Cash Flow Management in a Basel III World

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1 SEPTEMBER 2012 Cash Flow Management in a Basel III World Table of Contents Cash Flow Management..2 Achieving Cash Efficiency..2 Forecasting is Critical...3 Balancing Security, Liquidity and Yield...4 Time for a Reassessment..4 EXECUTIVE SUMMARY Basel III is a regulation that principally targets the banking sector and consequently attention has been focused on its impact on banks. However, the implications of Basel III are no less profound for companies. In particular, Basel III will change how their deposits are treated in terms of banks run-off ratio and collateralization. These changes could have implications in terms of banks ability to offer meaningful returns on corporations longer-term investment cash in particular. As a result of these changes, companies will have to rethink how they invest their surplus cash in order to obtain acceptable yields while ensuring they have the liquidity and level of security they require. Additionally, corporations must make sure that their cash flow management in particular cash flow forecasting moves cash through the company efficiently and predictably in order to facilitate efficient use of surplus cash.

2 Cash flow management in a Basel III world 2 CASH FLOW MANAGEMENT The link between Basel III and companies cash flow management is not immediately obvious to many corporate treasurers. It is widely appreciated that Basel III is one of the most important regulatory changes to have emerged in recent years as governments, central banks and regulators work to bring greater stability to the global financial system. However, the general perception is that the impact of the regulation s principal measures increased capital reserves, improved liquidity and restricted leverage will be isolated to the banking sector. In reality, the impact of many Basel III measures are already being felt by companies as banks change their operational behavior in advance of the start of implementation in Perhaps the most important impact of Basel III for companies relates to changes in the treatment of companies deposits in terms of banks run-off ratio and collateralization (with cash, sovereign debt or other high grade securities) requirements. Specifically, while short-term operating cash will become valuable to banks (as it only requires 5% collateralisation), longer-term investment cash will be less sought after by banks, as it requires collateralisation of up to 100% depending on the type of firm and deposit. As a result, yields on deposits for investment cash which are already historically low because of low interest rates are set to remain low to offset the associated capital costs for banks. Companies in search of acceptable yields will have to find new investment options. Given the huge cash balances many companies have built up during the uncertain economic environment the top 50 Global companies have around $1.9 trillion in cash how this cash is recycled and invested is of crucial importance. ACHIEVING CASH EFFICIENCY The most important tool in addressing the challenges posed for companies by Basel III is cash flow management. To be sure, most corporations cash flow management has improved significantly in the period since the onset of the financial crisis in The seizing up of credit markets meant that conserving and recycling internal liquidity became paramount for all companies and visibility and control of liquidity became watchwords for every corporate treasury. Now in the Basel III world, corporations must redouble their cash flow management efforts and make sure they can account for every dollar of liquidity. Centralisation and consolidation through automated liquidity structures such as physical cash concentration and notional pooling structures continue to Under Basel III a company s short-term operating cash will become valuable to banks as it requires 5% collateralisation, versus 100% which will be required for longer-term investment cash depending on the type of firm and deposit.

3 Cash flow management in a Basel III world 3 be at the heart of any efficient cash flow management strategy. However, it is important for companies to take a holistic view of their liquidity management and some banks offer a range of additional services such as enhanced payable/receivable management, multilateral and multicurrency netting, FX deal monitoring and execution services/exposure management and intercompany loan administration that can deliver significant benefits in terms of efficient working capital management. While sophisticated liquidity management structures and technologicallyadvanced solutions such as multilateral and multicurrency netting have an important role to play in improving liquidity management, it is the routine task of cash flow forecasting that plays the most crucial part in facilitating companies response to the new environment ushered in by Basel III. Only by knowing where their cash is and when it will be needed can companies make sure that they use it efficiently. As companies look for more attractive investment options for their longer term investment cash than traditional bank deposits, clear insight into cash flow will be indispensable. FORECASTING IS CRITICAL One reason for the increased importance of cash flow forecasting in the Basel III era is that a possible destination for investment cash following the introduction of the regulation will be longer-term deposit accounts, which will benefit from lower collateralisation requirements for banks. Over the last 12 months a number of banks have developed Basel III compliant products such as notice accounts, evergreens and stable deposit accounts with tenors or notice periods of 90, 120 and 180 days. Necessarily, locking cash up for long periods requires a corporation to know with certainty that it will not need immediate access to that cash for the tenor or notice period. That knowledge is only possible if an effective cash flow forecasting model is in place that clearly segments cash into defined liquidity buckets. During the 2008/2009 crisis, some companies ran short of cash and were unable to gain access to credit or break their deposits to undertake some day-to-day tasks such as paying their employees. Every company has a responsibility to ensure its cash forecasting is accurate to prevent such a calamity. Cash flow forecasting will be increasingly important as banks develop longer-term deposit accounts that benefit from lower collateralisation requirements for banks. Locking cash up for long periods requires a corporation to know with certainty that it will not need immediate access to that cash for that period of time. At the same time as companies may decide to lock up deposits for longer in order to gain higher yields, they are also looking at options to increase their investment in short-term government bonds, commercial paper, other marketable securities and most importantly in money market funds (MMFs). Such funds, which are typically AAA-rated, are already an important investment instrument for

