Treasury Today Country Profiles in association with Citi

Cash pooling – an introduction

The cash pool is a perennial feature of banks’ cash management offerings. Indeed, cash pools are arguably the most popular – and certainly the most frequently discussed – cash management product. In this article we take an in-depth look at how cash pools operate and the various types of pools available.

Overview

A cash pool is a banking structure which allows the balances on a number of separate accounts to be treated collectively. This concentration of balances optimises the amount of interest companies both pay and receive, as the bank will consider the pooled balance when calculating interest. Use of a cash pool can also help a company to improve its liquidity management, as total cash balances are managed centrally rather than locally.

Cash pools can be arranged to include accounts held in the name of separate legal entities, thus enabling a group to pool the balances of all its operating subsidiaries. Cash pools can also be established on both a domestic and cross-border basis. Whilst the accounts within a cash pool are most often all denominated in the same currency, it is becoming increasingly common for multinationals to establish multi-currency cash pools.

Companies wishing to establish a cash pool will need to enter into detailed discussion with their bank(s) about the type of cash pool best suited to their particular needs. A contract will have to be signed by all parties participating in the cash pool arrangement, chiefly the bank(s) providing the service and the holders of all accounts in the pool. This gives the bank(s) the authority to debit and credit the accounts in the cash pool according to the rules established by the company.

Types of cash pool

There are many different types of cash pooling arrangement available. While banks offering cash pooling services take great care to highlight the uniqueness of their offerings, there is often little to distinguish between the services available. Cash pools can be broadly categorised as falling into one of the following types:

  • Physical pooling/Cash concentration

  • Notional pooling

  • Single legal account pooling

  • Reference account structures

  • Multicurrency pooling

Physical pooling/Cash concentration

In this arrangement, the balances of all the accounts in the cash pool are physically moved into and out of a single central account.

Physical pooling requires one account in the cash pool to be designated as the ‘master account’. This will act as the header or target account into which all surplus balances within the pool are swept. Similarly, all debit positions within the cash pool are covered by funds being transferred from the master account. The header account is usually held in the name of the group treasury.

Key benefits
  • Control of funds centrally.

    The concentration of all of a company’s surplus cash into one account, generally managed by the group treasury, will improve its control over cash. If the net balance of the cash pool is positive, this aggregated balance can be used to invest in overnight or short-term deposits, such as money funds. Indeed, companies with large treasuries often have dedicated staff managing these investments.

    The establishment of a physical cash pool enables treasuries to exercise greater control over cash flows. Ideally, all subsidiaries should participate in the cash pool, as this provides the centre with more information about the daily cash flows that exist throughout the company.

  • Reduction in credit facility requirements.

    Establishing a physical cash pool means that the treasurer need only negotiate one credit limit for the entire group. This avoids the need for separate credit arrangements to be arranged for each subsidiary participating in the cash pool.

    The treasury has a high level of visibility over the balances of subsidiaries’ accounts in this type of arrangement and can thus control the disbursement of cash. A subsidiary experiencing cash shortfalls can be funded from the master account at a cheaper rate than could be arranged locally. The treasury should be able to reduce borrowing costs significantly by using the balance aggregation to arrange inter-company funding.

Disadvantages
  • Inter-company loans created.

    The physical movement of cash between accounts creates a series of inter-company loans between the master and participant accounts. This can have complex implications, particularly with regard to:

    • Withholding tax.

      In some countries, withholding tax may be levied on inter-company loan interest. This is because tax authorities regard the payment of interest on inter-company loans as an inter-company payment rather than as a bank payment.

    • Thin capitalisation.

      In some countries thin capitalisation rules apply – these restrict the level of financing a subsidiary can receive from its parent/major shareholder. Companies are often able to offset the cost of such loans by deducting the interest charged as an expense for income tax purposes. In order to prevent abuse of this advantage, many countries have introduced thin capitalisation rules. The ratio of debt to equity a company is allowed before it is classed as being thinly capitalised varies considerably from country to country. Indeed, even within the EU there is no common position – the permissible levels vary from a 1:8 equity to debt ratio in Slovenia to 1:1.5 in France and Germany. Thin capitalisation levels need to be closely observed when running a physical cash pool to ensure that the redistribution of funds from the header account amongst the subsidiary accounts does not breach these rules. This is of particular concern when cross-border cash pooling is implemented.

    • Legal issues.

      The transfer of monies between a company’s subsidiaries creates legal issues due to the co-mingling of funds. Care must therefore be taken with the structuring of inter-company loans to ensure that they are legal. Often separate credit agreements will need to be put in place for each loan.

  • High banking costs.

    The physical transfer of cash between accounts will incur high banking costs, particularly if a large number of movements takes place and/or cross-border transfers are involved.

  • Cash flow forecasting.

    The master account will fund any cash shortfalls and invest in surpluses on a daily basis. Some degree of cash flow forecasting will therefore be required to manage these positions effectively.

  • Concentrated banking arrangements.

    Most cash pooling arrangements require that all participant accounts are held with the same bank. This may cause problems for companies with operations in many countries – a bank which is strong in one country may offer a more limited service, or indeed no service, in another.

Main variations
  • Zero balancing.

    Cash movements into and out of the header account are structured so that all subsidiary accounts are left with a balance of zero. Typically zero balancing cash pools operate on an intraday basis, with sweeps occurring daily (usually at the end of the working day). The net balance in the header account is therefore available for overnight investment.

  • Target balancing.

    Also called conditional balancing. In this arrangement, cash sweeps are arranged so that accounts in the pool are left with a pre-determined target balance after the sweep. Different target balances can be set for the constituent accounts in the pool. In fact, is often possible for the treasurer to set negative target balances (ie an overdraft facility) on some of the participant accounts.

  • Interest reallocation.

