Cash call
October 2009
Thomas Meade gets back to basics on treasury management in turbulent times
Cash management should be the least exciting of activities but in the whirlwind of the last two years it has been anything but. The great banking crisis that broke in 2007 was not forecast, the policy reactions of governments were both novel and stupendously large, and the future outcomes remain uncertain. It has reminded us that all investments, including cash, are risky and that we should always work on the principal that anything could happen, because one day, maybe not tomorrow, but one day, it really will.
When I started in the cash management business my then boss, who had been around the clock a few times, applied one overriding principal to investing cash – keep it simple (or in my case ‘keep it simple stupid’). He liked to paraphrase Warren Buffet, ‘use a model that any idiot can run because sooner or later an idiot is going to run it.’ An instruction like ‘keep it safe’ cannot be misunderstood.
Looking after cash is both simple and surprisingly difficult. I think difficulties arise because there is often not a clear enough understanding of what cash is or what can be expected from its investment.
The value store
To me, the main function of cash, especially for charities, is as a store of value. Put a pound in and at the very least expect to get a pound back. If money is put into anything that doesn’t have that clear characteristic then don’t call it cash as its nature has been changed and it has become another sort of investment with its own set of unique opportunities and challenges.
I believe the second major function of cash is as a medium of exchange. Cash is there to be spent and at some point it will be, so it must be ready to be used when needed.
The third function of cash is, of course, as a source of income but this function, while vitally important is too often given undue prominence over the first two and its pursuit, without reference to the need for security and liquidity, a recurring source of problems.
So we should expect cash to maintain its value, be available when we need to use it and produce an income. In investment jargon this is expressed as security, liquidity and yield (SLY).
Treasury policies
The best way to prepare for an uncertain future is to a have plan that is based on proven principals but which is adaptable to changing circumstances. For cash management, a treasury policy can provide such a framework. The best examples I have seen lay out in clear terms an institutions risk appetite expressed through minimum credit ratings, levels of diversification, a list of banks and building societies that can be lent to with maximum exposures for each, assets that can be used (e.g. deposits, treasury bills, certificates of deposit) and possibly maximum maturities or bands of maturities based on likely cash flows.
For a treasury policy to maintain its effectiveness it needs to be regularly reviewed to ensure its relevance. Its everyday application must be monitored by people who are separate from those carrying out investment. In my working life I have come across excellent examples of this and have also unfortunately seen cases where the day-to-day cash management bears very little resemblance to the often lofty ideals of the institution’s treasury policy! The best ones usually have a quarterly review of cash management by an investment committee which includes people with relevant experience. Such committees can bring discipline to the process and can challenge comfortable routine or misguided assumptions.
A time for caution
The time to be cautious is before destabilising events occur and, over the last nineteen months, the old certainties have certainly been blown away in a perfect storm of debt, default and doubt. From the rescue of Northern Rock, the Icelandic collapse, the failure of Lehmans and the near implosion of the entire banking system last autumn, the problems have come in seemingly endless waves. Interest rates are at 300 year lows, the overall credit worthiness of banks has declined dramatically and the fall in value of assets once seen as ‘near cash’ has caused considerable problems to the unwary. The one bright spot in the short term has been the (eventual) willingness of governments to support both individual institutions and the financial system as a whole.
While bond and equity holders have suffered losses during the banking crisis, depositors, with the exception of those in Icelandic banks, have been largely protected. Individual bank failures are increasingly unlikely so long as banks have a credible government standing behind them.
The money market is a very different place to what it was two years ago. There is a much greater spread of rates being paid by banks for similar maturities. This tiering reflects the
disruption caused to the market by the crisis and the differing needs of banks for funding. The larger banks have also become much more aggressive as regards direct marketing for deposits as they try and reduce their dependence on wholesale funding through the market.
disruption caused to the market by the crisis and the differing needs of banks for funding. The larger banks have also become much more aggressive as regards direct marketing for deposits as they try and reduce their dependence on wholesale funding through the market.
As ever there are risks and opportunities in the new environment which is emerging but the old principals remain unchanged and a structured approach to cash management through the filter of security, liquidity and yield will always be relevant.
As for interest rates themselves, we have had bank rate at 0.5 per cent since March 2009 and at some point they will rise – but who knows when?
Too much stimulation
Although it is expected that the monetary and fiscal stimulus provided by the government will impact further on the economy, the magnitude of the effect and its timing is uncertain. Given this uncertainty it was surprising that the MPC felt it necessary to expand the size of the quantitative easing programme to £175bn taking commentators and the market by surprise.
There is a danger that if the economy recovers at a faster pace than currently anticipated by the MPC then the extra stimulus will push the recovery even faster, risking an upswing in asset prices and possibly the general level of inflation. The MPC could then find itself in a very exposed position, faced with the prospect of having to find an exit route from QE, having to raise interest rates and still fund the government’s massively increased borrowing. With global sentiment improving the next three months will be pivotal in determining how the
MPC responds to events.
Outlook
The consensus view is that bank rate will not rise until the first quarter of next year at the earliest. While there are good reasons to support this view the economy is receiving an extraordinary stimulus through a combination of lower interest rates, lower exchange rate and direct government intervention. Although there are variable lag effects I would expect an improvement in economic news towards the end of year. Once any sort of positive traction on the economy becomes evident I anticipate that market rates could firm considerably and just as in August 2007 when the money market gave us the first warning of problems to come an improvement there could be the best sign of an upturn in late 2009 and 2010 (see the LIBOR graph in figure 1 below).
In the past twenty years the average number of months from the low point in base rate to the first rate rise has been just five months with the range being between one and twelve months. All the turning points have been in the second half of the year, with September October being the turning points on five out of seven occasions. No one can precisely know when the cumulative effects of all the kitchen sinks thrown at the economy will produce some kind of traction but we must remain aware that the current level of base rate in the UK may be shorter lived than many now expect and at some point base rate will move closer to the 5 per cent average it has maintained since the MPC’s inception in 1997.
Author: Thomas Meade
Thomas Meade is the investment director for Royal London’s cash management business. After joining the Union Group in 1978 he moved to Guernsey and established a new branch of Union Discount Company, UFM Channel Islands. Tom returned to London in 1988 and was appointed investment director in 1991. Union Fund Management was renamed Royal London Cash Management in 2001 following its acquisition by the Royal London Group.
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