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What's a Central Bank?

And what can it do for your institution? Find out about this holistic approach to building financial strength.

By Chris Cowen, Laura Sander, and MaryLou Merkt

In fact, during the past several years, the cohesive management of an institution’s treasury functions within a central-bank structure has been a consistent strategic theme in higher education—and the concept is applicable to institutions of all shapes and sizes. Routinely used within for-profit corporations, the central bank has recently become a priority for many college and university treasurers, and a number of universities have successfully deployed such systems.

A Holistic Approach to Financial Strength

At its core, a central or “capital” bank is simply a way of allocating responsibility and managing the entire balance sheet within a college or university to optimize resources. Such a comprehensive treasury management structure embodies a framework for thinking about and managing various university functions holistically. Importantly, the use of this structure is not only a matter of consolidating functions and operations but also involves managing the interrelationship of these functions.

Efficient allocation of responsibilities relies on evaluating various functions, determining where it makes sense to look at them on a “portfolio” basis, and identifying efficiencies that might be gained by managing resources across the institution rather than within individual schools or departments. The types of resources that can be managed centrally include staff time and expertise; the institution’s overall interest-rate risk tolerance and the amount of debt outstanding; and the mix of operating assets and liabilities. Depending on the amount and level of management expertise and attention committed, the bank can also serve as a means of generating unrestricted resources to support public goods across an institution or to fund administrative priorities.

Typically, many functions are appropriately performed in each of the component divisions of an institution, particularly at larger organizations. Such functions might include preparing accounts-payable requests, providing detailed reports on sponsored research spending, and gathering documents for reimbursing travel expenses. In other instances, however, it is more efficient for one group to hold the knowledge and expertise for the entire institution. Examples of functions that benefit from centralized expertise include debt issuance, treasury and cash management, and administration of operating assets. These types of functions require specific knowledge and would be costly to replicate in each division of an institution. Additionally, by viewing these functions centrally and thinking about their relationships on a portfolio basis, the institution is able to more efficiently manage resources and increase wealth over time.

Consider, for example, how an institution might decide on the level of liquidity it holds as short-term investments. To determine an optimal amount of short-term investments to maintain, the institution needs to look at various potential uses of its liquidity. One use is to fund net cash outflows from operations and other cash payments. Regular cash forecasting can provide the school with estimates of how much liquidity will be required for this use. Another use is to cover interest payments on outstanding variable-rate debt. Short-term investments, which are generally taxable, serve as a natural hedge for variable-rate debt, and the amount of short-term assets to maintain on hand will depend in part on the type of variable-rate debt outstanding. For taxable debt, interest expense will be roughly equal to the interest earned on the short-term taxable assets. Therefore, the quantity of short-term assets necessary to hedge interest payments on taxable debt will be similar to the amount of taxable debt outstanding. For tax-exempt, variable-rate debt, interest expense is typically less than the taxable earnings on the short-term assets. Historically, the Bond Market Association Index, which serves as the benchmark for tax-exempt variable rates, has averaged about 68 percent of LIBOR, a benchmark for taxable short-term rates. At this ratio, an institution could hold approximately $100 million in taxable short-term assets for each $150 million of variable-rate debt.

As this example shows, examining different uses of liquidity to determine the optimal amount of short-term assets to hold cuts across several areas within a typical finance organization. The ability to view each of these functions together permits the institution to, in effect, create a “net assets manager” with the responsibility of growing net assets (institutional wealth) across time, which involves comprehensive consideration of a broad range of central investment, liability, and treasury management functions.

Facilitating More Strategic Approaches

Looking at functions across an institution on a portfolio basis takes advantage of the increased perspective gained by considering impacts on the whole entity rather than on each component unit. Such an overarching perspective can result in advantages in many areas. (See Figure 1 for a flowchart illustrating centralized processes for liquidity management across the institution.)

