Changes in Banks’ Ability to Pay Interest, Term Paper Example

Theme: How changes in bank`s ability to pay interest on corporate demand deposits will change cash management

The repeal of Regulation Q is aimed at fostering profitability and competitiveness among banks.  Corporate treasurers and financial officers will be significantly impacted by the opportunities available in the new banking landscape and by challenges that will arise as banks seek to pass on the costs of paying interest on deposit accounts.

Overview – impact on corporate cash management

The repeal of Regulation Q represents a qualified win for corporate cash managers.  With newly earned interest on hand, corporate cash managers will have to look at new ways to maximize profit and avoid paying unnecessary fees.  Money management tactics that were part of doing business under the restrictions of Regulation Q will no longer apply now that the regulatory environment has been altered.  This is good news for corporations, but money managers need to have an in-depth understanding of the new options available to them.

Cash managers at corporations of all sizes can now expect to earn money on previously non-performing balances. Smaller corporations, companies that have fewer cash resources and assets, in particular stand to benefit.  Despite the obvious benefits to businesses both large and small, there are some mitigating factors.

Banks will have to increase their transaction fees in order to pay for demand deposit interest.  If these cancel out corporate return on interest, then corporate cash managers and their companies will have gained little.  Some corporate cash managers may opt to continue to get the earnings credit rate to cover their banking fees.

The Dodd-Frank reform law has added a level of complexity to the role that corporate treasurers have traditionally played.  Competition among banks and fund companies will open the door to new profit-generating opportunities.  Corporate cash managers will be pressed to leverage relationships with their banks in order to take full advantage of new options.

Interest on commercial demand deposit accounts – threat to profitability?

Interest on commercial demand deposit accounts may threaten profitability in the short run, but a carefully developed profit management program holdssignificant potential for profitability.  Corporate cash managers who are unprepared, or who adopt an inadequately active stance in light of the newly deregulated deposit environment,risk losing out on long-term profit potential.

Coordinating carefully and thoroughly with banks will be key.  Working in conjunction, corporations and banks can devise coordinated cash management programs that provide a profitable return.

Because the change in regulation has come at time of historically low interest rates, companies are unlikely to see an immediate return.  The average consumer checking account paid an annual percentage yield of 0.78% in the first quarter, down from 1.02% in the year-earlier period and 1.43% in early 2008 (Wall Street Journal, 2010).  However, many businesses do not have high-dollar balances in their checking accounts.  When rates to go up, companies stand to benefit materially.

The new regulation allows corporations to get FDIC insurance to cover balances that pay no interest, or they can obtain $250,000 in interest-bearing accounts.  Corporations may find fund companies an attractive alternative if they are able to leverage higher banking fees.  If, as mentioned previously, bank fees offset gains from interest, corporate managers may be able to take advantage of better deals, such as short-term fixed income funds.

Potential risks of non-response to profitability issues

Being prepared to do business under the new regulations will help corporate treasurers avoid pitfalls and take advantage of opportunities.  “As banks use interest-paying deposits as an incentive to consolidate cash, and treasurers take steps to consolidate deposits, this change could result in additional counterparty risk” (LaRock, 2010).

Those who aren’t prepared to manage risk,who fail to thoroughly explore new ideas for cash management, will lose ground in the marketplace to competitors.  Banks have a vested interest in helping corporations make the most of new deposit options and comply with the complex regulations governing the post- Regulation Q playing field.

Treasurers can do themselves a favor by having a solid handle on their cash position and on all their available options.  “Only the informed cash manager will be able to assess the full impact of Regulation Q’s repeal, which is why practitioners should prepare now by evaluating

their account structures, short-term investments, bank fees, and account analysis processes” (Weiland, 2010).

Working together, corporations and banks can implement and optimize investment policies.  Failure to develop a plan of action means companies may be losing out on opportunities, for instance, to negotiate higher interest rates with their bank for any additional cash they may still have on deposit.

Corporate treasurers will be busy taking into account their existing business models, liquidity and cash management strategies.  This is the kind of planning activity that corporate cash managers must undertake to comply with Dodd-Frank and fully realize the profitability that the repeal of Regulation Q was intended to bring about.

