ACCA - The global body for professional accountants

With talk increasing about the eurozone taking the ultimate monetary step of negative interest rates to avert deflation, it’s time for CFOs to revisit their capital structures

Esther An

This article was first published in the June 2014 UK edition of Accounting and Business magazine.

If a nod’s as good as a wink to a blind horse, as the old saying goes, then Europe’s CFOs need to start reconsidering their direction of travel.

Since the start of the year a series of nods about negative interest rates have come from senior figures at the European Central Bank. In February, Erkki Liikanen, a member of the ECB’s governing council, told a House of Lords committee that negative interest rates were one of the tools the bank had discussed to counter the threat of deflation in the eurozone.

Then in March, Sabine Lautenschläger, an ECB executive board member, told The Wall Street Journal that the ECB still had options to counter the dangers of low interest rates. ‘We have room left to act.

The deposit rate could be negative, for example,’ she warned.

So with the eurozone heading for deflation, are negative rates a real possibility which CFOs need to factor into their future planning? And, if so, why do most CFOs seem so relaxed?

Perhaps it is because most economists and bankers believe that, despite the nods and winks, negative interest rates would represent a last resort for the policymakers.

Yet the deposit rate – what the ECB pays to banks that park money with it – is already at zero. What policymakers desperately want is for Europe’s banks to start lending to both companies and individuals again in order to stimulate the continent’s flagging growth.

The trouble is that while politicians want banks to lend, banking regulators want banks to continue shrinking their balance sheets to guard against the danger of a further systemic banking crisis like the one that paralysed Europe’s financial system in 2008.

And even if the banks were keen to lend, it is unlikely that many corporates would be eager to borrow from them while growth prospects remain poor, as Andrew Clare, professor of asset management at Cass Business School, points out. ‘So it doesn’t really matter whether you set negative interest rates or whether you flood the world with cash; there is no guarantee that any of it will have any effect at all,’ he says.

But even though there are doubts about whether negative interest rates would get Europe’s economy moving again, CFOs cannot entirely discount the possibility. One problem is that, in the absence of vigorous investing, many of Europe’s corporates are holding sizeable sums of cash on their balance sheets. They need to park that cash somewhere and some banks are reported to be increasingly reluctant to take it, especially at their quarter-ends and year-end.

When the Association of Corporate Treasurers surveyed 28 corporates at year-end 2013, it found five had encountered ‘significant reluctance’ from banks to take their cash. Two corporates even ended up paying interest rates to the bank for holding their money.

Just three companies reported that their banks had refused to take deposits altogether. But that low number could have been because ‘companies had been warned off approaching the banks that were not looking for deposits’, according to a briefing by Martin O’Donovan, the ACT’s deputy policy and technical director.

The villain of the piece in all this could be Basel III, the new regulations designed to make bankers more prudent. It incorporates a new liquidity test that focuses on banks’ ability to survive a market closure for 30 days and still have cash. Large corporate deposits of fewer than 30 days are not much use in meeting this test, because the presumption is that they will be withdrawn before the time is up.

Short-term corporate money may also harm a bank’s leverage ratio, especially at quarter-ends when measurements are taken. According to Basel III, a bank is supposed to keep a ‘tier 1’ leverage ratio – roughly, shares and retained earnings divided by average consolidated total assets – of at least 3%. But when lots of short-term money pours into a bank’s coffers, it adds to its liabilities and harms the leverage ratio unless the bank can lend or invest it quickly.

Despite this, cases of banks turning down cash or charging negative interest rates to take it are, for the moment, isolated. But they are a taster of what could be in store if negative interest rates become a longer-term policy of central banks.

With a recovery of sorts under way in Britain, that seems a distant possibility in the UK. But if the nods and winks emanating from ECB mandarins are anything to go by, negative rates cannot be discounted completely in the eurozone.

The key question is whether negative rates would have the effect intended. Few economists are convinced. ‘If I’m sitting on cash, would negative interest rates persuade me to take money out of a bank and invest in an environment loaded with risk?’ ponders John Glen, senior lecturer in economics at Cranfield School of Management.

In any event, as Glen points out, in a global economy which is interlinked, companies can choose to invest more or less anywhere.

Encouraged by negative interest rates to invest some of the spare cash on its balance sheet, a French or Spanish company could place it in a high-growth economy in Asia or South America.

‘With a global financial system, you press a button in one part of the system expecting a response there, but the response may be thousands of miles away,’ Glen points out.

A small price to pay

In any event, faced with a choice between negative interest rates and risk-weighted investments in an uncertain European economy, companies may be willing to pay a few basis points to keep the cash at the bank, suggests Clare.

But in a world in which interest rates are likely to remain low, even if they don’t go negative, it could make sense for CFOs to take a fresh look at how they manage corporate cash. Some have moved cash into money-market funds – which generally invest in AAA-rated government and corporate bonds. But money-market funds tend to reflect the overall investment environment, so the extra margin available from them when interest rates are low may be small.

In the current environment, CFOs who want cash kept in short-dated quality instruments should expect to pay a price, says a member of the Institutional Money Market Funds Association (IMMFA), who spoke on condition of anonymity. ‘If you want liquidity and a focus on capital preservation, you can still get it, but the returns are going to be compressed,’ he says.

This highlights the conundrum facing CFOs: should they hang on to the comfort of cash as a source of ready liquidity or place it in longer-term investments where yields may be better at the expense of short-term liquidity? But, perhaps, faced with even a slim threat of negative rates, this would be a good time for CFOs to review their capital structures.

‘If you are dissatisfied with the level of return you are getting, you need to build clarity around your cashflow and think about whether you are going to maintain the same capital structure,’ says the IMMFA member.

One spin-off from this debate could be more share buy-backs or companies deciding to return some of their surplus cash to shareholders.

Even if Europe escapes widespread negative nominal rates (where there is a minus sign before the number), the continent has been experiencing negative real rates (where interest rates are lower than inflation) for years. There could be more to come.

It’s time for CFOs to take off the blinkers so they can at least pick up on the nods and winks.

Peter Bartram, journalist

Last updated: 5 Jun 2014