Working Capital and Liquidity Management: Safety First

by Transaction Banking, Standard Chartered Bank

Losses in the US sub-prime market have had a global impact on corporate liquidity, which has driven corporate treasuries to take measures ranging from squeezing internal liquidity to tighter risk management of banking relationships.These and other initiatives were discussed during the ongoing series of thought leadership forums organised for senior Asian corporate treasury personnel by Standard Chartered Bank’s Transaction Banking team.

The sub-prime debt crisis has obviously had a profound effect on economic activity, which in turn has fundamentally affected the way in which corporations are managing their working capital and liquidity. In many cases, existing approaches to risk, investment (in terms of both cash and new ventures) and funding have had to change radically to cope with a new and very uncertain world.

Bank liquidity

One of the most noticeable environmental changes for treasurers over the past eighteen months has been the drastic reduction and repricing of bank liquidity. One consequence of the government bailouts of certain global banks has been the pressure on those banks to concentrate their lending in their domestic markets. In addition to this liquidity drain, there has been the more general reduction in confidence among banks, which has seen many of them radically tighten their lending criteria. Sabre-rattling by some governments over increasing capital requirements has only added to this caution.

One potentially bright spot amid the current liquidity gloom is the role of local banks.

Therefore, despite lower base rates, actual refinancing rates have increased. This in itself is bad enough, but several forum participants remarked on a further complication, namely a change in the basis upon which banks are pricing liquidity to corporate clients. The traditional convention of a margin added to a benchmark rate (such as Libor) had the virtue of transparency as well as conveniently coinciding with the way in which hedging instruments (such as interest rate swaps) were based on market rates. However, banks are now moving from ‘benchmark plus’ pricing, to cost of funds based pricing, which is making it extremely difficult for treasuries to hedge their interest rate risks accurately.

Unfortunately, for treasurers to gain a better insight into banks’ cost of funds is not a trivial task. One forum attendee remarked that some anecdotal evidence for specific banks was available and others are also pressing for greater transparency, but more formal calculation remains complex. For instance, Basel II is a significant factor in determining a bank’s cost of funds but the resources required for treasury to reverse-engineer partner banks’ regulatory cost of capital could probably be deployed more profitably elsewhere.

Treasurers are taking various steps to protect their existing bank liquidity sources. A relatively common strategy is to increase the frequency of bank contact and also the level of disclosure. The key objective in this process is to enhance bank partners’ comfort factor. Another strategy is to pre-empt the possible withdrawal of unused credit lines by drawing on them even if not immediately required. The negative margin achieved after depositing this surplus cash is seen by some treasurers as a liquidity risk premium well worth paying. [[[PAGE]]] 

One potentially bright spot amid the current liquidity gloom is the role of local banks. Many local banks in Asia had minimal or no exposure to the sub-prime problems afflicting some of their OECD counterparts. In addition they often have a strong retail deposit base (for example, in China local banks hold some 90% of all retail deposits). These local banks are therefore in a stronger position as regards both liquidity and lending appetite. One attendee remarked on this. “At times like year-end balance sheet dates foreign banks don’t really offer much support; therefore on those occasions we find local banks of more assistance,” he said.

Some multinationals are putting this into practice and looking to replace corporate level funding with local bank funding. Certain large Asian companies are taking a similar approach, as some of them have realised that the global banks which have required government bailouts have downgraded them from key client status. In both cases, corporate treasuries are taking a hard look at some of their global bank relationships and supplementing them with additional local bank relationships for funding as well as transactional business, such as payroll and collections.

Local banks represent a valuable liquidity opportunity for treasurers, but there are some caveats, such as relationship proliferation. Over the past decade corporate treasuries have been struggling to rationalise bank relationships, so building new relationships with local banks rather undermines that strategy. Furthermore, in some countries corporates with substantial borrowing requirements may find themselves having to open multiple new local bank relationships in order to access sufficient total liquidity.

Another complication is that larger local banks are unlikely to be content with just a lending relationship. They will probably be looking for some fee based business in return for liquidity provision, further complicating the already tricky equation of sharing such business among lenders. Nevertheless, these issues will probably be seen by most treasurers as a reasonable trade-off for the risk management benefit of diversifying liquidity sources in a drought. Certainly those forum attendees who have traditionally relied on a handful of global banks are seriously thinking about diversifying their liquidity relationships.

One attendee was emphatic that heavy reliance on ‘foreign banks’ was a mistake and that it was the local/regional banking community that had provided critical and early support. Therefore it was important to establish a broad banking structure that included top quality local/regional banks. In the past, having fewer banks was perceived as streamlined and efficient, now it is viewed as a strategic weakness.

