After the crash, here comes CASH: Why the world’s biggest banks want more from cash management

A STARKLY INEVITABLE feature of the global cash management industry is a steady consolidation of market share in the hands of a limited number of banks. Only large banks can now win global mandates. And only this select group of banks can handle the price compression that began in the US, has since spread to Europe, and is expected to accelerate following the introduction of the Single Euro Payment Area (Sepa), which will begin to be implemented from January 2008.

As corporates – even medium-sized companies – increasingly source from abroad, the demand for international cash management services is rising. At the same time, though, companies are seeking to reduce the number of bank relationships they have, so banks require market width – the ability to operate across a wide number of countries and markets. Similarly, the solutions required by corporates need scale in order to make them cost-effective.

As a consequence, local banks are increasingly sidelined and often don’t even feature on requests for proposals any more. But for the limited number of banks in the cash management elite – ABN Amro, Bank of America, Citi, Deutsche Bank, HSBC and JPMorgan Chase as well as the more geographically focused Standard Chartered – the rewards appear as attractive as ever.

For the first six months of 2007, Deutsche Bank’s global transaction banking had a pre-tax return on equity of 85%, compared with corporate banking and securities’ 42%. For the second quarter of 2007, Citi (see Credit crunch sparks flight to quality in liquidity management) had cash management net revenues of $1.05 billion – a 22% increase over the same period in 2006 – and transaction services made a phenomenal 125% return on risk capital.

How are such results possible? "Returns on equity are high in transaction banking because the capital that is being committed is largely intra-day," says Ann Cairns, head of transaction banking at ABN Amro in London. "Consequently, the capital required to run a business is much lower than for lending-based activities relative to the revenues involved."

As Basle II puts further pressure on risk assets because of its requirements for capital, there is a heightened focus on returns. "Cash management is liability-led, has low capital usage and a high return on equity," says Andrew Long, head of global transaction banking at HSBC in London. "Consequently, there is an increased internal demand for cash management [activity] as lending banks recognize the benefits it brings the business."

Earnings stability

Another driver of increased interest in cash management is its potential to increase a bank’s share price. While business-processing companies can trade at more than 20 times earnings, commercial banks trade in the mid-teens or lower. Unsurprisingly, CEOs of banks are eager to increase their exposure to the business-processing market – which for banks centres on transaction banking and cash management.

"Growth comes from being able to deliver great solutions, great service and terrific value" Paul Galant, Citi

The second characteristic of cash management that contributes to earnings stability is the longevity of relationships in the sector. "The stickiness of cash management comes from the fact that solutions take six to 12 months to implement and the average life of a contract is therefore between three and five years in order to make them financially viable," says Werner Steinmueller, head of global transaction banking at Deutsche Bank. As another banker notes: "Once you’ve got a contract, unless you really screw up, you get the renewal."

Consequently, earnings from cash management are strikingly less volatile than those from capital markets. In the period from the end of 2003 to the end of the first half of 2007, Deutsche Bank’s global transaction banking division had revenue volatility of 12% compared with the 29% for the corporate banking and securities division. "As capital markets revenues slump following the credit crunch, the attractiveness of the low volatility of cash management looks set to increase further," says Steinmueller.

Can the good times go on?

Can the profitability and strong revenue growth of leading cash management banks be sustained in the wake of Sepa and other initiatives? Although Sepa will undoubtedly have a significant impact on revenues by effectively turning all European payments into domestic payments – which cost less – many bankers believe it can. Cairns uses the analogy of the computer industry, where prices fall each year but volumes increase at a pace sufficient to maintain profitability.

Moreover, there continue to be significant barriers to competition in cash management that will protect margins. Technological innovations can be copied and Long estimates that "windows for profit" following a product innovation are now as little as 18 months. However, clients value service and consistency of delivery above all else. "The devil is always in the detail in cash management," says Jack Large, partner at J&W Associates, a cash management consultancy. "It’s a sticky business because it’s a simple fact that it takes years to be able to offer, for example, the consistent service across a region – let alone globally – that clients require."

To be sure, there are declining margins on the interest side of the business – such as money charged on overdrafts – as a result of increased pooling and cash concentration involving other banks. But provided a bank is confident of its pooling prowess, such flows should be two-way. "I always says that I’d rather give up 30% of the margin as a result of pooling, for example, rather than lose 100%," says Long at HSBC. "And if you do offer those services then you stand a good chance of gaining balances and operating accounts from other banks."