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Have Low Rates Ruined Treasury Management?

Treasury management remains an important line of business for commercial banks, but players need to adapt to a changing market, particularly in liquidity management.

Low rates seem to be the new normal. Not only has the Federal Reserve pledged to keep interest rates at historical lows through most of 2014, but the trend is further supported by downward pressure on rates in Canada and Europe.

One business that would seem to be adversely affected by low interest rates is commercial cash management. If short term funds are earning virtually nothing, why would companies pay for services to optimize investable cash?

Clearly, the economic environment has had an impact on treasury management. Over the past two years, treasury management revenues have been essentially flat. But only part of the slowdown can be blamed on low interest rates. Sweep account revenues, for example, have declined as companies avoided monthly fees of $100 to $300 to invest excess balances in low-yielding money market instruments.

One reason that low rates have had such a limited impact is that treasury management comprises much more that just cash-flow optimization. Approximately two-thirds of TM revenues are directly related to payment processing, an essential function which must continue regardless of the rate environment. As the float associated with checks declines due to lower volumes and electronic clearing, the link between payment products and liquidity has weakened.

Thus most of the recent revenue-flattening can be attributed to other factors. The shift from checks to lower-cost electronic payments has had a net negative impact on fees. Also the volume of payment transactions dipped during the recession (although activity is rising as the economy recovers).

On the positive side, declines in traditional cash management products have been largely offset by rapid growth in the use of other products, including purchase cards. TM services have also expanded to take on a larger share of the accounts receivable/accounts payable process, allowing companies to streamline financial operations and cut costs. We believe there are further growth opportunities with value-added services, including supporting clients‘ trade credit and collection operations, and financial document management. After more than three years of low interest rates, treasury management remains an important line of business for commercial banks.

Surge in Deposits

Perhaps the biggest impact of the current economic environment is the surge in commercial deposits. Companies have parked more than $1 trillion at banks, including $500 million in demand deposit accounts.

Chastened by the credit crunch, corporate clients are deliberately keeping their balance sheets liquid even as corporate profits rebound. Treasurers are simply hoarding cash until they feel more certainty about future business prospects. Especially among companies with restricted access to credit, the push for liquid reserves has renewed the emphasis on cash-flow optimization — even if returns on invested cash are essentially nil.

Companies have also shifted money from institutional money market funds, which have lost some of their luster after the Reserve Primary Fund “broke the buck“ (its share value dipping below $1) in the wake of the failure of Lehman Brothers Holdings. At a time when money market funds appeared vulnerable and yields were depressed by near-zero rates on short-term debt, banks became the more attractive alternative.

Low rates and unprecedented levels of commercial deposits dampened the impact of Reg Q‘s repeal (allowing banks to pay interest on commercial checking accounts). In other rate climates, this would have provoked a major change in treasury management, but so far this has been a non-event. Flush with deposits, banks have not offered high enough rates on interest checking to attract balances. In the long run, interest bearing DDA may become the dominant commercial deposit category, as in Canada and Europe. For now, however, non-interest analyzed checking remains the norm.

Of course, with record low earnings credit rates (ECRs) on account analysis, many companies can no longer cover fees with compensating balances, even at current liquidity levels. As an example, consider a hypothetical mid-market company incurring $5,000 per month in bank fees. At a 3% ECR, a company would need to keep $2 million in analyzed DDA with its bank to cover commercial fees. At current ECR levels of approximately 0.25%, required balances soar to $24 million. Some customers, newly exposed to the actual cost of TM services, have responded by scaling back product usage.

Most, however, have continued using treasury management services at about the same level as before rates plunged. Companies are writing fewer checks but making more electronic transfers. As noted earlier, commercial card usage is booming.

Legacy of Low Rates

Perhaps the most permanent legacy of the low-interest era will be a decoupling of payments activity and liquidity management. It is not a complete separation — payment services will still be an important draw for operating deposits, and liquidity management will still require payment services to move funds. But as corporate treasurers and banks have become more sophisticated, liquidity management has emerged as a distinct discipline within treasury management. More companies have established formal cash investment policies, and banks have fielded liquidity and commercial deposit product managers. Meanwhile, asset managers such as Blackrock Inc., Goldman Sachs and Federated Investors Inc. compete directly with banks for corporate cash investments.

Commercial banks should take a proactive approach to liquidity product management, particularly with organizational capabilities, pricing strategy and technology. On the capabilities side, teams should focus on product development and analytics. Pricing policies need to be supported by foundational pricing techniques (e.g., elasticity modeling, segmentation) that optimize current returns and can address a more normal rate environment whenever it finally returns. Three aspects of liquidity product management deserve immediate attention:

Product Development. Now, while rates are low, is the time to refine the range of deposit products to assure competitiveness and meet emerging customer needs. One priority is to understand the implications of Basel III‘s Liquidity Coverage Ratio, and design and position deposit products that will require a lower LCR while still meeting customer requirements. For example, as an alternative to MMDA and CDs for longer term funds, banks can offer deposits with no fixed term but a 30-day (or more) withdrawal notice requirement.

Now is also the time to consider promoting interest bearing checking as an alternative to sweep accounts and MMDA, and whether to set earnings credit rates at a premium to money market rates to encourage retention of operating deposits and to support treasury management sales. By addressing product issues now, banks can provide options when rates begin rising, easing the transition for both the bank and its customers.

Goal-Setting. Banks should set goals and standards to address the key factors that will define the profitability and stability of the deposit portfolio in the new environment. These include diversity of funding sources; balance volatility; pricing versus benchmark rates; and the average liquidity coverage ratio for the commercial deposit portfolio. To support these enterprise goals, banks should cascade various targets to regional heads, relationship managers and TM sales officers, including operating account balances, negotiated pricing margins and deposit wallet share.

Information Technology. Product managers and bank clients need information and analytical tools to manage liquid funds. Liquidity product managers need a workstation that provides timely data and historical statistics on flows into and out of each product, as well as views by segment and market, and performance data such as rates. These workstations should also provide tools to aid in forecasting the impact of market moves such as rate changes. For clients, this includes the ability to obtain current rates, forecast cash flows and invest funds through the online treasury management system or a dedicated liquidity portal.

Recent trends will ultimately redefine the field of cash management. Ironically, it may have taken a period when corporate liquidity was worth virtually nothing to highlight the importance of managing corporate liquidity.

Michael Rice and Steve Ledford are Partners in the Chicago office of Novantas LLC, a management consultancy.

For more information, contact Novantas Marketing

+1 (212) 953-4444