Cash pooling is an established technique for treasurers looking to make the best use of surplus cash. Notional pooling can be an attractive option for companies with a decentralised structure because the control of funds remains with local subsidiaries. However, this type of pooling has been affected by recent regulatory and accounting developments. We explore the theory and practice of notional pooling.
What is cash pooling?
A cash pool is an arrangement whereby the balances of a number of accounts are treated collectively. This may be done on a physical basis (known as physical cash pooling, cash concentration or simply cash pooling) or notionally. In this article we focus on the pros and cons of notional pooling but we start with a quick look at traditional cash pooling.
Physical cash pooling
Physical cash pooling, the more common form of cash pooling, involves the physical transfer of funds between participating accounts. A header account is set up and funds are swept from participating accounts to the header account. Negative balances on participating accounts may likewise be funded from the header account. Often this is set up as a zero balancing arrangement, whereby the balance of participating accounts is brought to zero. Alternatively a specified balance may be left on the accounts (target balancing). Sweeps may take place on a daily, weekly or monthly basis as required. It is also possible to arrange sweeps to take place intraday or even on a per transaction basis.
Physical cash pooling is associated with two key benefits. Firstly, by offsetting positive and negative balances, the company either receives more interest on the pooled balance or pays less in interest costs, depending on whether the net balance is positive or negative. Secondly, physical cash pooling enables the balances of multiple accounts to be concentrated into a single location, which may mean that any surplus cash can be invested more efficiently.
This approach has its disadvantages, however. For example, local subsidiaries may be reluctant to surrender control of their cash and local banking relationships may be damaged by concentrating surplus cash into a particular bank’s account. In addition, inter-company loans are created by the sweeping of funds to and from the header account, which can result in withholding tax and legal issues.
Notional pooling in theory
Unlike physical cash pooling, in a notional pooling arrangement the balances of several accounts are considered collectively but are not actually transferred. Instead the bank looks at the balances of participating accounts as though they were all in a single account.
Cross-currency notional pooling
It is also possible to conduct notional pooling on a cross-currency basis. In this case, balances in different currencies can be offset without converting funds into a different currency.
Often this is arranged by physically concentrating cash in each individual currency. Each header account then transfers funds into its cross-currency notional pool account. Usually all of the notional pool accounts are held in the same location.
If subsidiaries are using different banks, it may be possible to arrange cross-currency notional pooling using an overlay structure. In this case, the local bank concentrates the cash in-country. Funds are then transferred to and from a notional pool account held by the pooling bank.
Take-up of notional pooling is generally lower than physical cash pooling. J.P. Morgan Asset Management’s Global Cash Management Survey 2008 found that overall, 9% of the 314 respondents used notional pooling, 41% used zero balance structures, 28% used both and 22% used neither. Take-up of notional pooling was particularly low among respondents from North America.
Retaining local control of cash was the primary reason given for choosing notional pooling and tax and legal issues were reported to be the biggest obstacle.
Benefits of notional pooling
As with physical pooling, positive and negative balances are offset, resulting in increased interest yield/reduced interest cost overall.
Inter-company loans are not created. The associated accounting and administrative requirements are therefore avoided.
There is no co-mingling of funds.
Notional pooling is associated with lower banking costs than physical pooling as there are no daily transfers.
Subsidiaries keep control and legal ownership of cash. This can be particularly useful for companies operating on a decentralised basis.
A number of issues should however be taken into account when deciding whether to implement a notional pooling structure. These include:
Some countries, such as China, Malta and Turkey, do not permit notional pooling at all. Restrictions also apply in a number of other countries.
Right of offset
In order for different legal entities to participate in a notional pool, the entities have to give the bank the right to offset the balances and record the net position only on its balance sheet. Usually this is achieved by the participating entities signing a cross guarantee agreement. However, this can lead to complications as such guarantees are difficult to enforce on a cross-border basis and are not permitted in certain jurisdictions.
In addition, some companies may be reluctant to participate in such agreements. By specifying joint and several liability, the agreements imply that any of the pool participants can be held liable for the overdraft positions of the other participants. In other words, if Subsidiary A goes bankrupt leaving a cash deficit in the pool, and Subsidiary B has a cash surplus in the pool, Subsidiary B would be liable for covering the deficit (although usually this liability is restricted to Subsidiary B’s balance in the pool). Not all companies will be willing to accept these terms.
Under Basel II, which became effective in 2007, banks are required to maintain sufficient capital to cover operational risks. In the case of notional pooling, banks now also need to estimate, price and allocate equity to their potential loss, for example in case balances in a notional cash pool cannot be offset due to bankruptcy or bankruptcy protection or other local regulations.
In practice, this has not yet had an impact on the cost of notional pooling for corporates, although current market conditions could change this as Bas Rebel, Manager of Zanders, explains: “So far we see that banks for commercial reasons have not changed their pricing. It is hard to believe this will not change now that the solvency of banks has been eroded so much.”
On the accounting side, IAS 32 (Financial Instruments: Presentation) has also had implications for notional pooling. It is important for companies to be able to report notional pooling on a net basis because if the positive and negative balances are reported separately the balance sheet is inflated, which has an impact on balance sheet ratios. However, under IAS 32.42, assets have to be disclosed on the balance sheet separately unless there is (a) a legal right to offset them and (b) an intention to settle them on a net basis.
While the first requirement can be met with documentation, in order to meet the second requirement a periodical physical settlement is generally required. This usually takes place monthly or quarterly on an overnight basis and is carried out automatically by the bank. The company is free to decide which account the funds are swept into and funds may remain in the account for anything between one minute and 12 hours before being swept back. So the overnight position does not necessarily have to change.
