to spur these efforts. Pooling structures, both physical and notional, are being extended or refined, including focusing on regions which are typically seen as ‘difficult’, such as in China and other parts of Asia. Structures which facilitate greater mobility of cash assist in intercompany financing as opposed to relying on external financing. Even where there are withholding tax implications, it may still be cost-effective to lend internally and may be more reliable.

Working Capital. Companies are looking at the processes which affect working capital, such as payables and receivables. However, although it has been discussed for a long time, treasurers are also looking beyond their own activities to those of their customers and suppliers, in order to help secure the financial supply chain and reduce liquidity risk. For example, as Lisa Rossi, Deutsche Bank explains,

“Companies are looking to their banks for enhanced AP/AR processes and information flows. Where we have seen most interest in the past few months is in supplier financing. It is important to every company that their key suppliers stay in business, and supplier financing can be an excellent way of securing and enhancing these relationships and maintaining payment flows.” [[[PAGE]]]

Working capital improvements can be made through both large-scale, strategic initiatives, such as centralisation of payments and/or receivables into a shared services environment, and with smaller tactical enhancements. For businesses with low margins, and/or which retain low working capital levels, there is significant sensitivity to cash flow timing. Banks are increasingly introducing tools to give corporates greater control over this, as Lisa Rossi, Deutsche Bank continues,

“A corporate focus on liquidity risk has been highlighted by the shortage of credit, the increased cost of overdraft facilities and intraday liquidity charges. This latter point is rarely discussed, but tools such as timed and conditional payments can help to time manage payment flows. For example, using db-direct internet, treasurers can gain access to real-time cash positions. In tandem with db-cinq, they can see their payments and receipts queue, as well as have the ability to set priorities, manage liquidity and control risk.”

Cash flow forecasting

Another important element of managing liquidity risk is cash flow forecasting, still one of the more elusive disciplines of treasury. As Lisa Rossi, Deutsche Bank explains,

“Cash forecasting is another important area for corporates. Forecasting is not a perfect science, but companies are looking at past trends and future expectations of AP/AR flows and combining these with the current and future treasury positions to create an impression of future inflows and outflows to manage liquidity and risk.”

Assuming that companies have already accomplished some degree of success in forecasting cash flow by introducing better information flows, systems integration and support from the wider business, the next step is to use forecast information in risk models, such as stress testing. Forecasting techniques, such as trend analysis, cash flow sensitivity analysis and stress testing have been used in the past by only a minority of treasurers. This is starting to change as companies develop a greater awareness of liquidity risk, and use cash flow forecast information for risk measurement. For example, as Lisa Rossi, Deutsche Bank explains,

“Stress testing is a huge issue for banks, and increasingly for corporates. CFOs and treasurers want to see the impact of different scenarios and how they mitigate potential risks. Increasingly, this is becoming part of business continuity planning as companies make both physical and financial contingency plans.”

Investment

Having held a cup under every dripping liquidity tap in the organisation, how are companies then using their cash and managing their liquidity risk from an investment standpoint? Although the cash cushions of recent years may be less squashy and comfortable this year, cash levels of S&P 500 companies have tripled over the past five years, so it remains important for many firms to be able to access secure, flexible investments. Those singing the old investment mantra of security, liquidity start with a song and end with a mumble as yield has become far less of a priority than in previous times. Companies that have presumed that their investment strategy in the past was quite conservative have found that this may not be the case, as Steve Everett, Northern Trust illustrates,

"As a general rule, many organisations historically considered time deposits and MMFs as commodities so did not differentiate between them from a risk management perspective to the extent that perhaps they should have. Such investments were solely compared by yields and corporations incurred more risk in some cases than they may have actually preferred or realised."

He identifies the continued growth in MMFs, in both the United States and Europe, as an important means by which corporate investors have tightened their approach to liquidity risk through greater diversification. Furthermore, more investors have access to these types of product, and the expansion of government funds enables investors at the lowest end of the risk spectrum to take advantage of pooled investment products:

“Some investors who were prevented from investing in MMFs in the past, such as local authorities in the UK, are now permitted to do so. In addition, there has been a significant migration to government MMFs in recent months.”

The renewed focus on liquidity is a positive development for the treasury and banking professions as both seek more standardised solutions .

More information on this area is provided in the TMI Guide to Money Market Funds 2009 which accompanies this issue. However, liquidity risk has to be balanced with opportunity. As the markets stabilise, will investors continue to be willing to gain little or no return on their capital? To some extent, many of the behaviours over the past year have inevitably been reactionary, and as immediate concerns start to be alleviated, there is likely to be a cautious rebalancing of the risk/return appetite. As Steve Everett, Northern Trust predicts,

"The trend towards the most conservative investment products may ease and potentially reverse as investors become dissatisfied that they are earning no or little return on their capital. While until recently, the objective was to avoid losing money, investors' risk appetite is starting to increase, albeit modestly. In many cases, companies did not change their investment policies during the crisis, but introduced temporary constraints which they are now considering relaxing.” [[[PAGE]]]

Does this herald a reversal or cessation of the efforts which treasurers have made over the past twelve months to pre-crisis ways? While some of the immediate urgency may diminish, liquidity risk management is now firmly entrenched as an explicit treasury priority along with FX and interest rate risk management. Although things may change if the world’s economic climate enjoys another lengthy benign period, treasurers are likely to maintain their focus on maintaining visibility and access to cash. As Bart Ivens, ING summarises,

“The renewed focus on liquidity is a positive development for the treasury and banking professions as both seek more standardised solutions which are simple, cost-effective and easy to maintain. In the future, we see this emphasis continuing, with both banks and corporate treasuries lending or borrowing to finance specific requirements, and a focus on efficient processes and structures.”

It is important to every company that their key suppliers stay in business, and supplier financing can be an excellent way of securing and enhancing these relationships. LISA ROSSI

While treasurers are still likely to be faced with what we hope are post-crisis challenges, the ultimate outcome for treasury should be positive. With better recognition within the business, treasurers should receive better support for initiatives which may have been difficult to push to the top of the list compared with proposals from other parts of the business. Visibility and control are much-touted terms, but the challenges to achieving a centralised view of the cash position can often be internal rather than external, with business entities wanting to retain control over local cash positions and banking relationships.

The business case for cash centralisation has now never been stronger, again an advantage for treasurers. But liquidity risk as a discipline is still in its early stages, which will certainly evolve in the coming months and years. As credit facilities reach renewal dates, debt issues mature, the MMF market continues to develop, including opportunities for enhanced yield, and companies refine cash management structures and internal processes, the liquidity situation for companies in five years’ time could look quite different from what it does today. This should make companies more competitive, more nimble to take advantage of financial opportunities, such as M&A, and more resilient to future market volatility.