Liquidity timelines

Given the uncertain market conditions it is perhaps understandable that treasuries have become very focused on maximising the immediate availability of liquidity. To some extent this goes hand-in-hand with risk management (see ‘Bank liquidity risk’ below), but the overriding concern is to have as much instantly deployable cash as possible. Short-term balance sheet cash levels that would have been seen as inefficient two years ago are now regarded as provident. Wherever possible, forum attendees were clearly shifting cash from longer-dated instruments to seven day or even overnight deposits. The traditional stratification of corporate cash holdings across long, medium and short terms appears to be breaking down.

While the current conditions might throw up the odd cheap acquisition opportunity, companies were nevertheless clearly more comfortable moving long-dated deposits that they might be reserving for this purpose to the short end. In addition, companies were uncertain whether their long-term liquidity would be needed to fund their current business strategies. “As a CEO, do I make use of my existing expansion plans, or is now a bad time?” asked one treasurer.

If corporates are moving their surplus cash to the short end, the exact opposite applies in the case of their borrowing, where the overwhelming trend is to lock in liquidity for as long as possible. This has become particularly apparent in areas such as trade finance, where companies that typically roll their requirements over on a three or six month cycle are now trying to fix rates and commitment beyond three years.

Effective liquidity planning and maturity matching are obviously heavily dependent on accurate cash forecasting. Unfortunately, while many corporations regard this as an inexact science at the best of times, the current conditions have made it even more problematic. A large part of cash forecasting relies upon historical and seasonal data, which given the economic slowdown, no longer hold true. In time, as more ‘stressed data’ becomes available, the situation should improve. However, in the short term many corporates are expecting these forecasting issues to result in unnecessary overdrafts and over-funding.

Liquidity structures

Apart from banks, other sources of liquidity have also been drying up, with funding from commercial paper and bond issuance becoming patchy. As a result, treasuries have been again focusing on maximising the availability and utilisation of internal liquidity.  

However, attendee consensus at the forums was that only those companies with intercompany loan and in-house banking structures already in place could quickly implement processes to enhance internal cash flow. To general agreement, one attendee remarked: “We reviewed the merits of establishing an in-house bank a while back, but felt that there was little payback for all the time and effort that would need to go into completing such a project. At the time, bank lending was cheap and accessible and cash flow was not a problem”. With the benefit of hindsight, any review of the merits of such projects would be wise to take into account both the prevailing environment and a stressed environment. It would have been easier to get such projects approved if the benefits of such a structure were considered in the context of a liquidity drought.   

Company legal structure (generally devised by the tax department) is currently proving a major hindrance to those trying to implement intercompany lending. Furthermore, the objectives of the three departments (treasury, tax and legal) typically involved in creating new structures often conflicted. The tax department was focused on minimising tax, legal on shielding the parent corporation from legal issues that might arise from subsidiaries, and treasury on maximising and concentrating cash to provide short-term liquidity. However, on the upside, the current critical importance of maximising liquidity meant that treasury’s view was now being given considerably greater priority than in the past.[[[PAGE]]]

Trapped cash

The question of trapped cash was inevitably a significant part of attendees’ discussions and there was a fairly immediate consensus that in Asia this was simply a fact of life. Nevertheless, there were various courses of action open to treasury that could help minimise the problem. One basic requirement was to remain abreast of current regulation in each country; no small task in view of the fact that it was constantly changing and that frequent shifts in interest rates were adding further unpredictability.

The next step lay in understanding how this mix of shifting regulation and interest rates affected what was actually possible in terms of liquidity management. In this respect attendees identified the overwhelming need for a tool (possibly bank-provided) that would allow them to model the benefits of a regional/global pooling structure that could incorporate what was permissible in each country.

Another important role for treasury in minimising trapped cash (and capital) lay in engaging with regulatory authorities. This prompted a discussion on how best to accomplish this engagement to hopefully influence a reduction in regulation. Heng Li Koon of HP observed that some countries’ national banks facilitated this. “For example, Bank of China looks to banks to help give companies a voice with the government,” she said. “In addition, a long-standing presence in a country and a reputation for being a good corporate citizen typically enhances a company’s status and influence with the authorities.”

Trapped capital

While the question of trapped cash is a common concern for treasuries in Asia, the forum attendees also discussed the problem of trapped capital in considerable detail. Corporations hold substantial inventories in restricted countries as well as plant and equipment, which they regard as trapped capital. As liquidity from global banks has evaporated, treasuries have turned to local/regional banks and have been able to leverage the value of their trapped capital assets as collateral to support new local lending from these banks.

A corporation's overall opinion of a banking partner tended to be heavily influenced by its perception of the bank's regulatory relationships.