As with Basel II, it was originally expected that the requirements of IAS 32 would make notional pooling significantly less attractive. However, according to Bas Rebel, “The banks came up with the periodic settlement solution acceptable for external auditors and treasurers have been happy to adopt such a minor change. We have seen no shift of arguments in the discussion regarding notional and zero balance pooling.”
Banks may pass on the interest benefit of notional pooling in different ways. In some cases, interest is initially calculated without taking the pooling arrangement into account and a rebate is then paid to the group. In other cases, the net interest position is calculated and paid or charged to the master account. Depending on the pooling structure, interest may need to be reallocated internally between pool accounts. Due to transfer pricing restrictions, this will need to be carried out at arm’s length.
Other types of notional pooling structure have been developed, such as interest optimisation. This is a limited form of notional pooling whereby the bank arranges preferential interest rates for participating accounts without fully offsetting credit and debit balances. This may be possible in jurisdictions where full notional pooling is not permitted.
Notional pooling in practice
Headquartered in the US, Tenneco is a manufacturer of automotive emission control and ride control products and systems. Tenneco has operations in 24 countries, employs 21,000 staff worldwide, and reported revenues of $6.2 billion in 2007.
When Gary Silha, Assistant Treasurer of Tenneco, originally looked into replacing the company’s outsourced inter-company loan portfolio in September 2006, he had no plans to adopt notional pooling. Initially, he was planning to set up a pan-European zero balancing cash pool structure.
However, when the company’s global cash management bank issued its proposal, it did not deliver all the benefits Silha had hoped for. Rather than achieving a reduction in worldwide bank fees by consolidating transaction volumes, the proposal included an increase in bank fees of $15-20,000. This was because Tenneco’s global cash management bank could not match the pricing offered by the local banks, as the local banks were providing the basic cash management services for what amounted to below pan-European market pricing in order to maintain the relationship. “We would still have saved a million dollars in interest expense,” says Silha. “But an issue that I thought would be a positive bullet point for senior management turned out to be a negative one.”
In addition, although the cash management bank had coverage in all the required countries, it was not able to provide some of the services provided by the existing local banks, primarily in the areas of payroll and payroll related taxes. Consequently, instead of enabling Silha to rationalise the company’s bank accounts, the zero balancing arrangement would have required additional accounts to be opened with the cash management bank while local bank accounts would have had to be retained in order to cover the services the cash management bank could not provide.
A third concern was the considerable resistance presented by the local controllers, who did not want to give up their local bank relationships. Although the project had the support of senior management, and was set to save $1m in interest costs, the reluctance of the controllers to support the project was likely to delay it by many months.
The fourth and most serious disadvantage was that the existing local banks were currently offering off-balance sheet factoring facilities amounting to $100m. As the global cash management bank was unable to match this, the zero balancing arrangement would have led to a $100m increase in Tenneco’s debt.
The notional approach
With the idea of the zero balancing cash pool rejected, in January 2007 another bank pitched the idea of a multi-currency notional pooling arrangement to Silha. Although this structure is relatively uncommon in the US, Silha immediately saw its potential. “We realised that it overcame all the disadvantages associated with the zero balancing arrangement and brought advantages that the zero balancing couldn’t even touch. For example, with a notional pooling structure, you are able to maintain local bank relationships. It is also very easy to implement – each subsidiary opens a bank account with the notional bank and you’re ready to roll.”
The decision was therefore taken to set up a notional pool, incorporating 49 accounts in multiple currencies. The project was implemented in two phases. In phase one, the subsidiaries manually wired funds to/from their pool accounts with the bank providing the notional pooling which is based in Amsterdam. Phase two involved the automation of the process. Subsidiaries were given three options at this stage, and Silha believes this flexibility was a crucial aspect of the project’s success.
In the first option, the subsidiary bank reports the end of day balance to the pool bank each night via a SWIFT MT940 message and then sends a current day transaction message (MT942) to the pool bank at 14:00 CET the next day. The pool bank’s back office system uses the two messages to determine the account balance at 14:00 and then issues an MT101 request for wire (if balance is positive) or sends funds via an MT103 (if balance is negative), bringing the local cash balance to zero.
The second option is similar to the first but the decision to move cash is made by the back office of the local bank rather than the pool bank. If neither of these options can be achieved, the Tenneco subsidiary opens an account with the pool bank locally and then sets up a zero balancing end of day sweep from the local account to the pool account in Amsterdam. This is the least favoured option as it requires a local bank transition to the pool bank, which can be a time-consuming process.
As a result of the notional pooling structure, Tenneco has enjoyed the following benefits:
Interest cost savings.
The pooling arrangement has saved Tenneco around $1m per year.
The local controllers were very supportive of the concept.
Existing inter-company loan documentation was eliminated.
The previous inter-company loan portfolio had required documentation for each of the 44 participating entities. Each time a credit limit needed to be changed, a standard amendment agreement had to be signed, sometimes in dual language. A board resolution was sometimes required in order for the agreement to be signed. With the notional pooling arrangement, one agreement is signed during the implementation process.
Significant reduction in FX business.
Before notional pooling was implemented, Tenneco was carrying out around 950 hedges each year for a notional value of $7 billion in order to hedge the exposures brought by the intercompany loan arrangement. With the notional pool in place, 90% of these deals have been eliminated, significantly reducing the associated administrative workload.
Reduction in bank fees.
Whereas bank fees would have increased with the zero balancing structure, the notional pooling arrangement has reduced bank fees because the subsidiaries found that in some cases the cost of making third-party vendor payments from their notional pool account was as little as a third of the cost of the same transaction from their local bank account.
Whereas the project was originally intended to cover Tenneco’s European subsidiaries, it has now been rolled out on a worldwide basis including legal entities in New Zealand, Mexico, Canada and Singapore.