The 2013 guide to Liquidity Management: RBS – Beyond compliance: Strategies for a post-Basel III landscape

Basel III reforms imposing stricter capital and liquidity requirements on banks may significantly reduce their ability to lend to clients. As a result, lending rates are expected to rise and a significant amount of liquidity may be removed from the market. Releasing trapped cash

In light of this, post-Basel III, companies will need to maximize internal liquidity to reduce their reliance on other sources. The need to release trapped cash will therefore move higher up the treasurer’s agenda. Trapped cash, most significantly, prevents companies from using surplus funds they hold in one part of the world to offset their borrowing elsewhere. It can also restrict key strategic investment decisions and impede global plans for a business’s growth, by keeping cash within the country where it was generated. In this context, strict rules on releasing funds from emerging markets – where many companies have invested heavily – are a major roadblock.

Broadly speaking, cash may be trapped in some parts of the world due to local or external factors, or the firm holding minority shares in that market. Limitations on certain financial structures, regulatory insistence on compulsory reserves for loans and deposits, or tax implications for financial transactions, are all key factors. External causes include restrictions on investing abroad or intercompany lending, controls on converting and transferring currencies and high withholding taxes on dividends paid.

Opportunities as well as challenges

The good news is that cash previously caught behind a country’s borders is becoming more accessible. Regulatory reforms dealing with the issue in countries such as China, India, Russia and Turkey are easing the cross-border flow of funds and helping companies ensure strong liquidity management across their business.

For example, companies in India are now able to lend money to their overseas subsidiaries, as long as it doesn’t exceed 400% of their net worth. Central bank-approved pilot schemes in China that target cross-border intercompany lending (in both renminbi and foreign currencies), and cross-border netting, are enabling firms to tap into internal sources of liquidity and reduce funding costs. To ensure they manage their liquidity in the best way possible, companies need to understand fully what these reforms can enable and how they can use them in a way that facilitates liquidity and easier cash flow across their global operations.

At the same time, companies can also benefit from financial structures designed by banks to help clients manage their global currency positions. These include cross-border cash optimization and cross-currency notional pooling, both of which drive greater value from cash balances that would otherwise remain trapped in either the affected jurisdiction or a subsidiary.

Realizing the benefits – a case study

Maximizing the value of trapped cash involves managing cash across borders, while maximizing liquidity throughout the business and aggregating balances to drive improved returns.

One RBS client – a leading provider of wireless technology and services with global operations – was looking to do just this. Of particular concern was how to enhance the management of, and interest result on, its growing portfolio of local currency accounts. The treasury team was looking for a way to increase the interest earned from its operating balances, without losing the convenience of local accounts or entering into complex pooling structures. This was achieved by using our Cross Border Cash Optimization (CBCO) solution, part of our wider award-winning liquidity offering, a far less labour-intensive and more cost-effective alternative to sweeping balances into notional pools according to region and currency.

Without having to centralize accounts to a single location, CBCO automatically adds up the different balances and uses the total – notionally converted into an agreed base currency – to calculate a bonus interest payment. This benefit is paid monthly in the currency of the company’s choice, in addition to the monthly interest earned by each local account.

The company can now enjoy the interest rate advantages of a single account, together with the practical benefits of local accounts, while minimizing the time and resources needed to fund its local operations. Of course, this is just one of the solutions available, and the needs of each company should be carefully understood, through working with banking, tax and legal partners, before taking action.

Any approach to releasing trapped cash needs to be tailor-made to the company and the regulations involved. For example, it requires in-depth analysis of the relevant countries’ laws, the business’s organizational structure and its tax set-up.

Companies need to work with banks that have both the global reach and the local expertise to help them address local conditions and regulations, so that they can simultaneously minimize their trapped balances and maximize their liquidity and working capital efficiency.

Businesses that really grasp all of this, and work with their banking partners to align their bank’s solutions to their strategic plans, will find themselves a big step closer to managing their liquidity in the most efficient and effective way.

Regulatory reform and investment returns

Once trapped cash has been released, the potential to generate investment returns is significantly enhanced. Yet, here again, regulatory reform will have a major impact. Under Basel III, new liquidity rules could increase the cost of cash management and dent returns on corporate deposits.

The rules, updated in January 2013 and due to be phased in from 2015, are designed to ensure banks have a sufficient cash buffer in place to cover withdrawals in a stress situation. While January’s announcement actually lightened some requirements, the Basel III method for calculating this buffer – the Liquidity Coverage Ratio – is still based on somewhat conservative assumptions for corporate deposits. As a result, corporate deposits in general are likely to attract relatively lower returns than in previous years.

Some potential good news is that the Basel III liquidity coverage rules apply to cash that can be withdrawn within 30 days. This will potentially drive banks to offer new products and services/pricing models to encourage contractual terms longer than 30 days.

Another key factor in the new regulation is the split of deposit types into operational or non-operational. According to Basel III, corporate operational deposits can relate to payment clearing arrangements or to a company’s working cash used for payments, collections and the day-to-day running of its businesses. Operational deposits are considered ‘stickier’ because companies use the money constantly and are likely to keep doing so, even if unforeseen events occur. Non-operational deposits involve ‘surplus’ money that is not needed for immediate daily activities. Businesses tend to use these for liquidity purposes or short-term investments and they tend to be more rate-driven.

The interest rate a company gets on a deposit will be heavily influenced by which of these two categories it falls into, so it is vital that both banks and businesses fully understand the regulator’s definition of them. The complex set of tests required to classify deposits could result in some of them being classified as non-operational, even if the money is used for day-to-day purposes. For example, if the bank cannot clearly articulate what portion of the balances on an account is operational, or if the interest rate offered appears to encourage surplus cash being placed in that account, the regulator will classify it as non-operational – costing the bank more.

In terms of the amounts involved, Basel III requires banks to hold a liquidity buffer against 25% of all their corporate operational balances. The January announcement reduced the non-operational balance requirement to 40%, down from 75% previously – another positive change. In both cases, however, these percentages may represent an increase from what is required under current, local liquidity requirements.

The new landscape means that companies will need to take a broader, more holistic approach to their banking relationships when managing cash, to ensure a mutually beneficial partnership. It may also encourage firms to spread their business across fewer banks – a challenge, considering the trend in recent years to work with more banking partners to spread counterparty risk.

Although some of the finer points are yet to emerge, the imperatives facing corporate organizations are clear. To get the best value overall, businesses need to review their core banking relationships, fully understand the regulator’s new deposit definitions and be more vigilant than ever in their cash flow forecasts and account structures.

Outlook

Basel III presents treasurers with a number of challenges, many of which are yet to be fully defined. Yet it is already clear that both liquidity and investment return rates are likely to be negatively impacted. Understanding how to leverage regulatory reforms to release trapped cash, and then manage it effectively across borders, is therefore vital to improving both liquidity and investment returns in the post-Basel III environment.