As with any other business function, treasury has to adapt its actions to the prevailing environment if it is to deliver optimal performance, especially under the volatile market conditions in the past two years. Against this backdrop, treasurers have had to radically revise their priorities when determining their liquidity management strategies. In the immediate term, as confirmed by the corporate treasurers contributing to this article, a prominent example of this has been the far greater emphasis placed on the security and availability of corporate liquidity. However, in the longer term, other priorities emerge. These include the need to foster a "cash-friendly culture" in the corporation and the closer alignment of liquidity management with other treasury activities.
Liquidity availability
The credit crisis has driven an exceptional reduction in the availability of external liquidity sources, which has seen most corporates giving their liquidity management strategy high priority. There have been some variations on this theme; on a geographic basis, corporates in countries such as China have been less affected by the crisis and therefore have experienced less liquidity pressure. In addition, some of the largest corporates have been well supported with liquidity by their main banking partners.
Interestingly, this seems to have applied irrespective of whether these corporations were naturally cash rich; even industrial companies with extensive borrowing have benefited from this support, provided they were basically sound enterprises and established business relationships for banks. Nevertheless, outside these categories, many corporates have been under extreme liquidity pressure and have therefore focused on minimising their dependence on external liquidity wherever possible.
Some see the crisis as delivering a salutary and timely message. "The recent crisis has taught the market some important lessons," says the global treasurer of a multinational management consultancy. "Companies of all types were not conservative enough, and needed to reduce risk and increase liquidity. On the investment side, treasurers who had not already diversified their portfolio were not doing their job; chasing yields should not be the point. It also needs to be remembered that ratings are simply an opinion of creditworthiness."
Liquidity management: Objectives and resources
As a function with cost and risk reduction at its core, there can be little dispute that optimal liquidity management is a key objective for treasury. Any liquidity management inefficiencies implicitly increase cost either through interest charges on unnecessary borrowing or, if long cash, through sub-optimal interest compensation. By the same token, such inefficiencies also increase risk because liquidity is effectively a buffer against inclement trading conditions. Poorly managed liquidity that is dispersed, tied up in accounts receivable or inventory, or otherwise inaccessible increases risk by reducing the size of this buffer.
During troubled economic conditions when resources are scarce, treasury has to present a convincing case to obtain the resources needed to maximise liquidity. The way in which treasury goes about presenting this case largely depends upon the mindset of senior management and its understanding of the importance of liquidity. If the company is a frequent visitor to bond and commercial paper markets, then it is likely that management will have discussed liquidity frequently at management and board meetings and have a thorough grasp of its significance.
"Perhaps ironically, the bigger challenge for treasury is where a corporation has historically been cash rich and has never previously experienced a liquidity crisis," says David Blair, treasury consultant and former treasurer of Nokia. "In those circumstances, management is unlikely to appreciate the full implications and treasury will have to present a particularly compelling case for resources."
One of the most effective ways to accomplish this is through a mixture of history and numbers. In the case of history, another company in the same industry that previously neglected liquidity and suffered severe consequences -- such as material equity dilution, or large-scale redundancies, or perhaps even liquidation -- can prove an effective factual reference.
As regards numbers, the objective is to build credible projections that spell out the cost consequences of not having the resources to improve liquidity management. For example, if liquidity management remains poor, the corporation's rating will slip and the cost of rolling its outstanding commercial paper will increase. In a worst-case scenario, it may not be possible to roll it at all and it will require replacement with another external and more expensive source (if available). Then contrast this with the cost of internal liquidity (virtually nil) that will become accessible if resources are made available to upgrade liquidity management.
For some companies, the numbers have been sufficiently compelling to trigger a global cash management project, including a major rationalisation of banking arrangements. For example, Rentokil has historically always retained legacy bank relationships when making an acquisition, so had gradually accumulated some 200 bank relationships and approaching 800 bank accounts. "This lack of transparency resulted in approximately £50m of invisible cash, significant counterparty credit risk, and unnecessary bank charges/interest costs," says Edward Collis, treasurer of Rentokil. "In response to this, we have been running a global cash management project since early 2007. As part of this, we have appointed regional banks for North America, Europe, UK and Asia-Pacific, to replace the myriad of existing relationships. This facilitates the installation of liquidity structures that will ultimately result in central treasury handling all funding and liquidity management."
Liquidity management priorities
As mentioned, liquidity management has moved rapidly up the priority rankings in virtually all companies over the past 18 months, but within that general priority there are some particular specifics. "Corporates that are not financial institutions are not (or should not be) in the business of taking financial risks (they are not banks), but they should be able to take risks in their business where they have niche expertise," says David Blair. "Therefore, the major priority for treasury -- both generally and in the context of liquidity management -- is the reduction of financial risk so as to free up the capacity to take appropriate business risks that will in turn (hopefully) generate sales revenue."
