The business case for liquidity optimisation: Why, why now and how?

While a broad range of factors have emerged from the general economic malaise to influence these changes, three in particular have been prominent from a treasury perspective: counterparty risk; cost and availability of credit; and bank relationships.

Counterparty risk

Treasurers' perception of counterparty risk has changed dramatically since the autumn of 2008. While managing counterparty risk has always been an element of the treasurer's role, it has often been secondary to other types of risk management such as interest rate and foreign exchange. Counterparty risk has typically been limited to setting and monitoring counterparty exposure limits for surplus investment and foreign exchange, which although a valuable discipline, does not fully recognise all the potential risks inherent in a banking relationship. Since the onset of the financial crisis, treasurers have become increasingly risk focused in their choice of banks and the activities that they are prepared to conduct with them.

We see two parallel but opposing trends in the way that treasurers manage their counterparty risk in this new environment. In many cases, companies that have historically adopted a highly centralised banking model with one major and dominant global or regional relationship (those using a single global disbursement bank and a separate local collection bank network model, for example) are now seeking to establish a more diversified core of strong credit-based and full banking relationships. While the immediate fear of a systemic bank collapsing risk has largely subsided, treasurers are nevertheless seeking to limit their risk exposure to any individual banking partner. Their objective is to balance their dependency on a small number of core banks so that, if necessary, they can reroute all their banking transactions to an alternative bank at short notice, thereby minimising both credit and operational risks.

Conversely, companies that are either decentralised or with activities spread across multiple domestic banks, are seeking more timely and comprehensive cash flow information, as well as optimal utilisation and return on their global cash position. The fact that they have previously been distributing their treasury business across a range of banks also increases the risk of being unable to build a solid and meaningful banking relationship for longer-term support. This has resulted in these companies seeking to consolidate banking partners regionally and globally by putting in place technology to enable visibility across different regions and across positions with multiple banks. In addition, they are looking to set up arrangements with one or a few banks which allow for the centralisation of cash (with the effective appointment of one provider as the "liquidity management" bank).

The challenge for treasurers is finding the ideal intersection of these two countervailing situations; sufficient bank diversification to reduce counterparty risk, yet not so much that a core supportive relationship and operational efficiency are compromised.

The changing perception of counterparty risk is also affecting how treasurers invest surplus liquidity, with security and availability now primary concerns along with yield. Security considerations have not only driven treasuries to take the most conservative stances when assessing deposit-taking institutions, but are also being applied to their choice of instruments -- deposits are in favour, more complex yield enhancement products less so as they require a full understanding of the underlying assets. At the same time, the desire for ready availability of liquidity has seen treasuries significantly reducing the average tenor of their cash portfolios.

Cost and availability of credit

The second major factor influencing corporate treasuries' liquidity optimisation strategies is that credit is no longer as plentiful and inexpensive. This has substantially increased both the risk of funding gaps occurring and the spread between the costs of internally and externally sourced liquidity.

Consequently, treasurers have had to be increasingly resourceful in squeezing more cash from the working capital cycle, in order to smooth out peaks and troughs in corporate liquidity requirements and reduce overall liquidity costs. Some of the more popular strategies include tighter discipline on credit control and collection management, as well as moving from paper to electronic collection methods, and in some sectors and markets, increasing use of payee-controlled collection instruments such as direct debits. Other, more structural, strategies include implementing centralised treasury control over cash flows and banking relationships, often involving the appropriate treasury vehicles and more sophisticated regional liquidity management schemes.

The critical discipline underlying these efforts is cash flow forecasting. Due to the nature of their business model, companies in certain industries find developing accurate and timely forecasts extremely challenging. In the past, when liquidity conditions were more benign, many companies gave forecasting a lower priority. This situation clearly no longer applies and treasuries have been putting far greater emphasis on forecasting with a focus on timely gathering of raw forecast data from subsidiaries.

Relationship focus

The third important change is the profound shift in the way that corporate treasurers and chief financial officers (CFOs) conduct their relationships with banking partners, and vice versa. With banks seeking to reduce their risk exposure and hence becoming ever more selective in lending, and corporates seeking to manage their liquidity risk more effectively, it is in the interests of both parties to ensure that they fully understand the needs, aspirations and constraints of the other.

In some cases, multinational companies will be seeking new banking relationships in order to secure financing sources, particularly if they experienced a degree of uncertainty in the commitment on the provision of credit by their core banks during the recent market tightening. On the other side of the table, to justify the lending of scarce capital, financial institutions are increasingly sensitive on the quality of their balance sheet and their return on any associated lending. The net effect is that both corporate clients and banks are now seeking to consolidate more of their business to a few trusted relationships.

Implications

The scale of the task treasurers face in their response to the above factors is considerable. More specifically, the methods they use may necessitate changes in areas of the business outside their direct remit and may also have significant implications for the structure of the corporation as a whole. Some examples are outlined below.

Centralisation of financial functions and closer integration with treasury processes: To smooth the company's cash flow profile, payables, receivables and trade finance activities, coordination is needed not only within finance, but also with commercial parts of the organisation, e.g. sales and procurement.
Centralisation of borrowing and investment: A decentralised approach that permits local borrowing and investment can create inefficiencies from a liquidity perspective, such as unnecessary and expensive borrowing or suboptimal returns on surplus cash. Therefore, as with financial functions, greater centralisation of these activities may be necessary.
Technology investment and business transformation: Accurate cash flow forecasting requires a concerted business-wide effort. Local entities remain best placed to forecast their future cash flows and exposures, but it is essential they do so in a consistent manner across the entire organisation. Inconsistent practices, varying data sources and a strong culture of local autonomy are common obstacles that typically present treasury with a major data normalisation task and a less accurate forecast. Remedying this situation requires technology investment and a significant management effort to adopt common policies and practices. This exercise can be expedited if undertaken when re-engineering the internal cash management processes and establishing regional payment and liquidity solutions.

