LIQUIDITY INSIGHTS. Best practices for managing your cash investments. Cash deposits carry counterparty risk too

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1 LIQUIDITY INSIGHTS Best practices for managing your cash investments The series of events that froze credit markets during the global banking crisis had a deep and enduring impact for everyone involved in corporate cash management. But while the credit crisis was a period of deep financial trauma, it has also played a highly valuable function in highlighting misconceptions and shortcomings in the way that many organizations had previously approached the investment of their cash. In this brief document, we want to highlight 10 of the key lessons that cash investors have been able to bring away from the credit crisis. We hope this will open up discussion and enable organizations to identify how their cash investment processes and policies might be improved to ensure they are appropriate, flexible and can withstand both extreme market conditions as well as normal day-to-day challenges. Cash deposits carry counterparty risk too In the past, companies may not have associated cash held in a deposit account with counterparty risk. However, the credit crisis underlined the fact that money held on deposit is at risk should a bank suffer some form of financial failure. Organizations need to know where all their counterparty exposures are across the whole company, including all subsidiaries and across all geographic regions. This analysis should assess demand deposit accounts and sweep accounts used to hold cash and also investment products like time deposits and certificates of deposit. Even government-guaranteed deposits need to be assessed in terms of risk for example, what delays on liquidity might take place should an event happen to trigger the guarantee.

2 LIQUIDITY INSIGHTS Best practices for managing your cash investments High-quality securities are not immune from contagion risk Even if your selected securities are of high credit quality and their issuers are financially stable, they can still be affected by investor concerns either regarding the sector in which the issuer operates or about the type of security in question. During the credit crisis, for example, concerns about banks hit securities issued within the financial sector indiscriminately, leading to heightened volatility across the entire sector. Contagion risk can lead to illiquidity even in high-quality securities, and the impact of this needs to be considered, regardless of whether an organization intends to keep holding the investment or sell it. Should the company need to sell securities during the period of illiquidity, then it may have to accept capital losses; if it intends to keep holding the security, it may still need to report an unrealized loss if the mark-to-market value of a security falls. Organizations need to discuss how contagion events should be handled. This should be done in the context of the organization s agreed tolerances for gains and losses. Potential investments need to be assessed for liquidity as well as credit and interest-rate considerations Before the credit crisis, it was widely assumed that, provided a security was of high credit quality, an investor would be able to sell it at any time. Now it is understood that under extreme conditions, this is not always the case. Alongside assessing a security for suitable interest-rate and credit characteristics, investors are now starting to understand they need to examine its liquidity profile too to determine secondary liquidity. Liquidity risk analysis should include asking how easily different investments can be sold/redeemed under different scenarios and who is ultimately responsible for providing liquidity. Every feature of a security should be known prior to inclusion in an investment policy Prior to the credit crisis, cash investments were often selected primarily on the basis of their rating from credit ratings agencies and their yield. As a result, many organisations found themselves exposed to risks they weren t aware of and therefore hadn t accounted for in their risk management processes. 2 So that risks can be properly understood and managed, all the features of a security should be fully assessed and understood before inclusion in the investment policy. This 360-degree analysis might typically include assessing the collateral on repurchase agreements (is equity acceptable, for example),

3 the terms and provisions of credit or liquidity enhancement on variable-rate demand notes (VRDNs) and the risk profile of underlying pools of securities for asset-backed commercial paper and other asset backed securities. Moreover, it is important that acceptable security features are understood and approved, not just by treasury, but by all key decision makers in the company, including audit and compliance committees along with the board or other senior-level decision makers. An investment policy needs to be a living, comprehensive document The credit crisis was instrumental in laying bare the shortcomings in many organizations investment policies. Common omissions included unclear allocation of roles and responsibilities or lack of procedures to follow in the event a security fell out of compliance with the policy after purchase. Many firms also made the mistake of failing to keep investment policies updated. Out-of-date or ambiguous policies failed to align with an organization s investment goals or to properly account for all potential risks, and were often quickly discarded during the crisis. Management of cash reserves then became a board-level concern. To avoid this situation, an investment policy needs to be regularly reviewed and updated. Policies need to specify roles and responsibilities, as well as contingency procedures. This will ensure clear direction for the organization and treasury operation during all market conditions. Ultimately, an investment policy should provide a firm with flexibility to respond to changes in investment objective or market conditions, while still ensuring a long-term investment discipline, unswayed by short-term market panic or overconfidence. Due diligence is required across the investment chain While companies may previously have conducted due diligence on some thirdparty service providers, it is now clearly recognized that proper evaluation needs to take place of every party that touches an organization s investment including banks, investment managers and money market fund providers, brokers and custodians. This represents a significant commitment of time and resources. But as any weakness in the investment chain can have implications for the safety and efficiency of a company s cash, conducting due diligence is a vital investment. 3

