Does The Risk Return Equation Still Hold?

Financial stresses can develop a life of their own, as the aftershocks of 2008 evolved into sovereign concerns. Various banks continue to face challenges, with questions arising from their own financial exposures and resiliency, coupled with increasing regulatory obligations. This has compelled corporates, even as their cash balances rise, to revisit their banking strategies, with increased emphasis on counterparty quality and contingency capacity. Fortunately, as David Li, Head of Liquidity, Asia Pacific at J.P. Morgan Treasury & Securities Services explains, there are still ways in which both risk and return can be managed.

Today's liquidity landscape

As Asia commands an ever increasing share of global trade, Asian business is similarly commanding a larger share of a company’s overall business. Such a phenomenon translates to companies building up a sizeable amount of cash in Asia. While corporate cash levels in the region may not have matched the current high levels in the US, they are still quite significant and material in the context of an average company’s balance sheet. With continued economic growth projected for Asia, cash buildup is expected to continue, even after taking into account the capital expenditures that will be needed to bring capacity online to support future growth.

The increase in cash balances has brought about a challenge for Corporate Treasurers. While surplus liquidity has increased, the number of safe havens in which to deposit it has declined. Since mid 2008, many banks have suffered multiple downgrades from all three major rating agencies, while some banks continue to face challenges in financial stress tests. As a result, some corporations are having to more deeply consider their positions on counterparty diversification and contingency.

Just as the risk landscape associated with liquidity management has become more demanding, so has the return landscape, impacting historical risk-return relationships. A major factor here is the monetary response to the 2008 financial crisis, in particular protracted quantitative easing. We have now seen an unprecedented period of near-zero interest rates in various major economies, accompanied by a general elevation of risk levels, and downgrades for previously pristine obligors and sovereigns. Whilst we are now seeing some tentative signs of growth in the US, the potential for stagnation in Europe impacting Asia growth remains.

The impact of this inclement economic backdrop on bank counterparties is exacerbated by the impending introduction of Basel III.

One of Basel III’s objectives is to ensure banks are better capitalized and resilient, a consequence being that banks will become far more focused on ensuring that they have a sticky funding base that is linked to operating bank activities, rather than funding from discretionary deposits or hot money. The key part of Basel III that affects their behavior is the liquidity coverage ratio (LCR), which will make the taking of short term deposits in isolation relatively unattractive. Therefore, corporates only offering short term liquidity without other business may find banks unwilling to accept these deposits or only prepared to accept them in return for unattractive rates.

This combination of a dwindling number of well-rated banks and the focus of banks on stable funding strongly suggests that both deposits and transactional business will become increasingly concentrated with a few better rated transaction banks.

How corporates are managing their risks

While Asia treasuries may not be able to directly influence macro factors such as monetary policies or banking regulations, they can modify their banking strategy to improve the risk/reward of their liquidity position and to shape their individual liquidity landscape.

Decision support and visibility

Liquidity shortages during the financial crisis prompted many corporations to refocus on improving the visibility and mobility of corporate cash. Therefore, solutions that can enhance access or returns on trapped cash are in focus in Asia Pacific.

As regards visibility for supporting informed decision making, corporations in the region continue to invest in treasury management and ERP systems. There is also growing interest in the functionality of bank reporting systems. However, financial pressures on some banks are sometimes impacting their ability and commitment to invest in these capabilities and we are seeing growing variations on banks’ commitments to invest and enhance their offerings.

Transaction banking and especially cash management is a scale business. The cost of investing in technology platforms and maintaining full-service branch networks are becomingly prohibitively expensive, and while making such investments is good business sense, fewer and fewer banks are able to afford it. Only those with sufficient capital and robust balance sheets are able to do so. Corporates, in their quest to increase visibility and control over their cash, will be better off working with banks which have the same vision, and most importantly, capability to support their vision and initiatives. Ultimately, any improvement in visibility and control of cash will lead to better and more accurate cash forecasting and the potential to improve risk adjusted return, as it allows treasuries to better segment their cash balances among operating, surplus, strategic and reserve cash.

Interoperability

In terms of banking and clearing infrastructure, Asia Pacific is relatively fragmented. In certain countries it may therefore be necessary to use local banks to provide sufficient coverage or specialist services. This immediately raises the question of interoperability between these local banks and the corporation's primary banking partner.

SWIFT is top of mind in any discussion on connectivity and interoperability. However, in
J.P. Morgan's recent Asia Pacific Corporate Treasury Benchmarking Study, 66% of respondents stated that they did not currently use nor plan to use SWIFT in the next 12 months. Such a response appears counter intuitive. However, the reason could be due to the fact that a smaller number of banks in the region have the necessary capabilities and also because the cost of maintaining SWIFT corporate access may make commercial sense only where transaction volumes are sufficiently large. As such, SWIFT corporate access may currently be limited to the very largest corporates.

As the pressure grows to improve liquidity capture and mobilization, this inevitably throws the spotlight on the delivery of automated multi-bank overlay structures. As the tools/techniques readily available in other regions may not be as prevalent here, achieving the right structures in Asia Pacific is heavily dependent upon selecting a primary banking partner with the right technology and mindset.

Therefore, if a treasury is consolidating liquidity and transactional activity to a better-rated bank, it is vital to choose one that is experienced at collaborating on a SWIFT and non-SWIFT basis across the region.

Good. What about the returns?

What is the incentive then, for a corporate to bank with the lower interest-paying bank? One attraction could be earnings credit rates (ECR).

With all the right moves undertaken by corporate treasurers, they would be expecting some decent returns for their effort. Corporate treasurers may be disappointed if they expect pre-2008 levels of return. However, what may be a revelation is that there are marked differences in rates across what was once a uniform landscape of global financial institutions. For example, where USD deposit rates used to be markedly similar across the similarly-rated global financial institutions across the various countries, divergence has appeared in certain markets. Such divergence has also appeared in other currencies in certain countries as well. This could mean that some financial institutions are lacking deposit bases.

What is the incentive then, for a corporate to bank with the lower interest-paying bank? One attraction could be earnings credit rates (ECR).

In view of Basel III and the need for LCR-friendly products, it is likely that the use of ECR1 approaches (which adopt less direct ways of compensating clients for balances) will increase. At a basic level, these approaches include interest optimization, but the consolidation of both deposits and transaction banking business with well-rated banks opens the door to alternative hybrid instruments. A very simple example is a short term deposit that may have a low headline rate but that if not withdrawn within a certain period additionally attracts a rebate on transaction banking fees, resulting in an effective higher rate on the deposit.

The logical extension to this is for the fee rebate to be granted in an area outside cash management, such as FX. However, only a select few will be able to provide these products because the internal structure of most banks will raise issues over which unit will bear the cost of the subsidy - a point that will be especially problematic with global clients.

1 Where local regulations allow for such offerings

Conclusion

The management of counterparty risk is becoming more important among corporates, and is commanding an increasing amount of attention as part of their treasury and risk management. Over time, corporates will naturally move towards a more objective risk-assessment model, and will therefore be re-assessing financial counterparties and their own processes.

The second aspect of counterparty risk is ensuring that once corporate cash is at the desired bank it achieves an acceptable risk/return trade-off. That requires an insight into the way banks will be reacting to pending regulation and a willingness to realign corporate thinking to take best advantage of the shift.

A common theme in both these areas is choice of provider. While credit quality will be a major factor in this, it is by no means the only criteria. For treasury to remain competitive in the new liquidity landscape, it requires a provider with a global and flexible mindset that can square the risk/reward circle in these challenging times.

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