Challenges

In addition to these broader structural implications, treasuries also face a variety of more specific challenges if they are to enhance the efficiency of their liquidity management strategies. One of the most obvious is the selection of appropriate tools and solutions. While banks and vendors have worked hard in support of companies' liquidity management, the applicability of their offerings obviously depends upon individual corporate circumstances. One size does not fit all.

Treasury therefore needs a detailed and thorough understanding of the corporation's existing internal environment and the challenges, if present, when implementing or refining a liquidity management strategy. For example:

Corporate structure: Holding companies, subsidiaries, reporting lines, accountability.
Corporate culture: Degree of business unit autonomy, organic or acquisitive growth model.
Banking structure: Number of banking relationships and their relative priority, control/visibility of bank accounts.
Technology: Configuration and flexibility of existing infrastructure, expertise and availability of internal information technology resources.
Resources: Availability of human and financial resources for treasury projects.
Processes: Suitability for adaption, or replacement required.
Senior management: Likely level of engagement, understanding and support.

In the context of this information, the suitability of specific bank and vendor solutions to the corporation's circumstances should become clearer. In addition, the optimum scale of any project may also become more apparent. A global "Big Bang" approach may be tempting, but a phased strategy may be more advisable: resources might be limited, or corporate culture may suggest that a gradualist approach will gain better local cooperation.

Alignment

Successful innovation around liquidity management and optimisation requires closer integration and alignment of treasury with the business. In some corporations this process is already well underway, as treasury has been heavily involved in initiatives -- such as supply chain finance -- that require close cooperation with business units.

In addition, events of the past two years have meant that most CFOs are now far more involved with day-to-day liquidity management issues and have objectives more closely aligned with treasury. Consequently, this will make it easier for treasurers to drive the necessary business transformation.

A further alignment consideration is performance measurement. If liquidity management objectives are closely aligned with the performance measurement and compensation of local management, then treasury will be in a strong position to implement new techniques or internal business transformation to the wider corporate benefit.

Responses

From our conversations with clients, treasury's changing approach to liquidity management is already clearly reflected in the new treasury and investment policies that have been instituted in response to the rapidly changing economic climate. The scope and direction of these policies can be broadly divided into those that are internally and externally focused.

Internal

Centralisation of accounts payable and accounts receivable processes, and also in some cases the implementation of shared service centres to facilitate this. Infrastructure and process consolidation and standardisation all lead to an improved risk management framework.
Centralisation of investment and borrowing at a group/regional treasury level in order to achieve higher liquidity flexibility, reduced borrowing costs and enhanced control.
A commitment to make better use of technology to improve both the efficiency of treasury activities as well as the visibility and accuracy of cash flow forecasting at all levels.

External

Adoption of bank-neutral connectivity to reduce credit, settlement and operational counterparty risks.
Extending investment policies to focus not only on return, but also on the financial stability of the deposit taking institution, as well as any holistic bank relationship considerations (such as placing surplus cash with key credit providers).
Driving innovation, by seeking more creative solutions from banks that will allow companies to access liquidity in new ways, from both internal and external sources.

Benefits

While the various prerequisites and challenges involved in developing an effective liquidity optimisation programme may seem daunting, the benefits are considerable.

Once treasury has visibility and control of corporate cash, it can use surpluses in one part of the business to finance deficits in others, reducing the overall need for borrowing.
If, as part of the liquidity management programme, treasury has control over payments, collections and trade flows, then cash flow forecasting will improve and liquidity fluctuations should become less of an issue.
Borrowing requirements can be centrally managed, thereby leveraging the higher credit rating of the parent company to reduce borrowing rates.
Net surpluses can also be invested centrally, with the ability to secure higher returns by investing larger balances.
Counterparty risk in its various forms can be managed more effectively.
Centralising cash and treasury activities together with group liquidity and balance sheet management enhances their efficiency through greater automation and enhanced reporting. Control over cash can also be improved, with better segregation of duties and "auditability" of activities.
Many of the steps required to improve liquidity management create contingent benefits in other areas. For example, implementing bank-neutral technology also provides greater strategic flexibility around bank relationships, as well as streamlining processes and reducing costs.

However compelling this list may appear to the treasurer, others will also need to be convinced. Therefore, it is vital to establish measurable parameters to quantify these liquidity management benefits on an ongoing basis. This data will not only be of value in justifying any future liquidity management initiatives; it can also be disseminated throughout the organisation as a means of fostering greater general awareness of the value of liquidity management.

The future

While the economic situation may have precipitated a renewed focus on liquidity management, any steps taken now will be more than a response to a crisis. Irrespective of the business environment, corporations with strong liquidity management always enjoy a competitive advantage. Much of the recent emphasis on liquidity optimisation has related to its risk management advantages, but as conditions improve, the advantages associated with business expansion will probably move into the limelight.

An important benefit in this respect is the strategic flexibility that maximisation of internal liquidity confers. If an internally generated cash surplus is available, the corporation does not have to negotiate for external funding before making an acquisition or funding a new business unit. More generally, a strong liquidity position can ease the task of bank relationship management by simplifying the "fee for credit" equation. This is particularly apposite given that a large segment of the banking industry is unlikely to regain pre-crisis lending levels for the foreseeable future.

In the final analysis, any liquidity management enhancements established now can better prepare the organisation strategically. If conditions are difficult, they can ensure the company has the cash to continue trading. If times are good, the funds to underpin growth will be readily available.