Dodd-Frank brings with it sweeping change for the corporate landscape.  Companies will be compelled to redefine their cash management, risk management, trading and other related activities.  Financial officers have an unprecedented opportunity to bring new sources of revenue into their coffers.  But new management strategies must take into account the risks as well as the opportunities.

Banks can help smooth the transition, an important part of which depends on banks turning more to operating services rather than relying on rates, as they have in the past (See Figure 1, p. 18).  This is key to the long-term value of the demand deposit business.  Businesses recognize that changes in bank liquidity and capital requirements, unlimited FDIC insurance on non-interest bearingaccounts and other such regulations must be taken into consideration when devising deposit strategies.

Reassessing deposit portfolios

A reassessment of demand deposit portfolios must take into account the fact that banks are diversifying their deposit offerings in recognition of the fact that corporate customers will be scrambling for the best packages they can get.  Developing a strategic new approach to deposit portfolios will be more than a matter of maximizing new options for profit under Regulation Q.  Corporate financial managers will also be looking at ways to minimize the impact to the ways in which companies do business, to mitigate the consequent “shock to the system.”  Businesses will seek to put themselves in the best position they can without making a too-fundamental shift in their overall model.

As the demand deposit field becomes more competitive, corporations will expect banks not only to offer a more varied menu of services but to customize those specializations to suit very specific needs.  The key for corporations, and the banks that serve them, will be in coordinating services in a manner that maximizes profitability.  “The challenge in developing products lies not in their complexity but rather in bringing together the various lines of business and then executing the development efficiently” (Ledford &Seo, 2010).

A survey of 12 of the 24 largest banks found that, despite new latitude made possible by the repeal of Regulation Q, most believe that competing solely on interest rates would erode the value of demand deposit accounts.  Consequently, many banks are considering going to hybrid products that offer an earnings credit rate on balances until service rates are paid, and interest on excess balances.

The repeal of Regulation Q places banks in an unaccustomed position, that of concentrating on innovative corporate deposit products.  As such, banks have heretofore invested little in the way of time and money in developing innovative deposit products.  Innovation is sure to be a major part of the picture in the post-Regulation Q world and should offer treasurers the opportunity to.

Creativity and marketing will become a larger part of the picture than ever before.  “For example, a leading regional bank was able to win large deposit balances by creating a deposits

‘SWAT team’ that tailored the terms of deposit products within two days to meet the individual needs of large corporate deposit-holders” (Ledford &Seo, 2010).  Individual customization of products will have greater appeal for corporate customers.

For companies, taking advantage of the new deposit scenario will depend heavily on the corporate financial officer’s ability to leverage bank relationships, assess collection channels, monitor and prepare for potential counterparty risk, and seek out competitive changes from fund companies.

Interest-on-checking offers vs. money market or offshore accounts

Part of the reassessment corporate treasurers will need to conduct includes weighing interest-on-checking offers against alternatives they’ve used in the past to generate interest, such as having balances moved daily into money-market funds or offshore Eurodollar accounts.  Those that elect to leave money in their bank will have to determine how much counterparty risk they’re willing to take on.

“The repeal of Reg Q and the increased FDIC and reserve-requirement burden on banks will complicate the bank service-fee model for corporations. The earnings credit in soft dollars historically applied to balances in lieu of interest may now look less attractive or different on a bank-by-bank basis” (Myers, 2010).

Banks offer a variety of sweep investment instruments, ranging from repurchase agreements, commercial paper, master notes, Fed Funds, offshore instruments, and money market mutual funds. Growth within the various instrument categories varies considerably.

Corporations can benefit in a number of ways from sweeps, which offer liquidity, convenience, safety, selection and yield.  The relative importance of these advantages will vary depending on the size and structure of the individual company.

“Money market instruments are primarily repurchase agreements of U.S. Treasury securities.  These are the most common of sweep agreements because they are permitted by nearly all corporate investment policies” (Cantillon &Franzke, 4.2, 2008). Repurchase agreements are attractive to many corporations because they offer safety and 100 percent liquidity, although they generally represent the lowest return on investment.

Fed funds, commercial paper and master notes are other overnight money management options available to corporations.  Master notes give highly rated companies the opportunity to borrow from the trust departments of banks, while Fed funds are funds deposited by commercial banks at Federal Reserve banks.  Commercial paper is an unsecured promissory note issued for a specific amount.