However, this has to be accomplished at a reasonable cost. Hypothetically one could issue vast amounts of equity and sit on the resulting cash deposits, but for some companies that simply is not viable and does not in any case produce the necessary return that investors expect.
The key priority is therefore to establish the right balance by finding liquidity in its various forms, in sufficient quantity, at the right price. This is obviously not a static equation; during the credit crisis most companies will have significantly increased the threshold they consider acceptable for accessing external liquidity. For example, they may now be prepared to pay far higher prices for back-up lines than they would in the pre-crisis days of easy liquidity. This only serves to highlight the spread between the cost of external and internal liquidity, which in turn emphasises the importance of an effective liquidity management construct for increasing the availability of liquidity and reducing its cost.
Another priority for many companies relates to the maturity profile of liquidity as well as its source. "We are keen to ensure that our external sources of liquidity have the right maturity profile," says Collis. "For example, we moved the maturity of our debt out to 2012-13, through two bond issues of £75m and £50m in September and October 2008. Needless to say, this was extremely challenging given the circumstances prevailing in the debt market at that time; in fact, between the collapse of Lehman Brothers and the end of 2008, there were only eight bond issues by BBB-rated issuers globally, of which two were by Rentokil."
For others, the quest for improved liquidity management has made centralisation of control a long-standing priority. "A core objective for us is to have a treasury support model where cash is managed at the centre," says Patricia Greenfield, assistant group treasurer -- operations at AstraZeneca. "Even where central treasury cannot physically access the cash due to local regulations, central management is nevertheless achieved remotely by issuing extremely detailed and conservative guidelines to the local business unit. Furthermore, regular reporting requirements ensure that these guidelines are adhered to."
Linking liquidity with other disciplines
Instituting a "cash-friendly culture" in an organisation is ultimately something that has to be driven at board level. "Once the importance of liquidity is understood and emphasised there, it will naturally tend to percolate down," says David Blair. "However, to achieve more of an 'espresso effect', liquidity-related metrics need to be a commonplace element in employee compensation; for example, at Nokia net working capital rotation was, to varying degrees, part of all staff bonus calculations."
In addition to corporate culture, if it is to deliver optimum results, liquidity management strategy needs to be closely aligned with various other treasury disciplines such as credit and foreign exchange (FX) risk, and the corporate banking model. The credit risk associated with the institutions with which treasury might deposit surplus cash requires careful consideration. The moral hazard argument is so strong at the moment and so widely accepted that the concept of "too big to fail" carries weight. As a result, multinationals are less prone to leaving significant amounts of cash with non-global cash management banks, even after taking into account the government deposit insurance schemes deployed as temporary measures during the recent credit crunch.
On the borrowing side, what is the prognosis for banks with which treasury might have undrawn revolvers or committed facilities? On this point, some corporations have been drawing lines for which they have no immediate need because they are unsure whether the bank concerned will be extant, willing, or able to lend the money when actually needed.
A further factor influencing this sort of behaviour is that even where banks are still prepared to provide liquidity, their timelines have contracted sharply. "Most banks are now lending shorter term, which creates challenges for many multinationals," says the treasurer of the multinational management consultancy. "Previously, we could rely on borrowing via syndicated facilities of five to seven years; this commitment may now only be for a year, creating future cash flow vulnerability."
As outlined above, companies such as Rentokil have clearly aligned their banking model with their liquidity management strategy. However, others may link liquidity management with other disciplines. In the case of AstraZeneca, FX risk management is a related priority. "As a group we invoice each country in its own currency, provided we can hedge it from here," says Patricia Greenfield. "If there are exchange controls, then the invoicing will be done in hard currency such as in US dollars or euros. If the sale is to an AstraZeneca business, then that business is responsible for buying the US dollars or euros with which to make settlement, though we are gradually shifting that task to central treasury."
As regards the relationship between FX risk and liquidity, a further consideration is possible structural change in the market. In the wake of the credit crisis, there is the risk in some countries of a knee-jerk curtailment of the over-the-counter market. If this comes to pass, treasuries will effectively find themselves obliged to hedge using exchange-traded futures, which would be massively inefficient. The requirement to post margin against futures trades and then have to fund the daily (and in some cases intraday) payment of variation margin would result in unnecessary use of liquidity.
In addition to the risks associated with deposits or credit lines, the corporate banking model has other liquidity implications. Companies that already have (or are in the process of establishing) liquidity management structures need to be aware of the possible operational risks. If a bank administering a liquidity structure experiences difficulties that disrupt flows, then this has obvious immediate liquidity implications for the corporation.
