Treasury Today Country Profiles in association with Citi

In-house banks without expensive software

David Blair, Acarate

The current popularity of in-house banks (IHB) combined with the regulatory uncertainty surrounding notional pooling makes the case for multicurrency virtual accounts (MCVA) very attractive to a wide range of treasurers.

David Blair

Managing Director

Twenty-five years of management and treasury experience in global companies. David Blair was formerly Vice-President Treasury at Huawei where he drove a treasury transformation for this fast-growing Chinese infocomm equipment supplier. Before that Blair was Group Treasurer of Nokia, where he built one of the most respected treasury organisations in the world. He has previous experience with ABB, PriceWaterhouse and Cargill. Blair has extensive experience managing global and diverse treasury teams, as well as playing a leading role in e-commerce standard development and in professional associations. He has counselled corporations and banks as well as governments. He trains treasury teams around the world and serves as a preferred tutor to the EuroFinance treasury and risk management training curriculum.

Clients located all over the world rely on the advice and expertise of Acarate to help improve corporate treasury performance. Acarate offers consultancy on all aspects of treasury from policy and practice to cash, risk and liquidity, and technology management. The company also provides leadership and team coaching as well as treasury training to make your organisation stronger and better performance oriented.

Contact details:
Website:www.acarate.com

Notional pooling has been a favourite in treasurers’ toolkits for over three decades and primarily provides two key benefits:

  • Concentrating liquidity across subsidiaries without creating inter-company balances – multi-entity notional pooling.

  • Concentrating liquidity across currencies – multicurrency notional pooling.

In practice, most modern notional pools are multi-entity multicurrency notional pools.

These two benefits bring regulatory concerns as Basel III is being worked out in detail. Offsetting balances between different legal entities (eg subsidiaries) has required cross guarantee arrangements in some jurisdictions. Under some interpretations of Basel III, it may not be permitted for regulatory reporting – this would require banks to allocate capital against gross balances, thereby nullifying the economic benefits of notional pooling.

Offsetting balances across currencies is less contentious from a regulatory perspective – it is common practice in financial services and the regulators have established clear guidelines on the haircut (against which regulatory capital must be allocated) required to cover theoretical FX risk (normally based on the VAR of the gross balances).

This means that single entity multicurrency notional pools are on safe regulatory ground. Many IHBs use such pools to manage the IHB’s currency positions and cross currency liquidity.

In-house bank

The IHB has become increasingly prevalent over the past decade. For clarity, IHB can sometimes mean setting up a treasury centre; in this article IHB refers to the practice of centralising all flows and balances in the IHB entity which executes all flows on behalf of the operating entities, recording them in an inter-company current account.

IHB is so popular because it removes both flows and balances from the banking system, thereby creating huge cost savings and major risk reductions. Only one account per currency is required for the whole group, payments are aggregated and netted and executed on behalf of subsidiaries by the IHB. Subsidiaries no longer need bank accounts because all flows and balances are handled through their inter-company current account with the IHB.

IHB creates inter-company balances which will attract withholding tax in many jurisdictions as well as thin cap and transfer pricing issues. IHB does not inherently address cross currency exposures, and this is why many IHBs use single entity multicurrency notional pools to manage cross currency liquidity.

Virtual accounts

Virtual accounts have become a standard tool for treasurers seeking to increase auto reconciliation rates. The original idea was to break account numbers into two segments:

Company and customer graphics

This ensures that the originator of incoming payments is known, which helps with reconciliation to accounts receivable. Some use the second segment to encode the invoice number, but since this forces customers to change the account number to which they are paying for every invoice (causing operational risk and cost), it is not popular for business to business payments.

A more recent development has been to break account numbers into three segments:

Group and company and customer graphics

This allows multiple subsidiaries to use the same bank account. When used for payments as well as collection, the result is very similar to IHB:

IHB and subsidiary and customer graphics

Most IHBs use ERP or TMS systems to manage the process, which can see high volumes of transactions flowing through the IHB’s single bank account per currency. Three segment virtual accounts open the possibility of outsourcing that IT work to banks.

Multicurrency accounts

Multicurrency accounts (MCA) have become common in the retail space, and are now starting to be offered to corporates. The main use case is to reduce the cost of FX spreads on FX flows, which can be particularly heavy for smaller corporates who typically get banks’ so called board rates.

“Multicurrency virtual accounts are a valuable addition to treasurers’ solution sets. In addition to their intrinsic benefits they provide a useful path to the benefits of having an in-house bank.”

When MCAs allow debit balances, they become functionally equivalent to single entity multicurrency notional pools. Treasury would typically run several currency balances and offset them in a base currency to sweep funds to money market funds or other investment products. For example, if investment is in USD:

AUD EUR JPY SGD USD
200.00 300.00 40,000.00 500.00 (1,168.48)
0.75 1.07 115.00 1.43

Sweeping US$1,168.48 to the desired cash investment vehicle makes the net MCA balance across currencies zero, thereby eliminating idle cash.

Multicurrency virtual accounts

By combining three segment virtual accounts with multicurrency accounts, banks have the functional and informational basis to provide IHB as a service to corporates. (Forgive for a moment the irony of outsourcing in-house banking to a bank.)

One remaining challenge will be how to allow corporates to benefit from lowest cost routing (normally avoiding cross border payments in favour of local ACH type payments). Normal IHBs achieve lowest cost routing by locating their currency accounts in the country of the currency, thus having access to local (cheaper) payment instruments; they then provide lowest cost routing to their subsidiaries through the inter-company current account and payments and collections on behalf of the subsidiary. Two workable solutions would be either to use cross border ACH services or to locate a single currency virtual account in country which is swept daily to the MCVA.

This solution may not persuade large corporates with established IHB processes and systems to change, but for corporates who do not have single instance ERPs or a suitable TMS it could provide a cost effective way to access the benefits of IHB.

Banks may fear revenue cannibalisation – basically corporates are doing IHB to reduce costs, which means paying less to banks (as well as to reduce operational risk which has little impact on banks). Since (excepting regulatory costs) treasury is heading inexorably to greater efficiency (driven by competitive pressures), banks will conclude that cannibalising their own revenues is better than letting someone else steal their customers.

Multicurrency virtual accounts are a valuable addition to treasurers’ solution sets. In addition to their intrinsic benefits, MCVAs provide a useful path to the benefits of IHBs. MCVAs will be especially helpful for treasurers who do not have access to the systems required to run IHBs and those whose systems are heterogeneous.

The views and opinions expressed in this article are those of the authors.

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