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The 2012 guide to Liquidity Management: SEB - Moving to the next level in liquidity management

Having centralized liquidity, the next priority for treasurers is to quantify how much liquidity the company actually needs, and how to minimize the costs and risks associated with managing it. By Robert Pehrson, global head of product management (corporate segment), and Patrik Bergström, financial strategy, client relationship management, SEB Merchant Banking.

Over the past couple of years, treasurers and finance managers have proved very successful in leveraging cash concentration and notional pooling structures to optimize access to liquidity both regionally and globally. In most cases, large multinationals now have solutions in place to enable the efficient concentration of liquidity, cost-effective internal financing and the best use of cash resources. Having centralized liquidity, the next priority for treasurers is to quantify how much liquidity the company actually needs, and how to minimize the costs and risks associated with managing it. Prioritizing liquidity

There are a variety of reasons why liquidity has become such a significant area of focus, both operationally, making sure that cash is available for use across the business and, strategically, in terms of managing balance sheet and counterparty risk. The first factor is the scarcity of liquidity in the market, particularly for lower-rated companies. This situation has existed since 2008 and with ongoing volatility, a lack of market confidence and tightening regulations, the availability of liquidity is unlikely to increase. Interest spreads have increased, while interest rates are very low, and even negative in some currencies, such as DKK and CHF. In addition, certain types of corporate deposits are less attractive for banks compared with retail deposits, further depressing returns available to corporate investors.

While these factors are all significant in elevating the importance of liquidity management, perhaps the most important issue of all is liquidity risk, which was rarely mentioned five years ago. Volatile markets, such as in the Eurozone, combined with uncertainty over banks’ interpretation of Basel III, mean that treasurers can no longer be complacent about where their funding will come from in the future. This is resulting in corporates seeking alternative forms of funding, such as accessing the markets directly through corporate bond and commercial paper issuance, as opposed to relying on bank funding. In addition, they are increasingly leveraging their financial assets both to fund working capital requirements and manage liquidity risk, such as receivables financing and supply chain financing.

Six steps to strategic liquidity management

Liquidity optimization does not simply involve accessing as much cash as possible, however, it requires a careful assessment of how much liquidity is available, how much is required and therefore how much cash can be invested more strategically. Treasurers need to balance the need to maximize net interest income whilst continuing to support the business in the best way.

1. How much liquidity do we have?
A corporation’s liquidity position comprises more than the cash held in bank accounts, short-term investments and unutilized committed credit facilities. Treasurers need to establish a deep understanding of the company’s cash flows (figure 1) and how these are likely to change over a 12- to 24-month time horizon. They also need to have a clear view of the proportion of this cash that is trapped in entities and accounts in regulated jurisdictions, or as cash collateral tied to long-term credit or derivative agreements.

Figure 1: Key questions in liquidity management 
Source: SEB 

2. How much liquidity do we need?
This is a question that few treasurers have explored in the past, partly as the ‘right’ answer will be different for every company. A corporation needs enough liquidity to cover for the future cash outflows in the form of minimum capital expenditures, working capital at its highest seasonal point, committed dividend payments and short-term debt maturities. Calculating working capital needs should be relatively straightforward by taking a holistic approach to the financial supply chain. Other factors are specific to each industry and each company, such as external rating requirements and targets, cash flow risk and volatility, equity analysts’ view of cash holdings, cash flow risk and volatility, corporate investment strategy and benchmarking with industry companies. Spending time in this area can be highly advantageous, giving treasurers and finance managers greater confidence in the company’s ability to channel cash into strategic business investments that will bring long-term value to the business and enhance competitiveness. 3. How should we hold our liquidity?
As figure 1 illustrates, companies can hold and generate liquidity in different ways: funds from operations; excess cash in bank accounts and financial instruments, and in the form of committed facilities from banking partners. Again, there is no ‘right’ way to hold cash as it will differ by industry and individual company. In making the decision treasurers should balance costs and benefits for holding liquidity. Key areas in this respect include: cash flow dynamics; future potential investment opportunities; liquidity risk (eg, reliability of long-term bank financing); the cost of facilities and interest rates obtainable in the market. Ongoing market volatility also means that this is a question treasurers should revisit regularly.