Table 1: Comparative Blended Rates for Capital Projects

Year capital projects funded through debt issue

Type of Interest Rate

Interest Rate of Issue

Blended Rate

2002

Fixed

5.37%

5.37%

2004

Variable

1.23%

3.30%

2006

Variable

3.88%

3.50%

  • Ability to re-evaluate risk factors. The central bank system provides the information needed to consider taking on additional risk or spreading risk across multiple projects relative to internal management of the debt that a college or university issues in the external capital market. Institutions of all sizes typically issue external debt through one central financial office. This arrangement provides for efficient use of staff resources but may not necessarily take advantage of the institution’s overall risk profile or help reduce the amount of debt outstanding.

    Traditional methods of issuing and managing debt have focused on individual projects and transactions rather than on the institution’s long-term financial and programmatic objectives. Within an institution, each component unit wants a stable and low debt cost. To provide this stability, some institutions have historically allocated the debt service associated with each separate bond issue to the specific projects that were financed by that issue. This allocation allowed the institution to pass through debt costs directly to each project. To ensure even greater certainty, an institution may use fixed-rate debt (either natural fixed or synthetic fixed), in which underlying variable-rate debt is issued along with a swap to fixed rate. Despite being more volatile, variable interest rates have historically averaged below fixed interest rates, and therefore use of fixed-rate debt resulted in higher interest costs over time. Thus the traditional approach has resulted in potential missed opportunities to optimize debt-structure and bond-issuance timing across the institution.

    A central bank, however, may serve as a means of taking on additional risks that are most appropriately managed centrally. The use of variable-rate debt can reduce expected total interest costs across an institution, with the bank serving as the internal conduit through which debt is issued and the debt portfolio is managed. Managing an institution’s available capital, including external debt, on a portfolio basis is a corporate approach to borrowing. A typical objective of this approach is to establish equitable and consistent internal loan terms that apply to all projects within the institution, regardless of whether internal equity or external debt provides funding. This method allows the interest cost of multiple bond series to be pooled and blended. The blending spreads the risk of variability in interest cost across a greater number of projects and internal borrowers; and it achieves equity across schools, divisions, or projects.

    The following example illustrates how a portfolio of debt with different interest costs can be blended and how the use of variable-rate debt can lower the cost to all internal borrowers. Assume that an institution issued debt to fund capital projects three times in recent years, in 2002, 2004, and 2006, and that each issue was $50 million. The 2002 issue was fixed rate, and the 2004 and 2006 issues were variable rate. For this example, the rates for 2002 and 2004 are the average rates for those years; the rate for 2006 is the BMA rate in effect on June 21, 2006. The blended rates at each point in time are shown in Table 1.

    As the data in the table demonstrate, the use of variable-rate debt in 2004 significantly reduced the interest rate on the total outstanding debt, which was then $100 million. By the time the institution issued debt again in 2006, short-term rates had increased, which raised the blended rate. Depending on the frequency with which the institution reset the blended rate, changes in short-term rates between 2004 and 2006 may have also changed the blended rate during that period. By calculating an internal blended rate across various debt issues, all borrowers using the proceeds of the external debt benefited from the decrease due to the introduction of variable-rate debt into the pool. They faced budget uncertainty, however, also as a result of the use of variable-rate debt.

    A number of institutions have established a blended internal cost of funds, which incorporates not only this external cost of funds but also an overhead charge and an interest-rate buffer. The buffer is designed to insulate the blended rate from changes due to the issuance of additional debt, or the interest rate on variable-rate debt. Because the budgetary risk associated with changes in variable interest rates is borne by all borrowers and not a single project, most institutions find that they are able to bear a larger allocation to variable-rate debt without subjecting the institution to undesirable budgetary risk. The determined amount of the interest-rate buffer is based on whether the institution would prefer to achieve a lower current interest rate (which results in a smaller buffer but less budget predictability) or to maintain a higher current interest rate (which uses a higher buffer but lowers the probability that the rate will need to be changed over time, therefore providing greater budget predictability). The institution and its advisers may wish to run various interest-rate, investment-return, and borrowing scenarios to determine the internal blended rate that represents the “best fit.”

