Risk mitigation has its downsides too

With CFOs and corporate treasurers focusing on risk, companies are now better prepared for the unexpected than ever before. But are new banking regulations actually increasing the risk of companies not getting paid and reducing their ability to finance their businesses?

With all that has happened since 2007, companies have less tolerance for risk than at any time in recent memory. Most companies have taken huge strides in de-risking their financial and treasury functions. From de-leveraging their balance sheets to reduce credit risk, to reducing the number of banking relationships to counteract counterparty risk, to stress testing their systems to abstraction to get a handle on operational risk, companies feel they are now in a position to face whatever the world can throw at them.

“Our perception of risk has fundamentally changed in the last three years,” said Peter Van Rood, corporate treasury director at Akzo Nobel. “There has been a shift in focus by companies to be more conservative, especially when it comes to funding. Therefore we use less leverage now.”

The reduction of leverage in corporate balance sheets is well attested. During the past three years, most have focused on paying down debt and in many cases building up substantial war chests of cash. Apple, for instance, has $51 billion in cash sitting on its balance sheet.

“De-leveraging is a trend that three years ago was very theoretical but now it is very practical,” said Matt West, director and assistant treasurer in global treasury at Procter & Gamble. “It is now burned into our CFO’s soul. More and more companies are seeing the benefits of a conservative financial strategy.”

Accompanying the wave of de-leveraging, many companies have looked at their banking relationships in the wake of the Lehman Brothers’ collapse and subsequent meltdown at other banks. Many have concluded that to reduce their reliance on one bank and the risk they face if that institution collapses, they would diversify their banking relationships as far as was practicable.

And yet if you look at the policy response by many of the regulators to the crisis, such a strategy could hardly be more wrong. Most countries around the world have shown that they will do whatever it takes to prop up their banking systems. Even if banks are being allowed to fail, depositors are the last constituent group that will face any losses.

By that analysis, companies are actually adding to their risks by diversifying their banking relationships, as opposed to reducing them. And in the past three months, this situation has been dawning on many CFOs, who are now seeking to actively reduce their number of banking partners.

Paul Simpson is the global head of treasury and trade solutions at Citi in New York. He said that during the past three months, activity has increased to levels that he has not seen in years with Citi winning more mandates than ever recorded. And most of these mandates are coming from companies which are looking to consolidate their banking relationships to improve efficiency, increase real-time transparency and decrease operational risk.

“Much of what was meant to be pushing diversification is now actually pushing consolidation,” he said. “The first thing that companies need to look at is what extra risks they are taking on when they are diversifying their banking relationships. Can they do all that they were doing before and in the end will they pay more for less?”

Simpson points to a hypothetical company that has 20 suppliers and an equal number of banking relationships supporting those supplier relationships. By adding more banks to the mix you are adding complexity to the flow of business. “By supposedly diversifying your bank risk, you are actually adding to the risk that your supply chain might break down,” he said.

Follow my lender

Companies are following the lead of the banks in reducing their financial risks. The banks are reducing their risks at the behest of zealous regulators and politicians. As a result, companies are now entering into a world where they cannot take that much risk as a corollary to the banks being de-fanged by the authorities. And where companies cannot take risks, they cannot find rewards.

In the treasury function, this is most clearly seen in the way that cash balances are giving practically zero return. As central banks around the world maintain their ultra-low interest rate stance, companies with positive cash balances are being punished. Apple is said to earn just 75 basis points on its cash pile.

Banks are responding to this in a number of ways. They are allowing their corporate clients with cash on the books to co-invest in certain deals with them. Citi, for instance, is allowing its corporate clients to invest in trade receivables-backed paper, a form of financing only banks could hitherto participate in. Others banks are doing things such as automatic sweeps into asset management accounts or other third party funds.

This is not only a reflection of how scarce capital is in the banking sector but also how corporate cash balances are now being used as a steady stream of direct financing. This in some way mitigates the risk of getting no return on your hard-earned cash.

Another risk-mitigation exercise being undertaken by the regulators is having a negative effect on companies. In the trade area, the new Basel III capital accords are going to force banks to give trade finance 100% risk weighting. In other words, a dollar lent will result in a dollar having to be kept on its balance sheet.

The banks are united in their condemnation and there is some evidence that the regulators in Basel are listening. The key losers in this will not necessarily be the banks, but the companies who will not be able to use trade finance for their imports and exports.

By seeking to de-risk banking the regulators are actually increasing the risk of companies not getting paid. And all the evidence points to the fact that trade finance is one of the lowest risk forms of banking there is. A recent study carried out jointly by the International Chamber of Commerce and the Asian Development Bank found that of 5.2 million trade-finance transactions carried out by nine banks during the past five years, only 1,440 deals defaulted. This is a default rate of 0.03 %. The average tenor of the deals was 115 days. This shows why trade finance is part of the world of transaction banking alongside other low-risk forms of business such as payments and cash management. It is not necessarily credit related but it will be capital constrained.

“Capital is going to be very important for banks in the future and as a result banks may decide that supporting trade is not where they want to deploy their capital,” said Dan Taylor, president and COO of BAFT-IFSA, the transaction banking industry body.

The situation in trade, as well as with low returns and with the re-concentration of banking relationships, all follow the law of unintended consequences: by trying to take risk out of the system for banks, the regulators have actually increased the risk that companies will not be able to finance their businesses.

Looking out into the future, the effects of these regulations point to a period of heightened regulatory and political risks that companies are preparing themselves for. “Crises tend not to repeat themselves,” said Van Rood. “Problems with credit and liquidity will not be the next big risk out there. I think that foreign exchange problems and refinancing risks do remain on the horizon.”

Perhaps the lesson from all this is that risk cannot be completely taken out of the cash and payments cycle. Even though the authorities are trying to prevent what happened in 2007 and 2008 from happening again, in the process they are perhaps setting the stage for the next crises. Companies are looking carefully at how these new regulations and political machinations will affect them.

¬ Haymarket Media Limited. All rights reserved.

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