Statue of Achilles.
David Murphy (Deus Ex Macchiato) & I exchanged some views on his helpful series on Credit Valuation Adjustments on FT Alphaville this week which is a minefield to me.However, risk transfer and corporate funding are not. So this passage caught my eye (my emphasis)
There is another area where the CVA rules produce undesirable behaviour: smaller corporates. These firms trade derivatives to hedge their own bond issuance — corporates tend to issue fixed rate bonds but prefer to pay floating, hence entering interest rate swaps – or commodity prices, but they often don’t have large pools of cash that they’re willing to tie up as collateral. Thus they generate reasonable CVAs.
However, such corporates are often not themselves liquid in the CDS market, so banks can’t buy protection to reduce their CVA capital. Thus they have to charge the corporate more on the derivatives that they want to enter into.
That wouldn’t be so bad if the corporate had a rational alternative, but they don’t. Central clearing is also expensive, and that requires that someone post collateral, either the client or their clearing member. If the client hasn’t got the money, or doesn’t want to fork it over for this purpose, then they will have to pay their bank to do it for them. The net result of these increased costs is likely to be that corporates hedge less, and keep more risk. This is viewed as enough of a bad thing by the European Parliament that their current version of the EU rules implementing Basel contains an exemption from the CVA rules for some corporates.
There are alternatives. However, they require a re-plumbing of the methodologies corporates as well as bank and non-bank funders use to manage corporate credit risk and liquidity. That point was outlined in my opening comment:-
Another very helpful explanation. What I found particularly interesting is you say corporates have “no rational alternative”. I would suggest that the passive role corporates have played in the creation of credit risk transfer structures for their funding purposes is changing.
Corporate treasury are aware they do not want to be caught again as they were in 2009 by outsourcing funding liquidity risk (and ultimately their reputation and solvency) to their liquidity providers. As the financial infrastructure reforms after the GFC, corporate liquidity risk management – an understandable concern of any funder as part of their continual “Going Concern” assessment – is unlikely to rely to the level it did on the failed credit structures created by traditional credit intermediaries.
This will mean corporate treasury teams increasingly see value in building credit impairment reserves within formal captive insurance structures rather than simply held informally on their balance sheet. These enable corporates to better manage operating cash-flow, payment obligations and credit impairment as receivables fall due. By optimizing internal liquidity, such an approach also reduces demands on external funding. If the CRT mechanism also de-risks collateralised/sold assets within an ABL/ABS transaction, the banks RWA exposure amount improves as PD & LGD reduce, eliminating the need to charge the corporate for more CDS.
Of course, this solution isn’t favoured by banks with falling revenues and lower margins. But that is not an immediate concern for Real Economy mid-Cap CFO’s receiving terms sheets offering poor advance rates on short-term assets at funding margins that do not fairly reflect risk. Many corporates must therefore become their own credit risk underwriters as they can no longer rely on their banks or rating agencies methodologies or often generic credit risk data.
It’s no silver bullet but then, life is never that simple!
David’s response (again with my emphasis)
Thank you, that is a fascinating comment, and I agree with it.
One extra riff, if I may. You talk about corporate liquidity risk management moving away from the pre-crisis models, and I would agree with that. But right now there are three sides to that. First, where to get long term funds/manage their traditional cashflow (e.g. receivables, trade finance). You cover that admirably.
The second is managing short term liquidity in a world where there are more demands (such as clearing) and fewer supplies. Part of the answer to that will be collateral swaps and such like, but part of it will also be developing non-intermediated sources of contingent liquidity from non-banks (and possibly even non-financials). That brings me to the third part; surplus cash investment. With liquidity premiums as rich as they are, there must be sensible low risk ways for corporates to monetise these. It’s not obvious that banks will be able to monopolise these flows…
Again, David raises critical questions for any treasury team. I responded
Thank you for the generous words. You raise good additional points.
My first reaction to this is to turn to Supply Chain Finance. This model has developed significantly recently and can now be applied (with some help) by corporates with surplus cash flow (for example surplus cash impairment reserves within a captive/ ICC/PCC structure) into discharging their liabilities for purchases early, thus earning yield through discount benefits. The supplier equally benefits from improved cash flow and this virtuous circle potentially dis-intermediates the banks and monetizes the significant liquidity/collateral that exists outside the formal financial system for the benefit of the Real Economy, increasing the velocity of liquidity through the broader system.
What this exchange supports is a critical factor (and I would add financial asset) missed by most commentators. There is an abundant source of potentially ‘de-riskable’ short-term assets, that are often significantly underfunded. These assets – in many instances – are “promises to pay” that can be transparently structured and support faster Real Economy growth. However, they are a granular, dynamic, hard to track and unsexy asset. They require bank resource to manage. With Real Estate, bankers don’t have those worries. Yet trade receivables comprise around $20 trillion of Balance Sheet value in the US alone. By “underfunded”, for every $100 of a short-term trade receivables asset portfolio, corporates generally receive around $70 of liquidity with the remaining $30 sitting dormant as encumbered capital on each corporates balance sheet. In Europe the position is even worse given a much smaller proportion of non-bank corporate loans (EU 10-20% versus US 80-90%) and the role of the large European trade credit insurers who continue to sell a model to their clientsthat failed so spectacularly in 2007/8/9. Trade receivables are central to working capital and therefore essential to economic growth. Yet, there is almost no mention of this abundant asset in financial commentary.