    The rate charged on internal loans can be structured to provide a cushion against steep rises in variable interest rates and therefore increase budgetary stability, or the bank can absorb short-term rate spikes and be reimbursed by internal borrowers. By viewing the debt on a portfolio basis and considering the total interest-rate exposure rather than the exposure on a single transaction, the college is able to better manage overall risk and provide stability and a desirable long-term cost of capital. This perspective gives senior management and trustees a comprehensive view of the institution’s debt portfolio and allows them to manage total risk exposure and potential reward to work toward the optimal outcome of financial equilibrium.
  • Dropping the debt level. Through use of a central bank, the need for future external debt can also be reduced. The bank may serve as the ultimate payer of principal to bondholders and loan the bond proceeds to component units for their individual projects. The structure of the external debt to be repaid by the bank can be different from the structure of the internal loans repaid by the internal borrowers. For example, the external debt could be structured as a 35-year bullet maturity, while the internal loans might amortize over 20 years. When repayments are made internally, the funds can be re-loaned for other projects. Across time, this recycling reduces the amount of debt that must be issued to fund capital projects and achieves greater efficiency in managing the overall portfolio.

    While the recycling approach is often considered applicable only to larger institutions with continual project needs, the concept can also benefit smaller institutions. It permits the reuse of funds without requiring a new, inefficient bond issue for small projects, or draws on a taxable operating line of credit. By preserving outstanding debt on a low-cost, tax-exempt basis and minimizing the number of discrete transactions, the institution can reduce administrative burdens and costs and build financial strength over time.
  • Making the most of operating assets. In addition to providing budget predictability and stability to schools and units on the liability side of the balance sheet by implementing a blended internal interest rate, the central bank can also contribute significantly to maximizing investment income from operating assets (non-endowed assets).

    As on the liability side, each individual unit or department within an institution may be overly conservative with its operating assets when viewed in isolation. To be sure it can meet its operating expenses and other obligations, a unit has the incentive to keep its assets very liquid. Some large institutions allow individual campuses to maintain separate bank accounts with separate cash balances. At other institutions, cash holdings may be centralized, but schools or departments retain balances in operating funds in excess of their operating needs because they fear that placing assets in longer-term vehicles will prohibit their ability to access cash when needed. Another reason for retaining these balances is that the institution does not have appropriate incentives in place to encourage departments to invest the excess funds.

    Pooling cash through a central bank allows institutions to optimize their operating assets and still provide sufficient liquidity for component units. The “limited-term” assets held by the schools or departments can be viewed as “deposits” within the bank on which the bank pays interest. Bank managers are able to look at upcoming expenses across the institution and forecast cash needs across various periods of time. An operating or “limited-term” portfolio can then be constructed that extends the investment horizon while maintaining the required liquidity. By pooling assets from various schools at decentralized universities or managing various reserves or quasi-endowments as one entity at centralized colleges, most institutions will recognize that they are holding a greater amount of operating cash, or liquidity, than is reasonably necessary. Thoughtful construction of the investment portfolio can increase total wealth over time.
  • Generating unrestricted resources. A central bank can be operated by each institution with different goals and varying levels of management effort. Some central banks serve as conduits for various functions, passing through interest costs on a portfolio of external debt or paying deposit rates that correspond exactly with the amount earned by the bank in its investment of operating assets. Consider also the idea of a central bank structured in a way that generates unrestricted resources, an activity that should be a financial priority. This type of structure requires active management and the establishment of operating procedures and institution-specific objectives.

    One method of generating unrestricted resources is for the bank to be able to earn returns in excess of the interest rate paid on deposits of the individual schools or departments. For example, a bank might pay its depositors the 90-day T-bill rate on funds held within the bank while at the same time investing those funds in higher-yielding asset classes. In addition, a bank might hold working-capital debt, on which it pays short-term interest rates, and invest the proceeds at a rate above that short-term rate. The spread that a bank may earn from these strategies can be used to pay for projects and initiatives that benefit the institution as a whole and for which no individual unit would contribute the entire amount. Since the resources generated are unrestricted, the funds could also be used flexibly according to the priorities of the administration. Schools and departments may object that they are not receiving what is actually being earned on their operating assets, but most would prefer to forgo a small portion of earnings rather than to have to pay for public goods or administrative priorities from their own unrestricted funds.

