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Getting the most out of your liquidity under new regulations.

When it comes to the impact of new banking industry regulatory measures, Basel III perhaps leads the pack. regulators and governments around the world have begun to institute a series of measures intended to make the global financial system more robust. To date, 18 countries have final Basel III rules in force. Separately, the European Union has mandated implementation for all member countries, of which 9 have completed. at the same time, the Basel Committee continues to work on liquidity risk monitoring and operational risk capital requirements, which will be phased in over the next half decade or so.

One of the principle objectives of Basel III is to increase the amount of capital that banks must hold relative to their assets. additionally, banks will need to hold a certain percentage of those assets in high quality, liquid categories. these capital and liquidity requirements are intended to strengthen the overall banking system to withstand a possible future market stress event.

The Basel III measures that are already in place have major implications for corporate liquidity management and short-term investment strategies. Deposits which are linked to core underlying cash management operating activity will become more favorable from a regulatory perspective, whereas non-operating cash will be viewed by banks as less favorable in an increasingly constrained balance sheet environment.

At the same time, Basel III may impact an organization's ability to raise capital. For example, because Basel III is focused on capital metrics that use risk-weighted assets as a denominator, the provision of credit to non-investment-grade companies may become more expensive. In addition, committed liquidity and credit facilities to all clients will require banks to hold additional high quality liquid assets (e.g. US treasury Bills) and hence may also become more expensive. this makes it important that corporate treasury professionals fully understand the implications of regulations on banks and how they will impact their liquidity management and short-term investment decisions.

Liquidity Coverage Ratio: The Changing Value of Deposits

As Basel III's intent is to help ensure that banks are adequately capitalized in a potential stress scenario by putting strong liquidity and capital buffers in place, the resulting liquidity ratio requirements are dramatically changing the value of different types of deposits, and creating critical consequences for corporates. the Liquidity Coverage ratio (LCR), which went into effect starting at the beginning of this year, will be phased in over time. the minimum LCR will gradually rise from 60% to 100% in increments of 10% per year, with the final phase completed globally by January 1, 2019. the U.S. is currently on a faster timetable that calls for completion by large banks no later than January 1, 2017, although the largest banks are striving to reach this level as soon as possible, if they have not already.

The LCR is a short-term indicator that specifies for banks to have an adequate level of unencumbered, high-quality liquid assets (HQLA) which can be converted to cash in order to meet liquidity needs for a period of at least 30 days. For banks, the LCR is determined by dividing the stock of high quality liquid assets by the net expected cash outflow over a 30 day time period under highly adverse market stress conditions.

The net effect of the LCR is that deposits will be treated differently by sector and deposit type, manifested through different runoff assumptions. In particular, banks will view operating deposits, which are defined as funds that facilitate transactional flows, as more favorable. Operational services include cash management functions, such as payments, collections, and aggregation of funds, as well as clearing and custody activities.

Understanding How Short-term Deposits Will be Valued

Under Basel III, short-term corporate and institutional operating balances will have a 25% runoff, which means that 25% of the deposits are likely be withdrawn over 30 days in the event of extreme market stress. Conversely, insured retail deposits are viewed as significantly more favorable, due to the backstop of the FDIC (up to $250,000 per legal entity), thus receiving an assumed runoff of as low as 3%. Of the different types of corporate operating accounts, earnings credit rate (ECR) accounts are generally more desirable to banks, due to their direct linkage to operating activities, and can benefit corporates by minimizing transaction services fees, thereby improving EBIT.

When entities are able to reallocate funds without reducing operational services, that portion of deposits will be considered excess. In addition to excess, non-operating accounts include short-term time deposits with a maturity of 30 days or less and accounts with transaction limitations, such as money market deposit accounts. With these deposits there is an assumption that a higher percentage of balances would be removed from the bank in the event of a stress event. Non-operating/ excess balances are assigned a 40% runoff rate for corporations and government entities and 100% for financial institutions, making them the least valuable to banks. The highest LCR value is provided to term deposits with a remaining maturity of greater than 30 days, which have a 0% LCR runoff.

Deposits such as for U.S. state & local government entities that require HQLA collateral will also receive an assumed 0% runoff, due to mitigation of counter party exposure. However, collateralized deposits are deemed less favorable due to the encumbrance of those HQLA assets held to support the deposit. More favorable alternatives for these types of deposits may include money market funds or FDIC insured sweep products, among others.

While additional liquidity regulations such as the net stable funding ratio are still to come, it is safe to assume that yields received on non-operating cash will fall, while longer-term and operational deposits will continue to receive value.

Consolidating Cash Management Can Lead to Higher Yields

During the financial crisis, many organizations pursued a strategy of adding banking providers to diversify funding sources, and to limit counter party and operational risk. As a result of Basel III, the trend is now reversing, as both transaction service providers and their clients shift toward rationalization and consolidation to build economies of scale and mitigate risk through improved operational processes.

Banks will generally be most willing to hold balances from their core cash management clients, and would like to increase payment activity with their large depositors. As a result, banks may offer discounted cash management and payment fees for clients holding sizable balances, or provide attractive rates to those clients who also implement multifunctional payables structures.

As organizations plan to consolidate their cash management activity with preferred banks, it is imperative that comprehensive payment capabilities are assessed. Since operating flows include both domestic and cross border foreign currency flows, organizations may look to consolidate these two distinct types of flows with the provider that offers the most well-rounded capabilities. Similarly, for vendor payments, a common practice in the past has been to rationalize wallet distribution by using different solutions for various flows categorized by spend volume, strategic importance of the vendor and payment type. As the new normal sets in, behavior change in corporate treasury is likely and can be expected to lead to more consolidation of flows with fewer, but strategic banking providers. this horizontal integration of services requires careful rationalization of bank relationships, taking into account transaction and deposit capabilities as well as size and scale of the network.

This is the time when some out of the box thinking may lead to more favorable economics to corporates. For example, while not a common practice, there are pockets of domestic and cross border flows that exist outside the realms of treasury. this has been true especially of high growth phase companies and flows where payments are an integral part of the product or service offering, for example customer refunds and sales incentives. treasury can take a leadership role and promote best practices and encourage such partner organizations to use their lead payments bank. Similarly, adopting an Integrated payables approach for vendor payments and working closely with procurement and account payables or ganizations can help identify flows and associated deposits that can result in overall cash management optimization.

Organizations will also need to develop the right strategies for their excess (non-operational) cash. Given that excess balances will be more difficult to place in overnight bank deposit accounts, organizations may want to consider placing their cash in 31+ day structures or off-balance sheet instruments, such as commercial paper, money market funds (MMF) or Separately Managed Accounts, to achieve their short-term investment objectives. In addition, he higher potential costs on committed liquidity facilities will undoubtedly increase the importance of making maximum use of internal working capital and leveraging supplier finance.

As a result of these regulatory changes, entities would be well served to work closely with their banking partners to fully understand the implications of Basel III and other regulations impacting their relationships. By proactively developing strategies that drive value creation for both sides, corporates can potentially avoid many of the pitfalls of LCR requirements.

Michael N. Berkowitz

Managing Director, North America Head of Liquidity Management Services Treasury & Trade Solutions, Citi
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Copyright 2015 Gale, Cengage Learning. All rights reserved.

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Author:Berkowitz, Michael N.
Publication:Treasury & Risk
Geographic Code:1USA
Date:Mar 1, 2015
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