Published: September 01, 2010
You can tell that autumn has arrived: it’s very chilly and it’s pouring with rain. And it’s barely September. This is not a heartening introduction to an article on how corporate treasurers can deal with the challenges of constrained liquidity. After all, as far as I can tell, there appear to be absolutely no restrictions on liquidity whatsoever, certainly of the precipitation variety. Despite this, many treasurers have been forced to take measures to ensure not only their own liquidity, but also that of their suppliers and customers. While market confidence appears to be improving, as we approach winter, rain truns to snow, and similarly, with the proposed regulatory changes of Basel III, whatever the economic forecast, liquidity is likely to flow less freely than it has in the past. Treasurers responded well to the financial crisis in many respects, and have become accustomed to managing the financial needs of the company in a constrained environment. What is clear, however, is that there is no way back to the heady days of cheap, readily accessible cash.
The Basel Committee on Banking Supervision issued issued a new set of proposals (known as ‘Basel III’) in December 2009 to replace the existing Basel II capital adequacy requirements. These proposals aim to increase the resilience of the banking sector to future crises and impose more stringent regulations for capital adequacy, leverage ratios and liquidity requirements. The new rules will be formalised by the end of 2010 following feedback from banks, financial institutions and rating agencies, and will be rolled out over a two year period. The key proposals of Basel III are outlined in Figure 1, but many organisations have expressed concerns over the severity and speed of implementation of these proposals. There have been some efforts to make the Basel III measures less draconian, such as the revised counter-cyclic buffer proposals issued in July 2010, but as Erik Seifert, Head of Cash Management, SEB advises,
“While there is still some uncertainty about what the final requirements of Basel III will be, banks’ ability to lend will undoubtedly be restricted, and the value of relationship-driven deposits will increase. We are already seeing some evidence of a change of behaviour amongst banks in recognition of this, and the battle for liquidity has commenced, at least at a skirmish level.”
While this is not the only likely repercussion of Basel III for corporates, as long-term financing and investment are also impacted, the increased value of liquidity and importance of deposits has implications for both corporates and banks. For banks, capital structure is of particular importance, and as Erik Seifert, SEB continues,
“Transaction banking is becoming increasingly important for banks, as it is key to attract deposits into the bank.”
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The issue of relationship banking has been discussed for some time; what is clear is that the trend towards inter-dependent relationships between banks and corporates will continue, with the provision of borrowing, lending and cash management closely linked. This could create some challenges, as it potentially means that companies could lose efficiency by dividing their business across multiple banks, but as C. J. Wimley, EVP Corporate Solutions, SunGard AvantGard illustrates,
“One of the outcomes of the financial crisis, and in particular the reduction in credit availability, is the changing relationship between treasurers and finance managers and their banking partners. While there has been an overall trend to rationalise the number of banks, it is increasingly expected that if a bank offers credit, it will be invited to participate in other banking services, such as transaction banking, as a way of offsetting its risk and enhancing the value of the relationship. This means that many corporates are working with a panel of banks for cash management, often on a regional basis, which would appear to hinder efforts at efficiency initiatives such as centralisation. This should not be the case. Using multibank, bank-neutral connectivity channels, such as SWIFTNet (or multi-banking electronic banking systems provided by individual banks, although these are proprietary) enables information from multiple banks to be channelled through a single ‘pipe’. Furthermore, by leveraging new standards such as XML-based ISO 20022, information transmitted to and from banking systems can be standardised.”
With a higher premium on liquidity in the long term, treasurers now need to look beyond crisis management to a long-term business model for maintaining access to liquidity, and enabling the company to invest in business growth and competitive advantage. While there have been considerable changes in the way that many corporate treasurers manage liquidity, however, perception and reality may be a little different.
It is frequently stated that liquidity became a primary investment objective during the crisis, so treasurers invested their cash for a shorter tenor to ensure that cash was available when required. Linked to this, cash flow forecasting became a higher priority so that treasurers could better forecast their liquidity requirements. The reality? Yes, cash has been invested more conservatively and for a shorter tenor, but part of the reason for this is that accurate forecasting often remains difficult to achieve, and remains on many treasurers’ ‘to do’ list.
Secondly, we are often told that companies have been focusing on working capital and seeking to improve processes in order to release ‘trapped’ liquidity. While this is the experience for some companies, it is not the reality for a large proportion. According to the Trade Finance Survey, 2010 conducted by gtnews/SEB, only 53% of companies are actively engaged in working capital enhancement initiatives. Furthermore, according to working capital consultancy REL, only 34% of industries in the top 1,000 companies in the United States posted an improvement in days working capital (DWC) in 2009 compared to the previous year and a large proportion saw a decline. Amongst those who improved DWC, the average improvement was 21% while the average deterioration was 32.3%.
Therefore, while a small majority are seeking to optimise financial processes that contribute to working capital, a large minority are not focusing on this area. It would be wrong to argue that the possibility of better times ahead means that working capital no longer needs to be a priority. Working capital initiatives bring significant benefits, whatever the economic conditions, and directly contribute to a company’s competitive position. Furthermore, with no prospects that the cost of liquidity will reduce in the future, increasing the efficiency of internal processes to reduce costs, accelerate the cash flow cycle and improve access to liquidity should be of paramount importance. As Richard Spong, Financial Services Marketing Manager, Sterling Commerce, EMEA outlines,
“Research by the Supply Chain Council has found that supply chain and related activities represent between 60% and 90% of all company costs, so all affordable process efficiencies that meaningfully reduce those costs will directly benefit profitability, and should be attractive.”