“Money market mutual funds used in sweep programs are high-quality, short-term mutual funds managed by either the sweeping bank or a third-party advisor. The mutual funds most often used by sweeps are U.S. government or prime commercial paper funds. Many banks offer tax exempt funds as part of their sweep package” (Cantillon &Franzke, 4.3, 2008).  Banks usually charge a monthly fee for sweep account services.  These range from around $10 to more than $100, based on the size of the company in question.

Liquidity management accounts – banks as liquidity managers

Liquidity is a key component of banking.  It is, in a sense, the life-blood of any bank because the ability to meet cash demands directly impacts the institution’s ability to maintain confidence and attract customers.  Liquidity management will be a premium service for banks as they scramble to revise business models, and recalibrate pricing and fee structures in the interestof establishing a corporate customer base that provides an optimal return for both the bank and customer.

One of the more exciting opportunities, post Regulation Q, is the possibility that corporate customers will be able to structure their own portfolio accounts.  The key for banks will be to produce cash management services that are carefully tailored to meet their customers’ needs in the new financial reality.  The regulatory changes will mean increased flexibility for corporations and banks alike – both will move aggressively to take advantage of these circumstances, with banks occupying an important role – that of liquidity manager.

Part of the picture will place the bank in the position of revenue source, as a resource that optimizes liquidity as well as profitability.  Banks will make it attractive for corporate cash managers to keep most or all of their funds in specially structured bank accounts since, with the repeal of Regulation Q,their money will now be entirely productive (See Figure 2, p. 18).

The days of largely transaction-based relationships will increasingly become an outmoded business model for banks and for the corporate financial officers they serve.  Many companies will issue requests for proposals as they go shopping for the best deals but, given the market volatility in recent years, it is likely that corporations will opt for stability and continue to seek ways to “repurpose” their existing banking relationships. As liquidity managers, banks will be relied on for greater guidancethan before.

Hard interest/soft interest – which model is best?

One of the first tasks that corporate treasurers will need to perform is to analyze the company’s overall financial relationship to their banks.  This analysis should produce a better understanding of three fundamental costs: “hard” fees, which are investment fees that are disclosed and easy to determine; and “soft” fees, which are undisclosed, and might include the profit a bank earns on an interest-rate exchange.

Conducting a comprehensive bank cost analysis gives corporate financial representative a clearer picture of how much his company is spending on each of the banks they do business with.  Acquiring a breakdown of hard and soft fees will put companies to make more intelligent decisions as to the services they utilize.  In other words, they will have a better idea of what “a la carte” items are available on the various banking “menus” and be able to mix and match to their best advantage.

Tax considerations will also play an important role in corporate calculations since hard interest dollars, unlike soft interest credits, are taxable. In addition, services that are paid for with hard dollars can be expensed. Both companies and banks will need to consider, on an ongoing basis, the many new banking alternatives and tax implications that will continue to emerge now that Regulation Q has been repealed.

Risk minimization investing

Corporate managers will need to diversity their deposit portfolios, but too much diversification is risky.  The corporate money manager who tries to be too picky may end up outsmarting himself, creating operational inefficiencies that hamper profitability in the long run.

On the flip side, over-centralization, concentrating too many financial resources on one or two financial institutions, could lead to under-performance (Ryan, 2010).

New and more diverse banking options will likely motivate corporate treasurers to adopt risk management tactics, particularly as the U.S. continues to slog its way through an uncertain economy.  Corporations can utilize hedging techniques to minimize volatility and uncertainty.  Most importantly, risk hedging in asset management can play a major role in improving return on asset portfolios.

Gather cash assets, pay down debt ceiling

Corporate cash managers will be advised to gather and consolidate cash assets by, for instance, paying down their debt ceilings in order to take full advantage of new deposit scenarios.  The proper allocation of available assets will enhance a company’s ability to prosper from interest-bearing opportunities.

Companies may at some point need to dispose of cash assets to further enhance liquidity.  Futures can be utilized as a “hedge” to ensure that there aresubsequent gainsfrom thosecash assets after they have been sold.

Utilization of zero-balance accounts scenario

Many large corporations have been in the habit of employing zero-balance accounts to keep balances minimal.  For these wealthy companies, it makes more sense to avoid paying excessive fees since they are in cash-rich situations to begin with.