Some assume that because local banks in countries such as China and India had negligible direct exposure to the crisis (and are also buoyed by large retail deposit bases) that these banks represent an obvious port of call as both liquidity sources and service providers. In practice, the position is less clear-cut; local banks often have difficulty conducting credit assessment on multinationals, particularly where their local subsidiaries are not strong and lack parental guarantees. From the corporate perspective, the benefits of using local banks are also quickly dissipated if they are not equipped with current electronic banking technology and require manual workarounds.
However, even where the banking model is changed to address this sort of situation, other challenges arise. "We were determined to ensure that we had the buy-in from the individual local entities, when moving from the previously fragmented banking model," says Rentokil's Collis. "To that end, we retained an external consultancy to assist with this in explaining the benefits of the strategy to the individual businesses and that proved highly successful in obtaining that buy in. HSBC was also very supportive with this process."
Liquidity risk: Responsibility segregation
The management of liquidity risk is a defined treasury responsibility. Most treasury policies will include liquidity as an identified risk or would address it in some way under the rubric of liquidity risk or capital structure.
However, liquidity management is typically conducted at more than one level. On the one hand, there is the higher level of strategic liquidity planning; on the other, is short-term liquidity management. The latter is typically handled by the cash management department, while longer-term liquidity planning will normally be dealt with as part of corporate finance and capital structure.
The boundary between these two areas obviously varies from corporation to corporation. At AstraZeneca, in addition to regular cash flow forecasting meetings with businesses, quarterly meetings with regional finance directors are used to anticipate more strategic cash requirements. "If a region is likely to need a very large amount of cash, such as for an accelerated sales plan, then we would expect the regional finance director to flag that up," says Patricia Greenfield. "Particularly in regions with a more stringent regulatory environment, this advance notice is vital so that we can provide the necessary liquidity in the most efficient manner."
Liquidity investment
The period since mid-2008 has seen a drastic revaluation of risk that has radically affected investment strategies for surplus liquidity. Accessibility and security have become the major priorities, with yield taking a back seat. This is apparent from the way in which corporates have been borrowing at the longest possible tenor, while simultaneously investing at the shortest. The short tenor of corporate investments is both a contingency for unexpected business need (such as to cover a defaulting trading partner) and a defence against credit risk (the ability to pull funds immediately should the stability of a deposit-taking institution cause concern).
The emphasis on security is also reflected in the conservative nature of the instruments now being used. Innovative yield-enhancement strategies are out of favour and conventional deposits are in. Even where money market funds are being used, the level of scrutiny now being undertaken would have been unthinkable two years ago. Hardly surprising perhaps, as in addition to the general economic climate the market has recently witnessed only the second instance of a money market fund breaking the buck since the 1970s. (Reserve Management Corporation's Primary Fund in September 2008.)
While many treasuries have traditionally been fairly conservative in their investment strategies for surplus liquidity, events of the past two years have only reinforced this behaviour. "We have always restricted our investments to AAA funds and treasury bills; our view is that return of capital is far more important than return on capital," says AstraZeneca's Greenfield. "At the height of the crisis we further restricted that to treasury bills or treasury bill funds, though we have since relaxed this to include AAA funds again. The biggest issue for us was lack of transparency; previously, managers were unable to provide the frequency and granularity of information we required to fulfil our due diligence as regards the exact composition of funds."
The multinational management consultancy mentioned earlier takes a similar line. "Our strategy has always focused foremost on security and the crisis only accentuated this," said the consultancy's global treasurer. "Therefore we only invest in US treasuries, AAA-rated certificates of deposit or similar; I would question any treasurer on their strategy if it was anything other than preservation of capital."
The future
While the need to maximise internal liquidity is hardly a secret, this is still probably a work in progress for many companies. Even when it is accomplished, a further massive opportunity remains -- squeezing liquidity from the supply chain. The extraordinary efficiencies achieved in the physical supply chain have graphically illustrated what is possible, but by contrast the financial supply chain still lags far behind.
In part, this can be attributed to an overemphasis in recent years on high-level financial engineering, as opposed to low-level process improvement. In view of the fallout from some of that financial engineering, one can only hope that this focus will now shift. The scope for squeezing liquidity out of commercial processes is enormous, but it requires considerable effort dealing/negotiating with other departments in the company and other companies in the supply chain.
Accounts receivable is an obvious starting point in this process. It is not uncommon to find that 30-day payment terms require 45 days of financing because invoice issuance is inefficient. Or that there is no agreed definition with customers as to what constitutes 30 days; cleared funds into the supplier's account within 30 days, or cheque arrives within 30 days?
"It's a salutary point that these examples only represent the very tip of the iceberg," says David Blair. "While companies globally have been effectively compelled to enhance their liquidity management in the current environment, there is still ample scope left for improvement."
First published in HSBC's Guide to Liquidity Management in Asia Pacific. HSBC Bank plc. All rights reserved. Published with the kind permission of PPP Company Limited.
