Following queries on my ‘Cash management tools compared’ article, it seems useful to follow up with another view of liquidity management. In the previous article, I analysed how different cash management tools can help treasurers. Here I will look at the issues facing treasurers around liquidity management, and show how the different tools address those issues.

One global investable balance

Broadly the goal of balance management (aka liquidity management) is to concentrate cash balances across the group and around the world with the end goal being one global investable balance.

Treasurers want their cash in one place. They want all their cash under their control. They want to invest all their cash according to their investment policies. Of course, the specifics may differ (Americans will often have cash onshore and offshore separated to avoid Subpart-F issues), but the principle remains the same.

Certain business models (reinvoicing, principal structures, etc) tend to concentrate cash in a single legal entity, but in practice material cash balances will always be dispersed across the foot print of the group. This is an inevitable consequence of global business.

Dispersed cash

Cash is dispersed on different dimensions, each creating different challenges for treasurers (and thus requiring different tools). The three main dimensions are:

1. Legal entities: at a minimum, cash will be in one legal entity per country. Concentrating cash across legal entities will have tax and possibly regulatory consequences.
2. Bank accounts: different legal entities will have their own banks accounts (except in an effective in-house bank (IHB). In an international group, these bank accounts will be with different banks. Even when mono-banking, the accounts will be with different branches of the bank, which creates many of the same issues.
3. Currencies: entities are likely to have balances in their operating currency, and often in other currencies as well. One global investable balance must somehow be in one currency; preferably a currency with deep liquid money markets.

Now that we have clarified the three dimensions of the cash concentration problem, we can look at the specific challenges in each dimension and explore which tools best address these challenges. Before looking at how we can address these three issues, it will be helpful to clarify the tools we can apply – sweeping and notional pooling and IHB.

Sweeping

Sweeping means moving cash from one bank account to another. The bank accounts may belong to the same legal entity or to different legal entities. For example, cash may be swept from a legal entity’s operating account (often onshore) to the same entity’s pooling account (often offshore).

When used in conjunction with multi entity notional pooling to create an overlay, sweeping does not create intercompany balances (because cash is swept from an operating account in the name of the legal entity to a notional pooling account in the name of the same legal entity; thus the cash stays in the same legal entity). Sweeping between legal entities creates intercompany balances. Typically operating entities sweep to a treasury or head office entity. As stated above, intercompany balances create tax concerns including transfer pricing on resulting intercompany interest and related BEPS issues.

A pure IHB does not require sweeping, because operating entities do not have any bank accounts since the IHB handles all their payments and collections on behalf of the operating entities through the IHB’s bank accounts. In some countries, for regulatory or commercial reasons, the IHB may use local bank accounts in the name of the operating entity; in this case, the IHB will use sweeping to concentrate cash. In both cases, the IHB creates intercompany balances, so from a legal entity perspective the IHB has the same effect as sweeping (intercompany balances) even if from a bank account perspective there may be no sweeping (because the operating entity has no bank account).

Sweeping can be done in various ways – manually, by standing order, by corporate systems and by banks. The difference between these is in the degree of automation and the service provider. The result from both legal and cash management perspectives is substantially the same.

Sweeping can be one way and two way. One way sweeping typically moves excess cash from operating accounts to a pooling account, so that the operating entity is always depositing cash in the pooling account. Two way sweeping allows the operating entity to have an overdraft, so when the operating account is short of cash the sweep is from the pooling account to the operating account. In many arrangements, the previous night’s sweep is reversed the following morning so that the operating bank account reverts to its original balance during banking hours.

Multicurrency notional pooling is the only (cost effective) way to concentrate cash across currencies.

Even in mono banking, there will still be sweeps between the different branches and entities of the bank to concentrate funds. One advantage of mono banking is that the bank can sweep funds across its network at close of business with good value – this means that the cash is 100% concentrated with no leakage (not every bank will offer this to every corporate, the bank needs globally integrated liquidity management itself to do this cost effectively). Cut off and other technical issues mean that sweeping between different banks can never be 100% effective.

Sweeping cannot address the currency issue because the cost and complexity of the overnight FX swaps that would be required is prohibitive.