    This approach allows an institution to focus on increasing net assets, especially unrestricted net assets, over time. Absent a central bank structure that permits the institution to examine both the asset and the liability side of the balance sheet, a college may incorrectly assume that reducing liabilities increases net assets over the long term. Rather, the strategic use of debt and the active management of liabilities in concert with the management of assets can permit the university to examine its true cost of debt and equity capital and make strategic decisions regarding the entire balance sheet.

Moving to a New Model

Concept to Reality at Furman

In 2005, Furman University, Greenville, South Carolina, began planning for a significant new bond transaction. In the past, it had viewed each bond issue or bank loan as a discrete transaction tied to individual projects. As the size of the debt portfolio increased and the university employed a variety of debt structures, including variable-rate debt and derivative transactions, it determined that a more comprehensive approach was desirable. A debt subcommittee made up of trustees was established to develop and implement a central-bank approach.

A primary outcome of this initiative was that the board and management began viewing the debt as a portfolio, rather than as a series of transactions. Portfolio management techniques were adopted, such as targeting a blended cost of capital, establishing and managing a single internal reserve, determining debt allocation limits, and replacing taxable bank lines of credit with tax-exempt debt. The university also determined that it could easily handle a greater variable-rate allocation in its debt portfolio. The central bank provides the infrastructure to permit Furman the flexibility to unlink external debt from internal repayments, allocate a greater amount of operating funds to higher-yielding assets, and generate confidence in internal processes among members of the governing board. The structure and approach enable strategic discussions with members of the debt subcommittee regarding portfolio management and resource accumulation rather than tactical discussions regarding transaction execution. This improved financing structure promises to provide the institution with greater financial flexibility and enhanced financial performance for years to come.

As with most initiatives, there is no single way to build a central bank structure. Nevertheless, certain steps and considerations are common to all institutions, and an individual college or university may consider a wide variety of specific actions by consulting institution peers, advisers, and bankers who have been involved in similar implementations.

Here are a few common steps:

1. Determine what the institution hopes to achieve by putting the central bank mechanism in place. Establish clear and achievable priorities that balance competing needs and objectives. Since the central bank is not only a new structure but also a new approach to viewing the balance sheet on campus, it is critical that you acquire buy-in and support at the governing-board level and throughout the organization. Creating clear policies regarding liability and asset management helps to articulate the new framework. While this work may be time-consuming, more effort spent on these issues at the front-end ensures that the bank functions according to the institution’s desires and that the finance and treasury offices contribute to carrying out the programmatic objectives of the institution. Decisions regarding capital expenditures, debt issuance, cash management, and treasury operations, among other areas, can now be considered comprehensively and strategically.

2. Create the infrastructure to manage the central bank approach. This work includes establishing account coding and allocation methods, in effect, enabling you to determine a balance sheet, statement of activities, and statement of cash flows for the central bank. In addition, build the infrastructure such that it encompasses a process for evaluating investment opportunities and for forecasting capital needs, cash obligations, and funding requirements. Whatever infrastructure you establish, tailor it to the institution’s unique needs, as no two central bank structures are identical. Receiving input from colleagues, peers, and advisers can help the senior staff in this process.

3. Regularly review and report on the process. Old habits—at both operating and governance levels—are often difficult to break, and the institution may find itself reverting to former project-specific decisions or debt transactions and examining financial decisions without regard to the larger strategic context. Through regular reporting, analysis, and review, the specific benefits of the approach can be observed and considered. Such transparency will support acceptance of the central bank concept and recognition of the benefits it provides in strategic, comprehensive balance-sheet management and wealth creation.

Chris Cowen is a managing director at Prager, Sealy & Co., LLC, New York City; Laura Sander is a vice president at J.P. Morgan Securities, Boston, and previously served as assistant treasurer at Harvard University; MaryLou Merkt is vice president for business affairs at Furman University, Greenville, South Carolina.