Cash Management Prices Ignore Risk
Even though many cash management services entail considerable credit risk, traditionally banks have not taken the full cost of risk management into consideration when pricing these services.
These expenses should include the cost of capital necessary to support potential losses as well as the cost of operational systems and procedures necessary to control the risk.
Since few banks allocate capital to cash management services on the basis of risk, the concept of risk-based pricing is foreign to most cash management business managers. However, recent Federal Reserve proposals to modify measurement of daylight overdrafts, as well as other payment system concerns, should prompt managers to rethink their pricing strategies and add the full cost of risk management to their equations.
Recent Fed proposals leave little doubt that the central bank will be assessing fees to banks that incur daylight overdrafts in their reserve accounts. To the extent that these are caused by customer overdraft positions, managers should consider passing the expected fees on to the customer.
In addition, the Federal Reserve is considering expanding the self-assessment guidelines for determining the daylight overdraft cap a bank is allowed. Currently, the cap is based on a multiple of the bank's adjusted primary capital, which is determined by a number of factors, including the bank's ability to control positions across Fed Wire.
A future expansion is likely to include controls for nonwire money movement such as automated clearing house (ACH) transactions. If this occurs, the risks associated with nonwire services will have a direct impact on a bank's daylight overdraft cap, above which Federal Reserve fees could be incurred.
Payment System Concerns
Some bankers are concerned that the relatively low price of automated clearing house transactions could encourage high-dollar wire transfers to switch to the ACH, adding risk to the overall payments system. The advent of corporate-to-corporate payment formats in the mid-1980s highlights this problem, since it encourages using the ACH for high-dollar payments.
Wire transfer systems are designed to handle single high-dollar transactions. Security is extensive, and with same-day settlement, temporal risk is slight.
On the other hand, the ACH was originally conceived as an electronic substitute for low-dollar, high-volume consumer checks. Future valued batch processing offers low-cost delivery. ACH payments are more secure than the check payments they replaced, but they are not as secure and assume more temporal risk than wire transfers.
Transfer Costs Will Rise
Fed pricing for daylight overdrafts will help prevent the unwanted migration of high-dollar wire transfers to the ACH because it will increase the cost of the transfer. The Federal Reserve debits a bank's reserve account later in the day for wire transfers than for ACH credits, resulting in lower daylight overdraft fees for banks that use wire transfers for large-dollar transactions.
Similarly, inclusion of ACH controls in a bank's self-assessment could result in higher costs to banks that allow large-dollar ACH transactions.
To discourage the unwanted migration of wire transfers to the ACH, managers could consider incorporating these added costs into their pricing policies.
There are three basic ways to manage credit risk: exposure reduction, risk control, and risk funding.
* Exposure reduction. Standard banking techniques offer many creative ways to reduce risk exposure. For example, banks have traditionally adjusted their availability and collectibility schedules, within the confines of Regulation CC to reduce check collection exposure.
Similarly, banks incur credit risk when they send direct deposit of payroll credits to employee accounts through the ACH. The bank obligates itself to make payments when it delivers the file to its local ACH processor, usually the day before payday, even though its corporate customer is generally not required to fund the account until payday.
This credit exposure could be eliminated by requiring the customer to fund its payroll before the file is delivered to the ACH processor. Negotiation of collateral or guarantees may also reduce credit exposure for cash management services.
Although exposure reduction techniques are generally not expensive for banks to implement, they often result in higher customer costs.
* Risk control. Programs to control risk, on the other hand, can involve changes in operations and are often expensive to implement. Risk control is designed to monitor the actual level of risk as it changes and to refer transactions to the proper credit authority for approval before execution. Examples are the use of intraday funds control systems to manage daylight overdraft positions and the establishment of dollar limits on the size of ACH files.
* Risk funding. Provisions must also be made for any losses that do occur. Although banks insure loan losses by deducting a provision from earnings to create a reserve, most do not use this mechanism to insure against cash management losses. Ideally, reserves should be built and capital allocated to the bank's cash management businesses in proportion to the risks involved.
To determine the levels of credit risk to be financed, the following have to be considered: how much risk remains after implementing exposure reduction and risk control procedures, the operational dependability of those efforts, and an analysis of the likelihood of loss from the remaining exposure.
Effect on Customers
Once the dynamics of credit risk management costs are fully understood, it is useful to discriminate between product and customer risk components.
The first priority is to accurately quantify the costs of credit risk management for each cash management service. Pricing decisions should take all costs into account.
Next, the costs of risk management must be allocated to customers in proportion to the risks they create.
A formal assessment that measures the dollar exposures of riskier customers should be conducted for each cash management product. Include characteristics such as the history of dollar flows by product as well as the risk grade assigned to the customer by the bank's credit authorities.
Riskier customers require increased monitoring and controls and higher capital allocation. For perceived value, most cash management customers are willing to pay a reasonable margin over legitimate costs. Just as in lending, those customers that represent a greater credit risk to the bank should be willing to pay a premium to cover additional costs.
Mr. Paul F. Mayland is vice president of cash management at Manufacturers Hanover's Geoserve division and a director of the National Automated Clearing House Association.
