Corporate treasuries are managing historical levels of cash. Cash balances for the Standard & Poor’s (S&P) 500 easily exceeded US$1.5 trillion in the third quarter (Q3) of 2016; the highest level in at least 10 years. Treasuries continue to stockpile cash as uneven global economic growth challenges corporate ability to strategically deploy cash. While there is cause for optimism, particularly at the prospect of tax reform in the United States, behaviour remains cautious and stuck in the status quo.
Many companies choose to hold the bulk of their cash with overnight liquidity and without price risk, which greatly reduces the eligible instruments for investment. According to a recent survey by the US Association for Financial Professionals (AFP), companies are keeping more of their cash liquid, and among liquid instruments, have a strong preference for bank deposits over similarly liquid money market funds (MMF) or treasury bills.
Corporate preference for bank deposits
Various market factors and regulatory responses challenge this preference for bank deposits. Banks are placing strict limits on their appetite for bank deposits due to Basel III liquidity coverage ratio (LCR), and the leverage ratio, which may require banks to hold a percentage of the deposit as cash at a central bank – or a similarly low risk and low-yielding asset. Banks must then hold a certain amount of capital against these assets, the cost of which may exceed the value of the deposit. In addition, negative interest rates in Japan and across Europe further limit a bank’s ability to accept deposits.
Source: AFP 2016 Liquidity Survey
Corporate treasurers face their own restrictions on bank deposits through the counterparty limits within their investment policies. These limits do not necessarily align to the banks’ appetite, which may result in a paradox where the bank you want to place deposits with will not accept them – and the bank that will accept them has restrictions in your policy.
For many treasurers, the counterparty limit is determined through a risk analysis that incorporates multiple factors. The most frequently-used of these is the long-term or short-term unsecured debt rating of an internationally-recognised rating agency such as S&P, Moody’s or Fitch. It is becoming more common to incorporate senior unsecured credit default swap (CDS) spreads as well. As both debt ratings and CDS spreads measure senior unsecured debt credit risk, they do not provide an accurate reflection of the risk specific to your deposit when senior unsecured debt and deposits have different credit standings under bank insolvency rules.
Regulators are increasingly treating debt differently than deposits. In addition, while using a single-name CDS spread is often viewed as a helpful market-driven barometer of counterparty risk, certain CDS instruments are volatile, prone to broader market movement and may be too thinly traded to provide a meaningful measurement of risk. While these metrics might have served a purpose in the past, investment policies need to evolve to ensure treasuries fully understand the counterparty risk in order to place deposits efficiently and safely.
Now there is a metric to analyse deposit risk across your counterparties without the need to use debt-related metrics as a proxy. The rating agencies, specifically Moody’s and Fitch, have responded to new regulations affecting deposit and debt risk by introducing the deposit rating.
What is the deposit rating?
Recognising a need to distinguish where deposits sit in the risk spectrum, the rating agencies have developed a methodology specifically focused on deposit risk. The rating represents the banks’ ability to fulfil depositor obligations within a period, and like debt ratings are split into a long-term as well as short-term classification.
You may not be using them today as they were recently introduced; Moody’s revamped the deposit rating methodology in 2015, while Fitch established a deposit risk methodology and introduced it at the end of 2016. In December, S&P announced they are formulating a rating methodology that will incorporate subordinated and non-subordinated debt for 2017. Another reason adoption has been relatively low compared to debt rating is that the Moody’s deposit rating, which has the longest track record of publication, often tracked the long-term debt rating, minimising a need to incorporate the deposit rating. However, recent developments have caused a shift in how regulators are treating debt and deposits, and this has resulted in a divergence in the ratings.
For example, in September 2015, Germany passed the German Resolution Mechanism Act, creating a new statutory hierarchy of claims within the senior creditor class that applies retroactively to all outstanding liabilities, modifying the ranking of liabilities beginning in 2017.