A review of the corporate collection channel will suggest additional strategies for maximizing interest-leveraged opportunities for profitability.  “As banks begin paying interest on business checking, the new source of interest revenue could mean a narrower spread between bank checking returns and those of other short-term investments. Companies could choose to leave money on deposit since their returns are higher. In that case, the rationale for zero balance accounts and other cash concentration products would become less compelling”(LaRock, 2010).

Maintaining higher balances, avoiding bank transfer fees

There are other ways to determine whether or not it makes sense to pay or avoid fees.   There are complex calculations to help a company determine whether it makes the most sense to avoid bank service charges by maintaining high balances and offsetting their charges with earnings credit, or minimizing their balances, and paying their bank fees as normal expenses.

In today’s world, it makes sense to continue to minimize balances and pay for bank fees as expenses, but that is determined by the various rates being applied.“While it is too early to work with solid numbers, it is possible to model an optimal portfolio. By examining various rate scenarios, treasurers can determine how to rebalance their deposit portfolios in light of new deposit products and rate structures” (LaRock, 2010).

Adjusting the bank instrument mix to maximize return, profitability

There will be a period of adjustment for corporations and banks.  As has been discussed, corporate money managers will need to assess the full slate of new depository options open to them in terms of profitability, convenience and risk minimization.

Banks will incur a short-term increase in costs by paying interest on demand deposits. This increase will be mitigated by the fact that a large percentage of demand deposits already earn interest. In the long run, the effects of allowing banks to pay interest on demand deposits will without question be beneficial on both sides of the equation.  It will rid the industry of a historically problematic regulatory impediment and encourage increased competition and efficiency in the banking industry.

Conclusion

Now that Regulation Q is a thing of the past, banks are free to pay interest on corporate checking account balances for the first time since the Depression. Just how much that will affect where cash managers keep corporate funds remains to be seen. The need to adapt rapidly to the change in regulations, uncertainty about the long-term implications of the repeal of Regulation Q, and a shifty economic climate will likely make for a chaotic situation in the short-term.

In the long-term, cash managers will be able to leave more money in more banks without paying excessive penalties, meaning more profits over time (an increase in interest rates will certainly help).  “We may see companies redesign their bank account structures. This could affect liquidity practices significantly,” Carfang said, adding that cash managers and bank treasurers will likely communicate more frequently about rates on accounts and investments in finding ways to optimize their mutual profitability (Carfang, 2000).

“(Bank treasurers) will talk to the cash management business heads about what rates are offered for which deposits or investments. Together, they’ll figure out how to optimize the bank’s profitability based on funds transfer pricing,” Carfang said (Carfang, 2000).

When rates do begin to rise, banks will most likely lock in lower funding rates for products such as certificates of deposit, instead of taking floating rate deposits that stand to increase their costs when rates go up.  For the present, banks that have excessive liquidity in a time of low rates most likely won’t compete heavily for deposit accounts. However, this scenario will likely change when the overall economic picture improves.

When that occurs, corporations both large and small will reap the rewards of an interest-bearing deposit relationship with their banks, with increased profitability the end result.  The banking industry, corporate America and the U.S. economy in general stand to benefit from a more competitive environment.  Ultimately, that is the intention implicit in the repeal of Regulation Q.

In any event, corporate cash managers will continue to operate based on needs and principles that have always guided them: convenience, profitability and risk management.  Profitability will be themajor by-product of the repeal of Regulation Q when interest rates rise, but convenience and the ability to steer their companies through financial risk will mean a careful and thorough reassessment of deposit portfolios arrived at through close coordination with the banks.

References

Carfang, Anthony.  “Regulation Q’s Repeal Would Mean Chance to Stop Deposit Drain.” American Banker. 6 October 2000.

LaRock, Paul.  “Analysing the Dodd-Frank Effect on Corporates.” Treasury Strategies. 14 September 2010.

Ryan, Vincent. “Take Control of Your Bankers.” CFO Magazine.  1 October 2010.

Weiland, Peter. “Dodd-Frank Reform Law Will Have a Lasting Impact on Account Analysis.” 27 July 2010.  http://www.gtnews.com/article/8067.cfm.

Sidel, Robin.  Wall Street Journal.  “Interest Turns to Corporate Checking.” 14 July 2010.