Business Enhancement Associates Aha! Moments: Are Earnings Credits a Good Deal?

Keeping cash in bank deposits can offset service fees, but the savings may not be as large as the treasury department thinks.

CFO.com:
Bruce C. Lynn

Most creditworthy companies are holding more cash and cash equivalents (i.e. short-term investments) than at any time in the last decade.

What is not so clear is what companies plan to do with all of this liquidity. Some investors have decided that it belongs to them and have sued companies (see Apple) to force them to return some of it. Other companies are content to just invest their “excess” cash in financial assets until that time when investing it in current or future businesses makes economic sense.

But there are fewer safe choices for short-term cash investing, and even the perceived safest choice — depositing the money in a commercial bank — comes with risks and, perhaps more important, costs.

Companies investing excess cash in financial assets, according to the latest Association for Financial Professionals’ liquidity survey, are investing in fewer asset classes. In 2012, most companies used less than three “investment vehicles” (Treasuries, bank accounts, money market funds, for example), the survey found. In 2009 the number of permitted investment vehicles was closer to eight. ...

Evidence of this search for safety over yield is the increase in the use of bank certificates of deposit (CDs) as an “investment” vehicle. According to the AFP survey, 50 percent of companies have cash in bank CDs, ...

Besides, companies still need bank services, and using balances to pay for them has proven effective for companies and banks. ...

As a result of federal monetary policy and the market volatility for short-term loans from the Federal Reserve Banks, financial institutions have taken to using their earnings credit rate (ECR) as a “chip” to get companies to keep deposits in banks. (Earnings credits are applied to a company's average daily balance and are used to pay for banking fees.) Example: I have a client with about $400 million in a top-tier bank. The bank is offering this client an ECR of 50 basis points. This same client is using another well-known bank, but that bank is offering an ECR about a third of that rate for a smaller deposit balance.

English: Category:JPMorgan Chase (Photo credit: Wikipedia)

... In the old days an ECR was actually market-based. Banks used the T-bill as an index. Today ECRs are “administratively” (i.e., relationship) based. Several years ago JP Morgan actually admitted to this approach.

Even at 50 basis points a bank can still make a decent spread by lending the deposits to others, but be careful what you wish for. Some banks will give a large ECR to corporate customers but charge them above-market prices for cash management services, effectively neutralizing some of the largesse. This sleight of hand is relatively easy to do. Example: everyone “knows” what LIBOR is, but who knows the market price for an ECR or a lockbox? Maintaining a bank account? A funds transfer? The large banks offer more 1,500 different cash-management services, so for the customer bidding out cash-management services is a cumbersome method of price discovery.

Logo of the United States Federal Deposit Insurance Corporation, which incorporates the seal. (Photo credit: Wikipedia)

Finally, both of the banks my client uses continue to charge it 13 basis points for FDIC deposit insurance, insurance they can no longer use with the re-instatement of the 250,000 coverage limit. This cost lowers the “net” ECR. Actually identifying this rate is not easy, given the opaque nature of the cost analyses sent to the customer.

Confusion over total or net costs may lead a company to hold cash or buy bank CDs, thinking the approach will bring both safety and return; however, there is a flaw in this choice.

Whether a company needs to keep funds in a bank for operating reasons or whether it buys a CD, it is taking on the credit risk of the financial institution.

Deposits at a bank generate an FDIC charge for insurance that cannot be fully used, inflating total service costs and reducing the net ECR to the company.

Buying a CD will eliminate the FDIC expense which, in the case of my client, is a large monthly number. But it will not eliminate the credit risk.

Buying Treasury bills directly or investing in government money market funds will eliminate credit risk and could yield a larger, safer return.

No good deed goes unpunished. Companies that buy CDs with fixed maturities will have to spend more time on their cash forecasts, so that the cost of being short (overdraft charges, early termination fees) does not become significant. Even money-market funds may not give companies the freedom to redeem at any time, given some of the latest regulations which will soon be imposed on the investment community by the Securities and Exchange Commission.

Speaking of regulations, the death of Regulation Q has allowed banks to pay interest on checking accounts; yet, few banks have really trumpeted this new ability. There may be many reasons for this omission but one that suggests itself is that it is not in a bank’s best interest to get into a highly visible “interest rate arms race” with the competition when its ECR “stealth campaign” is working just fine.

Bruce C. Lynn, CTP, is a managing partner at Financial Executives Consulting Group. He has more than 20 years of 20 years of corporate and banking experience in all aspects of treasury and financial management, including treasury operations, cash management, strategic planning, credit, and treasury systems. He is a Certified Treasury Professional and has an MBA from New York University’s Stern School of Business.