Regulatory changes designed to strengthen banks are having the unintended consequence of tightening corporate access to bank borrowings, and are increasing the costs of actual and unutilized facilities. The current climate of uncertainty about the future course of economies and markets is adding to the difficulties confronting corporate treasuries.
The July AFP Corporate Cash Indicators® clearly showed a significant and sustained jump in cash holdings among U.S. corporates in the second quarter of 2015. Although the October AFP CCI revealed that the pace of cash accumulating has slowed down, companies are still reluctant to spend.
U.S. corporates are accumulating war chests of liquidity in a time of increasing uncertainty. It is difficult to determine whether these war chests are being built because of a lack of attractive investment opportunities given the slow growth of global GDP, the fear of another liquidity squeeze, or just a pervasive malaise based on general uncertainty.
The nature and timing of the next crisis are unknown, but in a tightening regulatory environment, which has the unintended effect of reducing liquidity provisioning by intermediaries, assuring an uninterrupted supply of working capital is a corporate treasury result that should resonate well with board-level concerns.
The one precedent from recent history that is of obvious relevance is that the last liquidity crisis was best managed by corporates that used sophisticated and accurate commercial cash forecasting processes, usually through integral modules of their treasury management systems. Such insights led some to perform early debt and equity-based preemptive refinancing operations, and others simply to stockpile cash. These corporates had assured their medium-term liquidity so that they did not have to scramble for increasingly scarce and expensive financing when the crunch came. Accordingly, they were able to finance sustained commercial activity and withstand declines in profitability and turnover—and were well-positioned competitively to take maximum advantage of the recovery. And in extreme cases, effective liquidity risk management facilitated some companies’ very survival in testing times.
Today’s general situation may be different from 2007-08, but the current surge in corporate cash holdings vividly illustrates the scope of concerns of many organizations. Treasurers should analyze the situation very carefully, and consider the costs and benefits of actively reducing their level of liquidity risk.
The risks underlying today’s commercial paper market
Focusing on the current realities of corporate short-term financing, it is clear that the new regulatory regime has in effect restricted banks’ abilities to take on risk, as part of the systemic program to stabilize and secure the provision of banking services. Presumably unintended consequences of this development have been a squeeze on the banks’ abilities to advance credit to clients, and an increase in the net cost to corporates of actual and standby credit.
In normal times, corporates were happy to take advantage of the disintermediation opportunities presented by the capital markets, most notably by the commercial paper market. According to the Fed, the growth rate of the annualized volume of AA nonfinancial domestic CP issuance has surged about 88 percent over the last two years. This makes an interesting comparison with the sharp fall in CP issuance for 2008.
This illustrates the increasing importance of the capital markets in funding corporate America, but how should the risk of such a program be evaluated by the issuers? What is their relative level of financing dependency on CP? There is a temptation to regard a CP program as a medium-term variable rate liability structure; but as most U.S. CP is issued in the overnight to 30-day maturity spectrum, the actual liquidity stream provided in a crisis is in that same overnight to 30-day spectrum and depends on high frequency rollovers being successfully negotiated. In a future crisis, if the capital markets door is again slammed shut to many corporates, the victims will have little choice than to revert rapidly to bank borrowings—which, if available, are likely to be expensive.
Corporates which regard this level of liquidity risk to be unacceptable can take several steps to lower such dependency on CP markets. Specifically, they can improve the management of their credit exposures, improve the generation of internal liquidity, and diversify their bank funding sources.
The next financial crisis will be felt in corporate liquidity in ways that are being amplified by current regulatory trends. The cost of accessing liquidity has increased. Prudent treasurers should assess their present provisions and systems for managing liquidity risk, and should address any deficiencies in their practices before the next storm strikes.
A longer version of this article will appear in an upcoming edition of AFP Exchange.