4. Who will provide liquidity?
Related to the previous question, treasurers should identify the most reliable sources of liquidity, which could be internal funding, banks, financial markets, suppliers and/or customers. As we have established previously, liquidity risk can come in a variety of forms, requiring a multi-faceted risk management approach. For example, we have noted the trend for corporate bond issuance, but also alternative sources of financing such as receivables financing and supply chain financing, leveraging companies’ own financial assets as sources of liquidity. Again, as the business evolves, and the shape of the financial supply chain shifts, the liquidity solutions that are optimal for a particular company are likely to change over time.

5. What should we do with surplus cash?
Working through the previous questions will give treasurers a clear view about short-, medium- and long-term cash requirements, and the liquidity buffer that is required to mitigate risk. Treasurers can therefore divide their cash between operating cash that is required in the short term, and cash that can be invested for a longer period. During the early months of the global financial crisis, we saw a flight to liquidity, with companies placing large amounts of cash in short-term instruments. Low interest rates and enhanced counterparty risk management techniques are now motivating treasurers to invest their cash more strategically to enhance yield. This issue has become further accentuated with the introduction of Basel III, as banks value some types of deposit more than others. Treasurers who have undertaken detailed calculations and scenario analysis to understand their liquidity needs will have more confidence in seeking the most favourable deposit terms and counterparties.

6. How should we manage the associated risks?
We have mentioned liquidity risk, which is a key factor in deciding on the tenor of investments, but other forms of risk, such as counterparty and sovereign risk, are also key decision criteria. One way of managing these risks is to diversify investments across counterparties, tenors, instrument types and locations, and leverage inherently diversified instruments such as money market funds. In addition, risks related to the supply chain need to be managed.

Managing complexity

The outcome of a more strategic approach to liquidity management is a greater appreciation of the complexity of the financial value network of which banks, bondholders, shareholders, suppliers and customers are all a part (figure 2). All of these stakeholders need to be considered as part of an integrated liquidity management strategy, as each brings various risks and opportunities in liquidity terms. This means that any decision that affects liquidity, such as sourcing funds through a syndicated loan, or extending payment terms to suppliers, needs to be considered in terms of its overall implications on liquidity risk. Consequently, a portfolio approach to liquidity, including a variety of financing sources, such as committed and uncommitted facilities, direct issuance, trade finance and working capital financing, combined with a diversified approach to investment, is typically the most successful.

Figure 2: The financial value network 
Source: SEB 

A portfolio approach to liquidity is inevitably more complex than a straightforward syndicated facility, so companies are turning to banks to simplify and streamline the way that these various techniques are managed. For example, with a financial value network that is likely to be large, diverse and extend over multiple continents, it is important to standardize the way in which this community exchanges information. This has led to the development and increasing adoption of XML-based standards, such as ISO 20022 for financial messaging. In addition, corporates are increasingly making use of bank-agnostic, multi-bank connectivity channels such as SWIFTNet for corporate-to-bank communication, and global platforms for programmes such as receivables financing to streamline global processes. Another way of simplifying the financial value network is to rationalize the number of stakeholders within it. In some cases, it may be beneficial to reduce the total number of suppliers, for example, to manage supplier risk and create economies of scale. In addition, many multinational corporations are rationalizing their bank relationships, and appointing regional banks that demonstrate best-in-class capabilities. This reduces counterparty risk, streamlines processes and also helps to mitigate liquidity risk by establishing reciprocal value relationships with banks that provide financing.

Working with the right bank that has a clear appreciation of the liquidity considerations that exist within the company, and an understanding of the wider industry dynamics, is essential. In doing so, treasurers and their banking peers can work together to build an optimized working capital and long-term finance model that reflects the current funding market and future regulatory changes, and enhances the company’s competitive position.

For further information, please contact

Robert Pehrson, global head of product management (corporate segment), SEB Merchant Banking

+46 (0)8 763 8786

Patrik Bergström, financial strategy, client relationship management, SEB Merchant Banking

+46 (0)8 763 8794

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