Notional pooling

Notional pooling is fundamentally different from sweeping in that there is no movement of cash, and therefore notional pooling results in bank balances whereas (legal entity) sweeping results in intercompany balances.

Notional pooling has two facets. Multi-entity notional pooling avoids the problem of intercompany balances. Multicurrency notional pooling addresses the currency problem. Multi-entity multicurrency notional pooling is common.

To the extent that groups have a requirement to concentrate cash from different countries, notional pooling is combined with bank account sweeping in what is often called an overlay. Since cash is swept from an operating account to a pool account both owed by the same legal entity, no intercompany balances are created.

Multicurrency notional pooling is the only viable way to address the currency issue (because the overnight FX swaps required to do so in a sweeping arrangement are too expensive and complex). Because of this, single entity multicurrency notional pooling is often used to address the currency issue when sweeping or when an IHB has been used to concentrate cash across legal entities and bank accounts. In this scenario, the single entity multicurrency notional pool will concentrate cash across multiple currencies which belong to the pool master or IHB.

1. Legal entities.

   Concentrating cash across legal entities may create tax and, depending on the country, regulatory issues. Since the regulatory issues are country specific, they are too diverse to address in this article. One key point is that regulatory issues are often less intractable than they seem when analysed with granularity. The tax issues relate to possible intercompany balances and the tax treatment of interest (or even the lack of interest) thereon. Intercompany balances will generate transfer pricing and BEPS concerns. The two common tools that address cash concentration across legal entities are sweeping and notional pooling. Sweeping between legal entities creates intercompany balances, which have tax and regulatory consequences. Notional pooling results in bank balances. The distinction is fundamental. The decision about which is preferable depends on the tax position and corporate culture. Corporate practice seems to be roughly equally spread, with a mix of hybrids as well. One common practice is to use multi entity notional pooling for day to day liquidity combined with intercompany balances in the form of term loans for structural borrowing.

2. Bank accounts.

   Bank account sweeping is required for all but the simplest liquidity management. If all the operating accounts are at one branch of one bank, then bank account sweeping can be avoided. Since most groups cover multiple countries and use multiple banks, bank account sweeping will be required. Notional pooling can only operate effectively (ie be capital efficient) in one branch of one bank. It is practical to arrange an end of day sweep of the concentrated cash balance to an appropriate interest bearing instrument – commonly a money market fund or bank deposit.

3. Currencies.

   The currency issue can only be addressed by notional pooling. Cross currency sweeping requires overnight FX swaps that are too complex and expensive to be effective. Without notional pooling, treasury will have to manage the concentrated currency balances manually – either by choosing to trade FX spots or swaps (which will not be cost effective) or by investing each currency separately (which is a lot of work and negates the scale benefits that cash concentration aims for). Notional pooling can address both the legal entity and the currency issues. These can be decided separately. So an IHB might use intercompany balances for the legal entity issue combined with a single entity multicurrency notional pool to address the currency issue. Other corporates use multi-entity multicurrency notional pooling to address the legal entity and currency issues combined with bank account sweeping to address the bank account issue – the result is often called a liquidity overlay or overlay structure.

Review and conclusion

Pulling this all together, there are two key decisions for treasurers.

1. Intercompany balances or bank balances?
2. Manual or automated currency management?

The answer to the first will determine whether to use sweeping or notional pooling to address the legal entity issue. The answer to the second will determine whether to use multicurrency notional pooling.

The two decisions are entirely separable as we have seen in the examples above. An IHB can also be adapted to any configuration of decisions.

The three issues in corporate balance management are to concentrate cash across legal entities, across bank accounts, and across currencies. Across legal entities the decision is between sweeping (resulting in intercompany balances) and notional pooling (resulting in bank balances). Sweeping is the only way to move cash between bank accounts, and is required in all but the simplest arrangements. Pure IHB does not require sweeping but results in intercompany balances and does not address the currency issue. Multicurrency notional pooling is the only (cost effective) way to concentrate cash across currencies. All of the above can be combined to suit the needs of diverse corporates.