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Black swans, fat tails and running out of cash

The shocks of the US election, the Brexit vote – even India’s decision to eliminate high-value currency notes – are all stark reminders companies should prepare for the unexpected.

Those who are unprepared are at risk of a company’s worse nightmare: running out of cash (physically, in the case of Indian businesses).

" How can companies immunise themselves against the outcome of the latest unpredictable vote?"
Shailesh Venkatesh, Product & Solutions, Transaction Banking at ANZ

Although the market’s response the US election was a whiplash one, the danger was – and remains – volatility and the prospect markets could rapidly evaporate liquidity.

If the greenback falls, companies with assets in US dollars could see their value suddenly drop and they could face a cash crisis.

If their collateral is in US dollars, counterparties could ask for more money to cover the drop in value. If there is not enough cash to do so, they will be unable to pay their bills, spurring a knock-on effect with customers and suppliers who will in turn face a liquidity squeeze.

We live in an age of the unexpected; of so-called fat-tail risks and black-swan events. How can companies immunise themselves against the outcome of the latest unpredictable vote? How do you ensure, as a treasurer of a company, you are not caught by surprise?

The word ‘liquidity’ comes from the Latin ‘liquidus’, to denote something flowing freely and consistently. In the banking and business world ‘liquidity’ is synonymous with assets that can be easily converted to cash.

Not having cash on hand to fulfil obligations in the short term can be crippling for both individuals and companies.

On the other hand, too much cash may mean a company or individual is missing out on investments that will pay off in the long term. Having too much or too little cash means it is not flowing smoothly, hence there is no liquidity.

Globally, particularly in the US, levels of cash held by major corporates are rising. While that is a good hedge against a shock event, it is not a good use of cash, especially in a low-interest-rate environment.

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Cash on hand is a safe hedge against shocks on financial markets or a company’s supply chain but too much cash reduces the return on invested capital.

HOW MUCH CASH?

A metric to evaluate the effectiveness of treasury teams would be to look at the difference between (A) return on invested capital (including cash) and (B) return on invested capital (net of cash). The extent to which B is greater than A indicates the negative impact of cash to shareholder returns.

It is clear corporates globally are grappling with the challenges of effective liquidity risk management. The recent GTNews Transaction Banking Survey 2016 confirms the services most likely to be under review by organisations are cash and liquidity management.

While this is not surprising, what is notable is the increasing gap between the demand of these services and other banking solutions.

Products and services to manage liquidity risk have long been available but implementation is often hindered by many factors within corporations. These can range from cultural issues, conflict of interests and inadequate resourcing to political will.

LIQUIDITY RISK

Running out of liquidity starts first and foremost with structural aspects of the balance sheet. The issue of managing the residual risk is where attention is often deficient.

Often, articulating the benefits of an effective management for residual cash is missing. How can treasurers drive effective management of cash beyond the structural issues of the balance sheet?

FIVE LIQUIDITY MANAGEMENT TIPS FOR BUSINESSES

• Clearly articulate your goals

• Get the board to endorse the goals (even at the cost of being measured and tracked against!)

• Create a win-win policy between treasury and business units

• Don’t be afraid take hard decisions fair to the goals articulated and endorsed

• Do not ignore counterparty risk (even small losses can cause significant damage to reputation)

Treasurers must start with defining treasury policy, processes and procedures which clearly outline the objectives and desired outcomes. It is crucial for company boards to actively endorse this.

A simple treasury policy emphasising visibility, automated tracking of inflows and outflows and counterparty risk management can establish basic guidelines for change and cooperation across the organisation.

This is a necessary foundation for effective treasury management that centralises cash and establishes cash levels appropriate to the size and volatility of the business.

The simpler the goal, the easier it would be to articulate and measure against. Organisation-wide willingness to embark on control of cash can be better achieved through a board mandated treasury policy.

TREASURY RESOURCES

A significant challenge for treasurers continues to be resourcing. In the last 10 years, there has been much said about the treasury in an organisation playing a much wider and strategic role in enterprise-wide risk management but the resources added to this space haven’t necessarily kept up with the rising expectations.

Resourcing needs are likely to be higher in periods of initial implementation. A clear board-mandated policy can give treasury the licence to add resources, cross-skill staff and re-prioritise initiatives during the phase of implementation.

In my own experience of observing successful implementations of projects, I have seen the most impact where treasury has operated with the right resourcing armed by a clear mandate from the board.

While treasury is the author of this policy, the board’s mandate ensures there is an agreed governance model for accountability in line with the policy which will further provide an impetus to getting broader support for implementation.

STAYING FOCUSSED

The risk of running out of cash can never be completely hedged. In case something untoward happens, having a plan means energy is focussed on the response rather than the emotions of how or why it was allowed to happen.

This policy can become the guiding principle which pushes the organisation towards enterprise wide risk management.

For example, account rationalisation can be an emotional and challenging topic within an organisation with many different entities, currencies of operations and banking relationships.

It is not uncommon for companies in Asia to open bank accounts with multiple banks based on the convenience of their trade partners. Such bank accounts, while perhaps beneficial from a customer service angle, clearly obscure cash visibility, if that is a goal outlined by the policy.

TRANSACTION CLARITY

Another simple goal that mitigates risk is automated inward confirmations. Many companies rely on an army of people identifying inward receipts and applying them to outstanding invoices.

Often a payment transaction needs information from multiple sources to complete the story around the transaction - costing time and money.

Finally, centralisation of cash with treasury to extract greater returns on cash through increased scale and bargaining power for investments and borrowing can lead to the whole organisation benefitting from the outcomes.

Shailesh Venkatesh works in Liquidity Management - Product & Solutions, Transaction Banking at ANZ

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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