Risk versus Return in a Period of Change

Q (gtnews): US and UK interest rates have been at record lows for more than six years; while eurozone rates reduced to the same level more recently they may well stay unchanged for longer. Do you have a detailed picture of how your corporate clients have responded to this low-rate environment?

A (Suzanne Janse van Rensburg): Absolutely. Corporates will always seek to find the balance between security liquidity and yield that meets with their business strategy, risk appetite and investment policy – the order of priority which each company places on these will drive how they respond to the low interest rate environment.

From speaking to corporates – where they are being charged – it appears that some seek out other counterparties that are not charging and placing their balances there. To give an example, one corporate client has moved to a local in-country bank. However for some clients this means that they may be losing visibility of their cash as they may not have a broader relationship or electronic banking platform from that counterparty, it may also mean that they have to manually move funds to that provider.

It will be interesting to see just how things unfold in Europe over the near term as implementation of the Basel III regime doesn’t take place until October 1. Until then, it is all well and good as the liquidity coverage ratio (LCR) requirement hasn’t yet been implemented in Europe. When it is, we may well see a change and more European banks move towards charging.

However, some European banks will have funding gaps in these currencies – where that is the case in order to fund that gap they may hold deposits at 0% rather than charge. It is, however, important to note if the market moves towards charging these banks may find themselves awash with these currencies and may then still need to charge.

Corporates understand that this is the environment in which we are now operating. Many have chosen to continue to hold their deposits where they are and build in the cost of business. Other corporates are revisiting their investment policy and considering going out the curve or taking on more risk in order to avoid being charged or in a small number of cases receive a return.

Other corporates are revisiting their investment policy and considering possibly going out the curve, taking on more risk in order to avoid being charged or, in a small number of cases, receive a return.

Whether a bank passes on negative interest or a deposit fee to clients really depends on several factors, which include:

  •  Balance sheet requirements – do they have a funding gap?
  •  Is the bank a direct clearer of that currency(ies)?
  •  What steps can the bank take to mitigate the charge where possible?
  •  Technically, are they able to do it?
  •  Legally, can they do it?

Are the low returns on many investments encouraging treasury departments to consider allocating some money to those with greater risk, but more attractive returns?

Yes, that’s very much the case and it’s all down to a change in mind-set. Pre-2008, typically short-term was seen as being one month, medium-term was up to 12 months while long-term was more than 12 months. In today’s changed environment, one month now counts as long-term. Basel III and the LCR will further drive this change.

The main ways in which negative yields are being managed are arguably through extending duration and keeping credit risk the same, or by keeping duration the same and going further down the credit structure to take on slightly more risk. Treasurers are using both methods for different buckets of their liquidity, depending on their cash forecasting ability. Some are focusing on a “barbell” strategy whereby they maintain a higher proportion of lower-yielding – sometime negative – investments, combined with a small portion invested longer-term and with higher risks (often maximising other currencies they hold too) to offset the negative returns in euros.

Some corporate clients are revisiting investments that they abandoned in 2008 or shortly after. The trend is likely to continue; indeed we’re only at the start of it. Some treasurers are now considering unrated money market funds (MMFs) for a portion of their liquidity, offering T+1 to T+3 day access to cash as opposed to same day, along with slightly higher yields. Generally, there is something of a mix in what’s happening and the differing responses adopted.

Another example of the above, which remains popular but is starting to become harder to find, is longer-term structured deposits with notice periods. Some of these term deposits (TDs) have maturities out to five years.

In addition, management has become increasingly more involved since 2008 in determining the corporate’s risk appetite – particularly if this involves either taking on something new or deciding to assume a greater degree of risk than before. Board members participate more in the decision making and agreeing exactly which products should be considered.

What advice would you offer treasury departments on how they navigate these exceptional conditions?

There are a number of different actions that corporates can consider and underpinning each of them is the need for regular communication with their banking partners. Any balances outside of business as usual (BAU) operational flows in negative central bank currencies should be pre-notified to ensure the bank can help reduce or mitigate the associated costs.

They should regularly review their investment policies, considering both their company’s risk and tenor appetite, as well as considering the following points:

  • Is there a need to implement jurisdiction-specific and/or currency specific investment policies?
  • Could diversifying across other banks enhance yield? This will be particularly important one Basel III is implemented and they start building in the LCR.
  • Discuss or consider if it is appropriate to limit operations in negative interest rate jurisdictions and/or certain currencies.
  • Is repatriation or paying down debt a better alternative to holding deposits?
  • Can relationship banks offer interest optimisation or cross currency enhancement products that can help mitigate the impact of negative rates?
  • Could core banking relationships be leveraged to better effect?

There is also evidence of some ‘thinking outside of the box’, such as in supply chain finance (SCF) where some corporates are reviewing new and innovative options. Having said that, there is unfortunately no ‘silver bullet’ and for some stronger currencies you have to go to as much as nine or 10 years even to get only zero yield.

It’s a very interesting environment to be operating in, whether you are a corporate or a bank – although one that’s only challenging for the corporate if their bank isn’t able to support them.

We mentioned board members’ greater involvement in decision-making; of course getting their approval takes time, so treasury should start planning as early as possible, particularly as the market in a number of currencies has been highly vulnerable. It doesn’t matter if the policy that is approved ultimately doesn’t get used – the important thing is to ‘get all your ducks in a row’.

Trade Finance: Thoughts on Supply Chain Finance and Secondary Trade

Supply and sales chains: a return source?
Supply chain finance (SCF) activity has seen a huge increase in recent years. In the vast majority of cases, corporations prefer to have a third party – typically a bank – provide the funding, but for those awash with surplus cash, self-funding can generate substantial and predictable returns. Furthermore, where financing is only provided on the basis of approved invoices, the risks are low.

On the flip side, it may also be possible to generate returns from small and medium-sized enterprise (SME) customers in a similar manner by formalizing the practice of charging interest on late payments. For those concerned with credit risk, an alternative might be to charge a premium over and above the cost of trade credit insurance to reflect any extended settlement terms allowed.

Secondary trade
The redistribution of trade finance transactions has grown dramatically in recent years. While much of this is still conducted on a bank-to-bank basis, a growing number of other financial institutions are also becoming involved. By the very nature of their role, many corporate treasurers are already far better qualified as potential investors in the secondary market for trade finance.

In line with the underlying transactions, these repackaged trade transactions have a predictable life cycle and risk profile. Furthermore, risk can often be tailored to specific appetites since many trade finance redistributions are sliced into various risk/return tranches.

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