    Some banks allow the interest payable to the cash pool to be redistributed between the participant accounts. The bank calculates the interest payable after balances have been swept from the participant accounts to the header account. Central treasury can, if the net balance of the cash pool is positive, benefit from a ‘turn’ (the difference between the credit and debit rates) which may be shared with the operating subsidiaries.

  • Mirror accounts.

    Some banks offer a service whereby mirror accounts can be set up for the participating accounts in a cash pool. Sweeps on the participant accounts would be booked through the mirror accounts, leaving the operating accounts to function as if they were not part of the cash pool. Each participant account and its mirror account will net to zero after the sweep has been performed. This arrangement can help operating subsidiaries to reconcile their account balances and track the inter-company loans created by the cash concentration.

Notional pooling

In this type of cash pool, the balances of participant accounts are theoretically concentrated for the purposes of interest optimisation – no physical movement of cash takes place. The bank organising the cash pool offsets the debit and credit balances of the accounts in the cash pool and calculates the interest to be paid/charged on a net basis. This arrangement is also called interest compensation.

As no physical transfer of cash takes place in a notional cash pool, it is not usually necessary for a master account to be created. However, a company choosing this type of cash pool would need to identify the account that will receive/pay the net interest – this account is sometimes referred to as a master account.

Key benefits
  • Subsidiaries maintain autonomy.

    As no physical concentration of cash occurs, subsidiaries participating in a notional pooling arrangement maintain autonomy over their bank accounts and retain their cash balances. The group however achieves similar economic benefits as it would with a physical cash pool.

  • Less administration.

    As balances remain with each legal entity (ie no inter-company loans are created), notional pooling requires far less administration than physical pooling.

  • Lower banking costs.

    Notional pooling incurs far lower fees than physical pooling as the bank operating the pool is not required to transfer cash between accounts.

Disadvantages
  • Balance sheet enlargement.

    The balance sheet of both the bank and the company involved in a notional pool can become unnecessarily large. This is because there are no physical cash transfers occurring between the various accounts in the cash pool.

    Specifically, a bank offering notional pooling services may find that it is unable to offset fully the debit and credit balances appearing on its balance sheet. This will affect the way in which the bank allocates capital, which will in turn affect the interest compensation paid to the pool. This can become a very important issue as banks have to allocate capital to all their lending. If the gross overdrafts on the participant accounts have to be carried on the banks balance sheet, there will be a charge to reflect this, which may or may not be made explicitly. This will partially offset the gains that are made.

  • Legal issues.

    In some countries notional pooling is prohibited. Additionally, the way in which net interest is calculated may vary from country to country.

  • Credit facility requirements.

    Separate overdraft facilities and credit agreements will need to be negotiated for each account participating in the cash pool. This can make managing liquidity across a company more complex.

  • Accounting regulations.

    IAS 32 sets out stringent guidelines on how the offsetting of financial liabilities and assets should be presented on the consolidated balance sheet, principally that:

    • Companies must have a legally enforceable right to offset liabilities and assets.

    • Companies must demonstrate an intention to settle liability and asset offsets on a net basis, or be able to realise the asset and settle the liability simultaneously.

These rules pose a particular problem for companies operating a notional pooling structure. Whilst the existence of legal documentation detailing the cash pooling arrangement between the bank and companies participating in the pool would satisfy the first requirement, proving the intention to settle offsets is more complex. In order to satisfy this criterion, companies may find that they have to perform at least one cash sweep every reporting period, ie every quarter.

Main variations
  • Interest optimisation.

    This is a limited form of notional pooling whereby a bank offers a company preferential credit and debit rates (ie it returns to the company some of the ‘turn’ it would normally benefit from). This service is usually offered in jurisdictions where full notional pooling is not permitted.

  • Margin pooling.

    This arrangement is a variant of interest optimisation. In a margin pooling arrangement, a bank pays the company the benefit accrued by applying interest optimisation as a separate fee. The service allows for a bonus determined by the ratio between the debit balances and credit balances of the participating accounts. In effect, this operates as a sort of ‘loyalty scheme’ – the greater the offset between accounts, the larger the benefit paid to the company.

Other pooling arrangements

A form of cash concentration, in this arrangement a company maintains only a master account with a bank. This master account – which is generally managed by the group treasury – contains all the company’s cash and is effectively an in-house bank.

The bank maintains memo or sub accounts for all the participants in the cash pool. These sub accounts are used by the group’s operating subsidiaries as if they were not part of a cash pool (ie they control their own balances). However, all transactions on the sub accounts are booked to the master account. The master account is thus a summary account for all activity occurring in the sub accounts. The bank calculates interest on the master account balance, although this can often be allocated to sub accounts.

Single legal account pooling is not especially widespread, being mainly offered by the Nordic (and some UK) banks.

Reference account structures

Reference account structures are a method of including the accounts of subsidiaries which are not officially a part of the cash pool in a pooling arrangement. Subsidiaries may be unable (eg for legal restrictions in place in their home country) or unwilling to participate in a cash pool. In this arrangement, each subsidiary has – in addition to its normal domestic operating account – a reference account in the central pooling location. Balances on the local operating accounts are manually or automatically transferred to the subsidiary’s reference account in the central pooling location. These balances will then be notionally pooled, allowing for the full offset of debit and credit balances.

Multicurrency pooling

It is possible for multicurrency cash pools to be established, although most banks only offer this on a notional pooling basis. Banks usually calculate interest on notional multicurrency pools by theoretically converting all the account balances into a common base currency (eg euro) and performing notional pooling on that basis. It should be noted that banks will generally use a reference as opposed to the market rate to perform these conversions; the reference rate may well include a profit margin for the bank. Multicurrency pooling allows companies to achieve interest savings without requiring them to swap their offset positions in the foreign exchange market first.

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