Credit risk in current accounts

Part of the treasury manager’s daily job is to keep the current account balance close to zero at the end of each working day.  Surplus cash is invested, while shortfalls are covered by borrowing loans or withdrawing cash from deposit accounts and liquidity funds.  Credit risk management therefore focuses almost exclusively on the surplus cash invested, and tends to ignore any residual risk from the current account.

However, Moody’s recent downgrade of Co-operative Bank into speculative grade has brought current account credit risk into sharper focus in the past month.  The Co-op is the most popular bank for local authority current accounts, but at Ba3 it is now rated 7 notches lower than the Icelandic banks were when they defaulted, and it remains on review for further possible downgrade.  The bank’s 2012 accounts, published around the time of the downgrade, show that £3.7 billion or 8.5% of Co-op’s loans are now considered to be impaired, substantially higher than their £2.5 billion of capital and provisions put aside to cover losses.  No wonder they are selling other parts of the business to shore up the balance sheet.

The next most popular place for local authorities to bank is the RBS/NatWest group.  Moody’s currently rates RBS at A3, which despite including a three notch uplift due to extraordinary support from the UK Government, is at the bottom of many authorities’ investment criteria.   With the bank’s chairman, amongst others, urging the government to start selling its stake in the bank as early as possible, we could easily see the uplift withdrawn and RBS downgraded closer to its Baa3 baseline credit assessment.  RBS also faces being split up into multiple different banks – the EU is forcing it to sell hundreds of branches, the government is committed to a separation into retail and investment banks and now there is talk of further splits into good banks and bad banks.  These separate entities will all have different credit ratings, and it’s not at all clear which one local authorities’ current accounts will end up in.

Moody’s historic data shows that 0.3% of companies with a Baa3 rating defaulted within one year, rising to 0.8% within two years and 1.4% within three; for the speculative Ba3 rating this increases to 1.8%, 5.0% and 9.0%, so the probability of default is pretty clear.  But given that we keep the current account balance close to zero, is there actually any risk of suffering a loss given default?  The answer lies in what we mean by keeping the balance close to zero.

Treasury managers normally focus on the cleared bank balance – if this drops below zero, then overdraft charges will be applied, while if it rises above zero, then investment income is being lost.  However, the true balance of any account is the ledger balance, which includes cheques and similar items that have been paid into the account but are not available for withdrawal yet.  If a bank fails when you have a cleared balance of zero, but a ledger balance of £500,000, it’s the half million that’s at risk of loss.

We also need to consider other items in the course of clearing – what happens if a bank fails part way through the three day BACS transmission cycle, for instance?  Do the collateralisation, insurance and guarantee arrangements in place between clearing banks provide us with any comfort?  Or will they just ensure that all our grants and tax receipts arrive in our bank account just in time to be swallowed up by the insolvency process?

Finally, treasury managers should check the position with regards to pooled accounts.  It is common to operate several bank accounts at the same branch, some with large credit balances and some with large overdrafts, providing the overall net balance is close to zero.  I’ve seen a number of bank contracts recently where the bank can offset credit balances against debit ones, but the local authority has no such right.  This would protect the bank in the event of the Council’s insolvency, but not the other way round; hardly ideal from a credit risk management perspective!

David Green is Client Director at Arlingclose Limited.  This is the writer’s personal opinion and does not constitute investment advice.

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