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Earnings Credits: The Value Lever
Phillip Lindow , J.P. Morgan - David Berse, J.P.Morgan Treasury Services - 10 Oct 2013
In the second of a series, this article explores how, amid rapid market change, many treasurers are embracing earnings credits (ECs) to lower costs and boost shareholder value.

Corporate treasurers today find themselves in uncharted and turbulent waters. They’re navigating internal pressures and external forces that are creating deep structural change in the banking industry - and that call for renewed strategies for running efficient global treasury operations. Today, many treasurers are once again embracing the Earnings Credit Rate (ECR) as a practical and versatile way to strengthen corporate income statements and manage liquidity. This value will only increase as banks broaden the range of Earnings Credit (EC)-eligible service fees and apply the concept globally across entities, geographies and currencies.

The Earnings Credit is a calculation of the return that banking customers earn on funds held overnight in a demand deposit or current account at the specified Earnings Credit Rate. Rather than receiving hard interest, depositors receive this return in the form of an ‘earnings credit allowance’, which is then automatically applied against bank service charges.

Internal and External Forces Create New Challenges

Treasurers now operate with higher corporate profiles, greater responsibility and more intense scrutiny than ever before. And they face a fast-changing environment that demands agile thinking about a host of complex internal and external variables.

The inside view: cost pressures require new strategies. Faced with tepid global growth, economic uncertainty and persistently low interest rates, treasurers continue to operate under corporate mandates to do more with less. But new performance metrics tied to expense reduction can be especially tough to meet as bank service fees, for example, continue to rise. What’s more, global expansion is challenging already overburdened treasury staff to carefully and economically manage cash positions and investments across currencies, time zones, jurisdictions and multiple bank platforms.

Treasurers must also adhere to internal investment guidelines emphasising increased liquidity and preservation of principal. In a low interest rate environment, the risks of tying up cash often outweigh the rewards. As a result, directors are paying closer attention than ever to how much global cash treasurers are holding, what specific instruments they’re investing in and which financial institutions are holding these instruments. Increasingly, cash balances are becoming more challenging to manage as eligible options for cash placement decrease. Investment policies have become increasingly conservative, eliminating many of the investment options used prior to the crisis, and placing stricter balance limits on the remaining options.

Given these factors, treasurers are exploring strategies to offset costs, efficient ways to monitor and manage liquid assets, and safe investment solutions that minimise bank and sovereign risks - all while ensuring liquidity.

External factors drive alternative cash strategies. These internal challenges are intensified by complex external factors that are challenging the status quo - and further dictating how treasurers operate. New and emerging regulations are bringing unprecedented structural change to the financial services industry, and treasurers are responding to a new norm characterised by higher service fees, tighter credit and fewer investment options.

Treasurers are navigating several US regulatory changes that are driving increased liquidity and altering the investment landscape. When the Federal Deposit Insurance Corporation’s (FDIC) Transaction Account Guarantee Program (TAGP) expired in 2012, and Regulation Q was repealed in 2011, significant levels of cash could have flowed out of bank deposits. But instead, according to the FDIC Quarterly Banking Profile – as of Q213, non-interest bearing (NIB) deposits are still almost 70% of all bank deposits in excess of the FDIC standard maximum coverage limit of US$250,000 per depositor. This reflects treasurers’ continued interest in concentrating assets in demand deposit accounts (DDAs) and the value that treasurers and their boards place on bank deposits.

Treasurers are also preparing for new bank regulations that will reshape and revalue traditional short-term cash positions. The new Basel III global capital adequacy regulations, which are being phased in through 2019, places a significant premium on bank funding through DDA balances linked to operating activity. The Security and Exchange Commission’s (SEC) proposed additional reforms of institutional Money Market Funds (MMFs) also threaten to affect a traditional vehicle for short-term operating cash.

Together, these variables are causing treasurers to rethink approaches to generate shareholder value. As the regulatory landscape shifts, many treasurers are re-evaluating their global banking relationships and are using ECs derived from overnight DDA balances to unlock the intrinsic value of these relationships.

Earnings Credits: A Versatile Strategy

As treasurers cope with internal and external forces and reexamine their cash management strategies, many are turning to ECs as a practical way to address multiple objectives and challenges. ECs provide a stable and reliable way to reduce treasury expenses, maximise corporate profits and manage daily liquidity.