4 Investors need to diversify by security type as well as by issuer Organizations that found themselves unable to access their money during the depths of the credit crisis often discovered this was because they were heavily invested in one type of security, even if they were diligent about diversification by issuer name within that security type. In many cases, organizations held 80% or more of their cash portfolios in a single asset class such as auction rate securities (ARS) leaving them with next-to-no accessible cash when the ARS market started to freeze. Similar experiences occurred in the asset-backed and mortgage-backed securities market. For this reason, a company s investment policy needs to stipulate maximum portfolio exposures by security type in addition to acceptable maximum issuer concentrations. All corporate cash needs an appropriate benchmark An appropriate investment benchmark can enable a company to track long-term goals, define risk limits and provide firm-wide clarity around its performance target. During the credit crisis, many firms lost sight of their goals, or their performance against them, either because they had no benchmark or an inappropriate one. Benchmarks should be adopted for all cash investments. To be effective, a benchmark should be replicable (i.e., comprising investments that the company itself can invest in rather than simply tracking an interbank interest rate such as Libor) and appropriate to the time horizon, risk parameters and currency of the cash pool in question. Credit ratings can provide a starting point but further credit analysis is still required The limitations of credit ratings became increasingly evident during the credit crisis as a series of historically highly-rated institutions ran into difficulties. For organizations that believed they simply needed to look for counterparties and instruments with investment-grade ratings, this came as a shock. Ratings from credit rating agencies can be a valuable starting point when assessing appropriate investments and counterparties. However, relying solely on the credit rating agencies opinions may lead to purchasing securities where not all features or risks of a particular security are known. Credit ratings need to be augmented by further analysis based upon a company s own investment requirements. 4

5 LIQUIDITY INSIGHTS Best practices for managing your cash investments Moreover, it is as important to monitor the ongoing credit quality of the security after purchase as it is to do the upfront research prior to purchase. Companies should assess whether they have sufficient internal resources, both from an expertise and a time commitment perspective, to appropriately assess credit quality. If none is available, then the use of third-party investment managers can be explored. Not all money market funds are the same Over the past decade, money market funds have largely been treated as a commodity. Yield has often been viewed as the key differentiator, in combination with a fund s credit rating. But as recent events have shown, not all liquidity funds even AAA-rated ones are the same. What a fund invests in, how it is constructed and who it is managed by, have been shown to have a real and significant impact on the performance, liquidity and security of investor capital. Strict parameters for example those being revised under SEC Rule 2a-7 in the U.S. or the International Money Market Fund Association (IMMFA) code in Europe are helping provide common standards for investors. Even so, companies still need a thorough due diligence process to identify suitable funds. As well as evaluating the structure of funds themselves, the sponsor also needs to be closely assessed in terms of financial strength, track record, resources and credit research capabilities. Further discussion We hope this paper is of value in your cash investment discussions. J.P. Morgan Global Liquidity has produced a range of insight pieces to help organizations address many of the issues raised here. These include in-depth papers on instituting an investment policy and conducting due diligence on money market funds. If you would like to receive any other of our insight pieces or discuss any of the subjects in this paper, please contact your J.P. Morgan Global Liquidity Client Advisor. 5

6 For further information, please contact your J.P. Morgan Global Liquidity Client Advisor or Client Service Representative at: (852) in Asia (352) in Europe (800) in North America or visit The opinions expressed are those held by J.P. Morgan Asset Management at the time of going to print and are subject to change. This material should not be considered by the recipient as a recommendation relating to the buying or selling of investments. This material does not contain sufficient information to support an investment decision and investors should ensure that they obtain all available relevant information before making any investment. J.P. Morgan Asset Management is the brand for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide. The above communication is issued by the following entities: in the United Kingdom by JPMorgan Asset Management (UK) Limited which is regulated by the Financial Services Authority; in other EU jurisdictions by JPMorgan Asset Management (Europe) S.à r.l. Issued in Switzerland by J.P. Morgan (Suisse) SA, which is regulated by the Swiss Financial Market Supervisory Authority FINMA; in Hong Kong by JPMorgan Funds (Asia) Limited, which is regulated by the Securities and Futures Commission; in Singapore by JPMorgan Asset Management (Singapore) Limited, which is regulated by the Monetary Authority of Singapore; in Japan by JPMorgan Securities Japan Limited, which is regulated by the Financial Services Agency and in the United States by J.P. Morgan Investment Management Inc., which is regulated by the Securities and Exchange Commission JPMorgan Chase & Co. NOT FDIC INSURED NO BANK GUARANTEE MAY LOSE VALUE 6