4 Cash flow management in a Basel III world 4 corporate treasurers but their attractiveness will increase markedly following the introduction of Basel III as banks seek to push investment cash off-balance sheet. Investing in MMFs does not generally carry the same sort of liquidity risk as longer-term deposits: many MMFs have daily access to funds and even enhanced products have notice periods of no more than a few days. However, MMF investments do potentially carry greater risk than deposits. Firstly, there is counterparty risk associated with the fund provider. Secondly, MMFs also expose an investor to the credit risk of the underlying securities in a fund: companies need to do their own due diligence rather than just relying on ratings. BALANCING SECURITY, LIQUIDITY AND YIELD Only once a company has a full understanding of its cash flow and liquidity requirements is it in a position to be able to invest surplus cash. In order to effectively manage the risk associated with any investment, companies must devise and follow a clear investment policy that incorporates their requirements for liquidity, investment horizon and appetite for risk as well as the availability of resources to manage that investment. A central focus of any investment policy must be the understanding that every investment decision is a balance between security, liquidity and yield. Increased potential returns inevitably require an investor to accept a higher risk in the form of either lower security or less liquidity. A clear investment policy incorporates a company s requirements for liquidity, investment horizon and appetite for risk as well as the availability of resources to manage that investment. Understanding the balance between security, liquidity and yield has become increasingly important as companies begin to focus more on yield. During the post period, most companies placed the greatest emphasis on security and were happy to accept low returns. Now the weight of cash on many companies balance sheets means companies are ascribing greater importance to yield. As a result, some corporates have begun to place some cash with lower-rated, second tier banks that offer a higher return because of their requirement for cash. Making such investments may be a valid option for some companies. However, they must be made in full acknowledgement of the risks being taken and within the bounds of a carefully considered investment policy that accurately reflects the risk appetite of the organization. TIME FOR A REASSESSMENT The changes in the banking world in response to Basel III will have important consequences for corporations cash flow management and investment strategy. While Basel III may seem remote to the day-to-day tasks associated with cash

5 Cash flow management in a Basel III world 5 flow management, it should prompt companies to re-examine their existing working capital and liquidity arrangements. Most importantly, it should encourage treasurers to work with their banking providers to seek improvements in the core task of cash flow forecasting. As part of a concurrent review, treasurers must also take a fresh look at their companies investment policy. Circumstances have changed in recent years few banks are now AAA-rated for example and it is important that any investment policy reflects such changes. Most importantly, any reworking of an investment policy must consider a corporation s liquidity requirements and its risk appetite. Understanding the compromise between risk and reward has always been critical when making investment decisions but as the liquidity and investment environment evolves in response to Basel III, it will become even more important. Bank of America Merrill Lynch is the marketing name for the global banking and global markets businesses of Bank of America Corporation. Lending, derivatives, and other commercial banking activities are performed globally by banking affiliates of Bank of America Corporation, including Bank of America, N.A., member FDIC. Securities, strategic advisory, and other investment banking activities are performed globally by investment banking affiliates of Bank of America Corporation ( Investment Banking Affiliates ), including, in the United States, Merrill Lynch, Pierce, Fenner & Smith Incorporated and Merrill Lynch Professional Clearing Corp., both of which are registered broker-dealers and members of FINRA and SIPC, and, in other jurisdictions, by locally registered entities. Investment products offered by Investment Banking Affiliates: Are Not FDIC Insured May Lose Value Are Not Bank Guaranteed Bank of America Corporation BA-AD-0305ED