The discussions also covered the question of how the trapped capital issue might influence the choice of business models for new markets. The conventional model of putting plant, people and equipment in a restricted country to expand the business might be ill-advised at present, as the valuable capital involved would then be trapped.

A possible alternative was the distributor/agent model, which would support expansion plans but without needlessly tying up capital. This was also seen as a good method for gaining experience of a country in order to gauge how the business was likely to fare, but with minimal capital risk. However, even this preliminary toe in the water requires an accurate assessment of the country’s risk ratios and this was extremely difficult to accomplish when interest rates and spreads were constantly fluctuating.

While this is obviously a challenge, it is at least evidence of greater treasury involvement in investment decisions. Several treasurers remarked that it was now obligatory in their corporation for treasury to validate and sign off on all business expansion into new countries. While this did not in itself remove the risk of trapped capital (or cash) it did at least mean that treasury could assess the scale of any potential problem and plan for it. [[[PAGE]]]

Bank advisory

The discussions relating to trapped cash and capital also covered the advisory role that banks needed to play in these areas. One attendee outlined her corporation’s approach to this. “We have two categories of bank: day-to-day transaction banks and relationship banks,” she said. “We expect the latter to network with governments and regulators on our behalf. Local banks can help to influence local regulation, which is invaluable - especially in countries such as India and China.”

Apart from influencing regulation, there is an expectation that relationship banks will also provide early warning of pending or proposed regulatory changes. In the current environment, with governments likely to be making more frequent changes to protect tax revenues, this was particularly critical. As a result, a corporation’s overall opinion of a banking partner tended to be heavily influenced by its perception of the bank’s regulatory relationship. If a bank was frequently in the headlines for infringing regulations it did not bode well for the quality of its regulatory relationships, to say nothing of the potential risk of ‘guilt by association’ in using that bank.

The discussion also highlighted the point that banks’ regulatory relationships needed to be part of a wider liquidity advisory role. It was seen as vital for treasury to be able to enjoy informed strategic dialogue with banks over liquidity and related matters, without the conversation continually straying back to bank products. Banks capable of this were perceived as delivering significantly greater value.

Customer liquidity risk

The liquidity implications of customer settlement risk have been a growing concern over the past eighteen months. In order to minimise this, some corporates have been keen to increase direct debit usage by their customers. As a result, there has been growing interest in bank outsourcing tools that relate to large-scale management of direct debit portfolios.

The ideal is to have a consolidated enterprise-wide picture of all customer direct debits that allows portfolio level metrics on risk exposure. This obviously also provides early warning of any likely defaults and liquidity shortfalls.

With liquidity tight, most corporates are experiencing opposing settlement pressure from suppliers and customers. Apart from attempting to shorten credit terms, more suppliers are requesting letters of credit and advance payments. On the other side of the fence, customers are seeking longer credit and discounts. In order to reduce risk and improve the balance sheet, many corporates are now far more inclined to discount outstanding invoices; either in the form of early settlement discounts given directly to customers, or bank invoice discounting (non-recourse where possible).

Bank liquidity risk

When it comes to investing surplus liquidity, the emphasis is now very much on SLY (security, liquidity, yield - in that order). In order to minimise the default risk of deposit taking institutions (as well as customers), treasuries have radically overhauled their risk profiling methods. The frequency of such profiling has increased significantly, with several forum attendees now monitoring their counterparties on a daily or intraday basis.

This increased frequency has been accompanied by a change in the data used. Conventional credit ratings are now largely seen as irrelevant by larger corporations, as they are far too lagging an indicator be of practical use. Stock prices, market caps, general daily news and (especially) credit default swap rates are generally seen as far more relevant for this purpose.

The major shift to the short end of the yield curve mentioned earlier also has a bank risk angle. Apart from wanting liquidity immediately available for business contingencies, treasuries want to be in short-dated instruments that can be quickly exited if the deposit taking entity starts to look unstable.

Apart from deposits, companies are also far more aware of bank risks relating to letters of credit and similar instruments. As a result it was increasingly common practice for corporates to discount these instruments with a bank that had passed their credit screening process and was regarded as trustworthy.

Conclusion

Current treasury liquidity strategies give an overwhelming but entirely understandable impression of extreme caution. Yield is of far less importance than it was, and in virtually every respect security and de-risking are the main priorities. Ultimately, treasuries are trying to ensure that as much liquidity as possible is immediately available to their organisation.

That aside, for corporations active in Asia, trapped cash and capital remain major priorities and this is where they increasingly look to their banks. Whether it is in encouraging more relaxed regulation to release existing cash or providing early warning of tighter regulation to avoid further cash/capital entrapment, banks are expected to deliver. With liquidity currently at such a high premium, those that do are likely to find themselves rewarded.