Understanding how to improve the funding process requires knowledge of both the liquidity and risk management requirements of non-financial corporates. Most banks failed in these areas themselves, so their advise to corporate clients lacks credibility.
Banks should be acknowledging to clients that the financial world has irreversibly changed since the global financial system begun its slow collapse in 2007. Such acknowledgement, as with alcoholism or substance abuse, requires the financial system to admit that :-
- investors will no longer easily commit their funds to transactions or securities. They will not only want evidence high quality and granular credit risk analysis of referenced assets has taken place in a timely manner. They will also want to ensure it continues to take place on an ongoing basis.
- Information asymmetry creates mistrust. Traditional credit intermediation and rating methodologies must be rebuilt to eliminate it.
- Outsourcing financial risk management to banks has failed. Non-financial corporates are beginning to take greater control of the collation and supply of high quality, timely and granular credit risk information that is shared with key counterparties to maintain systemic confidence. This data underpins collaborative – not adversarial – funding methods and structures that funders historically offered as part of their service. Information asymmetry is no longer smart.
We are leaving a financial world where banks essentially sold more and more liquidity to customers only if the vehicle they used were bank-sponsored. Changing liquidity providers was extremely expensive when services and funding were bundled with one relationship bank, especially in Europe. The time it took and costs of renegotiating a new (complex) service and credit agreement were too onerous. A few years ago when liquidity was cheap funding costs were manageable. When the economy was good bundling mattered little. Corporates had appreciating assets, a thriving economy and importantly credit.
Things have changed. Clients are now getting wise to the service bundling and pricing tricks banks use. Increasingly, customers are a little more critical of the value for money. As for the price of liquidity now….well , the client receives a bundled price for all their services so it’s difficult to tell how much each service costs but they are smart enough to know one price may subsidize another. The clients income and ROCE are reducing (more encumbered capital, lower asset value, more credit risk uncertainty in a more volatile economy & higher liquidity costs thanks to general inflation). They’re not keen to see their funders pass on their increased costs to them.
Given further damaging allegations in the UK that banks mis-sold swaps, corporates will increasingly focus on protecting themselves from an imploding financial system, outsourcing less financial control to bank risk advisers and protecting their precious capital better. They can no longer accept their traditional funders shrugging their shoulders as they charge ever-increasing prices blaming “The Markets” or “increased regulation”.
It is also a fertile fallacy that corporates cannot do more to reduce funding costs. Many commentators and Financial journalist miss this point when often deferring to the financial lobby perspective. And those that are critical offer anger and vitriol rather than forensic alternatives.
Yet, for years, banks have been able to support overall corporate cash flow through their considerable influence over two of the three sources of cash flow you’ll see on any financial report ; cash flow from financing activities and cash flow from investment activities. Any weakness in operating cash flow could be supported by priming these other two sources. This not only enabled bonus pools to benefit; it also hid any fundamental weakness in the core business models of corporates. For well remunerated Executive Boards able to use funding & investment income to support the share price, procuring the services banks offered generated considerable benefits to financial metrics driving executive remuneration. Now the music has stopped, protecting and optimizing operating cash flow is critical to survival.
Corporates are focusing on the fundamentals:-
- Improving liquidity risk management
- finding new sources of contingent non-bank liquidity
- enhancing own credit risk management through the construction of formal credit impairment reserve structures available to support liquidity shortfalls that threaten the corporates ability to meet obligations as they fall due; obligations a phone call to the bank would have once solved.
- finding effective non-speculative uses for surplus cash.
All of these potentially undermine the ability of banks to generate fees. Banks would far prefer it if corporate treasury just swept each days surplus cash into banks overnight deposit accounts. At least that could support the banks own funding liquidity needs. And in this dilemma is the banks Achilles’ heel. Many bankers are too focused on maintaining their roles within a broken system to see what’s happening in the wider world. They fumble for soothing words and rationales to explain their recent behaviour as an errant partner would when they say “It’ll never happen again”. However, when trust has been broken it is very difficult to restore. The banks continue to engineer methodologies that generate short-term speculative financial value using complex chains and what are likely to be ineffective or unenforceable risk mitigation techniques; the ability to create credit with only a tenuous link to real assets that has been a feature of finance over the last twenty-five years has declined. What has emerged is a divergence between the imperative of many financial market participants and that of (most) corporates seeking to create sustainable economic and social value.
With this in mind corporates of all sizes must review their funding strategies and take greater ownership of the process. On the eve of the centenary of the sinking of the Titanic, corporates can no longer rely on being passengers. Outsourcing responsibility for their corporate wellbeing as a ‘Going Concern’ to those who have not only let them down, but fail to acknowledge their mistakes, is a situation no Executive Board can afford to repeat.