Another commonly held belief is that treasurers are both focusing on the potential for financing using the assets in the financial supply chain, and looking beyond their own supply chain to support their suppliers and customers. This is an area where we are seeing a considerable increase in activity, even though techniques such as factoring and reverse factoring (supply chain finance) are not new. Patrik Zekkar, Head of Trade and Supply Chain Finance Sweden, SEB explains,
“Corporates of all sizes are increasingly opting for alternative forms of financing such as factoring, and paying increased attention to risk mitigation in international trade. Every step of the financial supply chain represents an asset which could be used as another means of creating liquidity. For example, invoices, trade receivables or even purchase orders can be used as collateral for financing or cash flow enhancement. In an environment where companies of all sizes may have found it more difficult to source credit through traditional mechanisms, alternative financing arrangements can be a valuable tool (fig 2)."
The relationship between financing and risk management should not be underestimated. For example, while a supplier financing programme enables the buyer to extend days payable outstanding (DPO) it also reduces supply chain risk by supporting suppliers’ liquidity position. As figure 2 illustrates (courtesy of SEB) there are opportunities for financing and risk management at every stage from initial supplier negotiation through to post-shipment financing.[[[PAGE]]]
To take advantage of these opportunities, treasurers need to consider the financial supply chain in its entirety as opposed to considering each step individually. This changes the way that banks and their corporate customers work together, and how responsibilities within an organisation are determined. Banks have already repositioned their organisations to enable this, such as aligning cash and trade more closely, and connecting different parts of the transaction banking business. In corporations, however, there is still progress that needs to be made. For example, although treasurers recognise the importance of working capital, only 36% of treasurers currently have ownership of this area, according to the Trade Finance Survey, 2010 by gtnews and SEB. This is not easy to achieve unless treasurers can articulate to senior management the benefits of a holistic approach to liquidity and risk management throughout the financial supply chain. For example, looking at credit and collections, as C.J. Wimley of SunGard AvantGard emphasises,
“Centralising and optimising credit and collections management delivers benefits that extend well beyond the immediate confines of the collections or sales departments. Achieving greater predictability of cash flow is vital for liquidity planning and enables borrowing and investment decisions to be taken with more confidence, with the potential to reduce borrowing cost and increase investment yield. In an environment where credit is more constrained, and more expensive than during pre-crisis days, with no guarantees of continuous market access, this can be a very important consideration.”
There have been some successes so far. For example, one area that treasurers have become more engaged with in recent years is the use of trade instruments such as letters of credit (LCs). Despite the long-term shift from the use of LCs in favour of open account over the past 10 years, this was reversed in response to the crisis, and companies increasingly recognised the value of trade instruments for managing risk. The challenge now is whether to return to open account transactions, which may be problematic bearing in mind that many companies are working with new, unfamiliar trading partners as they expand their geographic reach. Richard Spong, Sterling Commerce outlines,
“Open account trading carries a higher default risk in some industries and countries than it did three years ago. To some degree, corporates may be prepared to pay a reasonable price for improved reliability of cash flow and improved assurance of supply chain revenue.”
The problem is that trade finance can bring its own challenges: often the processes are time-consuming and bureaucratic, and the timing of payment can be unpredictable. Furthermore, as Erik Seifert, SEB explains,
“Under Basel III, the likelihood is that letters of credit will also become expensive as banks will need to offset the counterparty risk. After a long trend from trade instruments to open account, this was reversed during the crisis as trust declined. The dilemma for treasurers now is what to do next: do they return to open account, or does there need to be a new alternative?”
This is an interesting challenge, not only for corporates, but in particular for their banking partners. The open account trading model and traditional modes of financing are not necessarily applicable to the financial environment of the future. Trade instruments too bring disadvantages, and may not address banks’ capital adequacy requirements, as they still need to offset the counterparty risk of the transaction. Erik Seifert, SEB continues,
“We anticipate greater use of standby LCs that are not counterparty-specific and therefore have lower capital allocation requirements; in addition, it may be that banks will need to develop new solutions in the future to help manage clients’ liquidity and risk management requirements.”[[[PAGE]]]
The potential for pragmatic, mutually beneficial liquidity and risk management solutions in the future is significant. While it will take some time for the requirements of Basel III to be finalised, and therefore how banks will incorporate these requirements within their business, there is a clear need for solutions that meet both banks’ and corporates’ needs. Some of these tools are already in place, such as supply chain financing, but to take advantage of these, treasurers need to be able to leverage the entire financial supply chain. Erik Seifert, SEB concludes,
“The price of liquidity has increased and corporates should not expect to see a return to the cheap credit of a few years ago. With this in mind, treasurers need to find new ways of maximising their access to liquidity. To do this involves working with a bank on a holistic basis, across the financial supply chain. Firstly, for example, we work with clients to help improve process efficiency, to release working capital at each stage. Secondly, we can look at taking assets off the balance sheet through leasing or vendor financing solutions as well as using receivables (as an example) as collateral for working capital financing, before having to commit the bank’s own balance sheet outright. This approach makes sense for both banks and their corporate customers: for banks, they can finance their customers without the need to offset counterparty risk with deposits; corporates can gain access to liquidity at a lower cost, and reserve bank credit lines for strategic as opposed to working capital objectives.”
From a trading perspective, existing paradigms, such as open account vs trade instruments may no longer be fit for purpose. While many transaction banking solutions have become highly commoditised, now is the opportunity to demand and deliver new bespoke solutions that enable corporate treasurers to contribute to the competitiveness of their organisations, and manage liquidity and risk effectively. After all, while an umbrella will help to keep off the rain, it may be far less useful when hailstones and snow start to fall.
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