Wednesday , 17 January 2018
Home » Cash » The liquidity paradox: what it means and how to solve it

The liquidity paradox: what it means and how to solve it

17CHRIS DARK, president, international, C2FO, looks at a finance problem that has now attracted the attention of politicians

Economies currently suffer from the paradox of having too much liquidity in certain areas, while having too little in others. Banks, awash with cash, are reluctant to accept deposits; larger corporations are stockpiling cash but running out of options of where to place it; while small and medium-sized enterprises (SMEs) are often unable to access funding due to its cost and scarcity.

The issue has become entrenched and is beginning to have material impact on business globally; so much so that it has attracted the attention of politicians, desperate to kick-start their economies to provide employment and higher tax revenues.

Central banks are also trying to avoid losing a decade of deflation and to inject liquidity into the economy, utilising the various tools at their disposal such as interest rates and quantitative easing. While these ideas are good in theory, the real problem is that they haven’t worked in practice.

Regulatory pressures

The 2008 credit crisis led to new regulations – primarily the Basel III capital adequacy regime – to ensure banks would de-risk their balance sheets.

One unintended consequence of these regulations was that banks had to firm their balance sheets by eliminating the business loans of their riskier clients – including SMEs. At the same time, banks also halved their lending activity to the SME base.

Over the last several years, this huge drop-off has starved an already ravaged segment of the business community. Banks that continue to lend to SMEs have raised lending margins, making borrowing expensive.

Fear around liquidity risk

For corporates, the crisis also left a culture of fear surrounding liquidity risk. When banks pulled back on credit lines it exposed many to bankruptcy, given the lack of liquidity. Treasurers moved to adjust the liquidity risk weighting of their exposure to banks, resulting in record cash levels on balance sheets for major corporates – while SMEs on the other hand continued struggling to maintain working capital.

Rather than reducing their liquidity risk by trying to reduce their exposure to banks, corporates instead shifted it into their supply chain by extending payment terms to suppliers. This additional pressure on suppliers further squeezed the corporate supply chains and created potentially a greater risk to their overall business – albeit without corporates really understanding the longer-term consequences of this.

Where there is no solution

This scenario highlights a further problem: banks are one of the main mechanisms used to introduce liquidity to the economy. The primary feeding tube for SMEs has been restricted, resulting in longer economic stagnation for much of Europe.

By comparison, the US economy has seen a faster recovery mainly because there is broader access to alternative funding sources and SMEs are less dependent on the banking sector for finance. However, these alternative sources of funding have fallen short of fully compensating for the decline in bank lending, so overall the US recovery is still disappointing in terms of economic growth.

Acceleration of payments

Although lending was the answer in the past, it is not the answer for the future.

Acceleration of invoice payments is the answer – where corporates make payments on approved invoices to their suppliers more quickly in exchange for a discount.

However, to be successful an acceleration programme must be consistently used by the suppliers who need it. The methodology used by legacy acceleration models (dynamic discounting) is restrictive: with “buyer push”, where corporates set the discount rate at which suppliers participate. This places the onus on buyers to have complete understanding of their suppliers’ cash needs in terms of their alternative cost to borrow and the timing of their needs, so it can only ever be hit-and-miss.

Ultimately, the end result is lower adoption and little impact on supply chain risk. In reality, risk may be increased, as the rates pushed onto the supplier are often penal and increase their cost base.

The answer

The natural conclusion is that a successful model must give suppliers control over what price they offer for early payment.

The win for corporates is that they can significantly de-risk their supply chain while also generating a risk-free yield on their cash of around 5-7 per cent annual percentage rate (APR).

The win for SMEs is they access the liquidity they need, when they need it and at a lower cost than alternative options. These businesses will immediately improve profitability and secure their operations. Moving forward, they will be able to expand, advancing the economic recovery and allowing their buyers to achieve their own growth ambitions.

This solution provides a win for banks and governments, too. Banks can focus on lending to less risky counterparties, without having political pressure to solve the SME liquidity crisis. Politicians are happy because SMEs have sustainable access to liquidity sourcing to kick-start investment, growth, and employment without increasing levels of public debt.

Sometimes the obvious solutions are the best. The above requires no complex paperwork, uses existing AP/AR processes, and genuinely has no losers. n

We are grateful to AFP (the Association for Financial Professionals) for allowing us to reproduce this article.

Leave a Reply