The value of earnings credits: Sprint’s view

For telecoms giant Sprint, using ECs to offset the cost of bank services has been a “win-win,” according to Jennifer Dale, assistant treasurer, and offers the company a range of benefits. “If you start with assessing returns, right now ECs are giving us better value for our balances,” says Dale. Cost reduction also plays a key role in the company’s use of ECs and is evident in Sprint’s ongoing initiative to apply working capital best practices. That effort has freed up approximately US$1bn since its inception, and the use of ECs has been an important part of the initiative. Dale refers to ECs as “the gift that keeps on giving,” because they provide the company with ongoing budgetary relief, not just one-time expense reductions.

Sprint is now also using ECs to offset credit card acquirer fees. J.P. Morgan recently introduced an EC programme for users of Chase Paymentech, TM a processor of merchant services. “We can now use earnings credits to reduce our credit card service fees and interchange costs – an expense control tool that was simply not available before,” says Dale.

A Hidden Benefit: Maximising Shareholder Value. ECs can also create significant value beyond the treasury budget. Treasurers are using ECR to improve key financial ratios. Specifically, ECR can enhance operating margin and potentially increase shareholder value, particularly as compared to traditional interest yielding investments. Here’s how. Using ECs to lower cash payment for bank service fees can reduce reported sales general and administrative (SG&A) expenses directly. Reducing SG&A in turn improves operating income, or earnings before interest and taxes (EBIT), and also impacts key financial ratios such as operating margin. For companies heavily leveraged or evaluated based on debt levels, using ECR to improve ratios such as earnings before interest, taxes, depreciation and amortisation (EBITDA) to interest and net debt to EBITDA can provide benefits as well.



As banks expand the types of fees that companies can offset with ECs, treasurers will have even greater opportunity to strengthen the income statement. For example, many companies book credit card acceptance fees, including interchange, under cost of goods sold (COGS) because these fees tie directly to revenue. By using ECs to offset these fees and thereby reduce COGS, companies may not only be able to improve operating margin; they could boost reported gross profit as well. We suggest that clients consult with an accounting or financial advisor about the potential financial impact of ECs.

Maintaining full liquidity. ECs are also ideally suited to help treasurers maintain and manage daily liquidity, so cash is readily available for multiple purposes. In today’s credit-constrained environment, this frequently includes self-funding working capital and capex for operations - a strategy that can mitigate credit risks and lower the cost of capital. DDA balances are fully liquid deposits that are accessible at a moment’s notice; are not subject to delays, cut-off times or market closures; and carry no extra fees or withdrawal restrictions. Liquidity is critical to companies with cash forecasting challenges that might have otherwise had to break term deposits and incur fees or wind down investments to meet unexpected working capital needs. Treasury staff can also take advantage of global bank portals, integrated with bank cash management platforms, to easily monitor and control global balances.

ECR: A New Lever for Banking Relationships

The market factors driving wider adoption of ECR are ushering in a new paradigm for relationships between treasurers and their banks.

Regulations can motivate banks to rebalance the services they provide, rethink the service fees they charge and take a more holistic view of client relationships. As part of this strategy, banks recognise the intrinsic value of ECR balances toward client return on investment (ROI), and are investing in new technologies and approaches that encourage client operating deposits. Look for banks to analyse the flow of corporate transactions and peg ECRs to the value of these cash balances. Banks are also creating new services that take advantage of global relationships, including programmes that make ECR a truly global solution for international cash balances - including balances held offshore for strategic purposes.

For treasurers, there’s a powerful opportunity at hand to re-think and re-evaluate global banking relationships to determine which ones deliver the greatest intrinsic value. As they focus on the large pools of liquid assets used to support global operations, treasurers can potentially offset more banking fees by negotiating ECRs based on DDA balances aggregated across entities, geographies and currencies as well as on the value of the broader banking relationship. Recent research has revealed a trend that is especially relevant to treasurers focused on cost control: companies that use earnings credits most aggressively also benefit from lower pricing on their banking services.

This combination of internal and external factors is creating a renewed focus on earnings credits by treasurers and increased motivation for banks, and bodes well for a versatile solution that marries cost control with liquidity management.