These changes created two statutory classes of uninsured, senior unsecured liabilities, whereby deposits – along with derivatives and money-market instruments – rank senior to vanilla senior debt. The objective of the regulation is to shift the burden of possible bank rescues away from taxpayers to creditors and investors by putting them on the hook for losses, otherwise known as “bail-in”. By subordinating senior debt to other liabilities, deposits are insulated if there was a bank default. This cushion provides deposits a lower vulnerability to default and potentially superior recovery prospects as well.
The German BaFin (Federal Financial Supervisory Authority) wrote the legislation in accordance with the European Union’s Bank Recovery and Resolution Directive (BRDR), a centerpiece of the EU’s response to the financial crisis. It is expected that other EU states will craft similar “bail-in” laws, which will be tailored to their respective sovereign laws and affect the debt and deposit rating of banks in those locations.
Following the legislation, Moody’s conducted a comprehensive review of 35 German banks, of which the deposit rating for 22 banks was upgraded by two notches. The upgrade reflects the increased security depositors now enjoy compared to the previous position in an insolvency event. Also in response to the legislation, Fitch chose German banks as the first institutions to implement the newly formed deposit rating, developed only six months earlier.
As might have been expected, the rating agencies also responded to the subordination of debt by downgrading the long-term debt ratings of many of the 35 reviewed banks. In many cases where deposit and debt rating were assigned the same rating, there is now a three-notch difference – a material differentiation of risk. CDS spreads were also affected and, as expected, increased the now subordinated senior unsecured debt.
|Bank||LT Debt Rating||Deposit Rating||Notch Difference|
|UniCredit Bank AG||Baa1||A2||2|
|DZ Bank AG||Aa3||Aa1||2|
This divergence between deposit and credit rating is conceptually similar to the debt rating split observed for many US banks that have a division between the holding company and a federally insured deposit taking operating company. The deposit- taking entity typically has a higher rating than the holding company. For many of these institutions, corporates have looked to the rating of their direct counterparty holding the deposits, which is typically the operating company.
European banks may not follow a holding company/operating company structure, but there is now a parallel in the increased deposit risk protection from the bail-in rules and a consequent rating split between subordinated senior unsecured debt and deposits. In both cases, companies should be looking at the most appropriate metric to best gauge the risk of their counterparty.
How should the deposit rating be incorporated?
As debt and deposit ratings diverge, companies using senior unsecured debt as a proxy for deposit risk are measuring a distorted assessment of their banks’ counterparty risks; potentially creating unnecessary constraints in deposit decisions. Treasurers have begun reviewing their counterparty analysis metrics to ensure deposit ratings are incorporated and contributing to an accurate reflection of the risk tolerance for their bank partners.
How the deposit rating is incorporated will depend largely on the level of discretion an organisation has in revising the investment policy. For many, these documents are onerous and difficult to change, requiring the board of directors or an investment council approval. In the cases where the risk methodology cannot be readily updated, treasurers may pursue an exception to a counterparty limit, for instances where a higher threshold would have been available had the deposit rating been applied.
For treasurers who can update the investment policy, they will need to be mindful of how different major rating agencies address depositor preference through their ratings. As discussed, Moody’s, Fitch and DBRS provide a deposit rating, which can replace or supplement the current senior unsecured debt linked metrics. S&P is in the process of updating its issuer rating and senior debt rating to contemplate bank bail-in rules, which when complete, should be reviewed as well.
As many companies conduct a counterparty analysis that incorporates multiple metrics, one strategy is to introduce the deposit rating into the risk analysis and perhaps weight it more heavily toward the overall risk score compared to metrics that measure debt credit risk (debt ratings, and CDS spreads). As the deposit rating grows in adoption and the divergence in ratings continues between debt and deposit, then the weighting on deposit toward an overall counterparty risk score would increase or replace debt driven metrics all together.
Helpful step forward
Risk management continues to be a critical pillar of the investment policy and more than ever treasurers need a precise and accurate understanding of counterparty risk to ensure cash is safely and efficiently deployed. As the risk landscape evolves, the means by which risk is identified and analysed must also continue to evolve and be refined.
With the issuing of the deposit rating, the rating agencies are providing a key component that should be incorporated to gain a more comprehensive understanding of risk. This is a helpful step forward and one that more companies are recognising and utilising within their risk analysis.
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