From the September Special Report issue of Treasury & Risk magazine

Rewriting the Rules: How New Financial Regulations are Expected to Impact Corporate Liquidity Management

In response to the financial crisis, regulators and governments worldwide have embarked on a series of measures designed to make the global financial system more robust. Two of the most significant measures are Basel III, which aims to strengthen the global banking system, and global Money Market Fund changes, including to Securities and Exchange Commission (SEC) Rule 2a-7, which are designed to better protect money market fund (MMF) investors. Both have major implications for corporate liquidity management and short-term investment strategies.

A large part of Basel III is focused on increasing the amount of capital banks are required to hold against certain assets. However, Basel III—which is due to be phased in over six years starting this year—also imposes liquidity requirements on banks. Both the capital and liquidity requirements of Basel III are designed to strengthen the banking system and should therefore increase corporations’ confidence in working with large banks. However, they are also likely to have consequences that companies need to anticipate. In particular, liquidity ratio requirements will change the value of different types of deposits placed with banks.

In the MMF realm, a series of reforms—following a one-year guarantee of MMFs to stabilize the market in 2008—have been introduced after the Reserve Primary Fund ‘broke the buck’ in the aftermath of Lehman Brothers’ collapse. For example, in 2010, amendments to SEC Rule 2a-7 aimed to strengthen MMF fundamentals by improving liquidity, reducing the quantity of lower-rated paper in MMFs and reducing the maximum weighted average maturity of portfolio holdings. The investment industry generally viewed these measures as positive and confidence boosting for MMF investors. However, more recent reform proposals have been less enthusiastically received. It is of concern to many that further measures intended to boost investor confidence in MMFs could have negative consequences for investors and the industry.

Liquidity Requirements Under Basel III

Basel III introduces two key liquidity ratios to strengthen supervision of liquidity risk: the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR). The LCR is designed to ensure that banks have adequate short-term liquidity and requires them to have sufficient high quality assets that can be sold to meet their requirements over 30 days. It is calculated by dividing the stock of high quality liquid assets by the net cash outflow over a 30 day time period under extreme market stress conditions. The LCR will be phased in from 2015. The NSFR has a similar objective over a one-year horizon but will not be introduced until 2018.

The implications of the LCR for short-term deposits are significant: different types of deposits will now be valued differently by banks. Under Basel III, insured retail deposits are most valuable (with an assumed 3% runoff ratio—that is just 3% of deposits can be expected to be withdrawn over 30 days). Insured corporations and financial institution (FI) deposits are slightly less valuable (with an assumed 5% runoff ratio) but given that FDIC insurance extends only to the first $250,000 in the US, such deposits represent a small category for banks.

For non-insured deposits, operating accounts (associated with cash management functions such as payroll and vendor payments, or custody activity) have a 25% runoff assumption for corporations, government entities and FIs. For non-operating accounts, such as short-term time deposits or savings accounts, there is an assumption that funds would be moved relatively easily should a stress event occur (as yield is often a priority for this type of cash), with a 40% runoff rate for corporations and government entities, and 100% for FIs. Finally, deposits with a remaining maturity of greater than 30 days will have a 0% run-off assumption.

The implication of these runoff assumptions, though they are subject to change, is that the rates received on non-operating cash are generally expected to fall while rates for a corporations’ non-operating cash should be largely unchanged. However, operating cash could become more valuable to banks than is currently the case. Consequently, banks are likely to develop a more holistic approach to client relationships in order to win clients’ operating balances. Incentives to encourage clients to maintain operating balances could include discounting fees to clients who are holding sizable balances or offering higher rates to clients who also perform payments and collections through the bank. Additionally, rates on long term deposits, including certificates of deposits and call accounts, are also likely to increase.

The Impact of MMF Reforms

Current reform proposals from the SEC for Institutional Prime MMFs include the introduction of a floating net asset value (NAV) based on the underlying value of securities in a fund. In addition, liquidity fees and redemption gates (to prevent mass withdrawal of funds during stress events), should a MMF fall below certain liquidity thresholds, are proposed.

The goal of the new reforms is to make MMF investments more secure. However, the introduction of a floating NAV, liquidity fees and redemption gates are likely to make MMFs less attractive to corporate treasurers. For example, a floating NAV will require corporations to mark their investments to market on a daily basis, and will expose investors to small, but more frequent, gains and losses of principal. They will largely eliminate one of the main attractions of MMFs: that they are stable and have a similar value to cash. Mark-to-market will increase accounting costs associated with MMFs and there may also be tax implications for gains and losses on MMF investments, although the Internal Revenue Service (IRS) has proposed changes to ease this impact.

Successive Association for Financial Professionals (AFP) surveys have shown that companies’ most important cash investment policy objective is safety of principal (75% of large organizations cited it in the 2013 survey). A floating NAV undermines that and raises the prospect of a loss of principal. Furthermore, the reforms also put liquidity—companies’ second most important cash investment policy objective (25% in the 2013 AFP survey)—at risk. It is important to note that no changes to MMFs have yet been approved, and given the numerous stages of the process, we anticipate that the earliest changes, if approved, would not be implemented until the second half of 2014.

Changing Investment Behavior

The combined effect of the introduction of Basel III and MMF reforms could be that corporations put more of their short-term cash into banks rather than MMFs. In contrast, FIs may obtain higher yields on short-term non-operating cash through MMFs.

Already there has been a substantial change in corporations’ investment behavior. In 2008, 25% of companies’ cash was in short-term deposits and 46% in MMFs.1 Now those statistics have reversed with 45% in short-term deposits and 29% in MMFs.2 Factors such as yield have contributed to this trend but regulatory change has undoubtedly been a driver as well. This trend is expected to continue. However, the MMF industry has a history of developing products to meet its investors’ requirements and it could yet find a way to attract corporate cash to new types of products.

In addition to putting more of their cash into short-term deposits, corporations may start to look at other types of investment strategies, such as separately managed or customized investment accounts. These types of accounts offer the potential for higher yield than MMFs (in return for reduced liquidity) while being tailored to the risk requirements and needs of the corporate.

Within the banking sector, there has been ongoing product development to reflect the changed value of various types of deposit to banks. For example, Citi® Liquidity Management Services plans to launch a call account with greater than 31 days notice to withdraw cash. Given the notice period and current interpretation, the account has a 0% runoff assumption in LCR calculations. As a result, Citi Liquidity Management Services is able to reward clients with a higher yield in exchange for reduced liquidity.

Similarly, Citi Liquidity Management Services has enhanced its cash management billing platform so it can reward higher balance clients with lower fees. Fees are tiered as an incentive to leave operating cash with the bank and encourage greater use of operating services. Banks are also enhancing their Earning Credit Rate (ECR) products (which offer clients fee offsets in lieu of interest, often at a higher rate than the interest would pay). Uniquely, Citi Liquidity Management Services allows its clients to offset a broad range of fees, including US and Western European Cash fees, Standby Letter of Credit and Custody fees, and expects to expand the range of transaction types that benefit from such arrangements in the future.

    1. Source: AFP 2013 Survey
    2. Source: AFP 2013 Survey

Michael Berkowitz, Citi

Michael Berkowitz
Head of Liquidity Management Services and Corporate Market Management
Treasury and Trade Solutions North America

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