Cash pooling is an established optimisation tool for multinationals looking to effectively manage liquidity, streamline bank account structures and lower bank transaction and, despite periodic bouts of concerns about its relevance, its future remains bright.
Regulatory change and the rise of new technology have led to question marks over cash pooling in recent years yet it remains an effective, valuable strategy for companies aiming to maximise the availability of internal sources of capital, especially when it is executed on a global scale.
There are two main types of pooling: physical cash pooling – also referred to as sweeping or zero balancing – and notional pooling. Cash pooling brings together a number of individual bank accounts to pool balances, optimise interest and improve an organisation’s liquidity management. And it can be executed across multiple jurisdictions, currencies and entities, depending on the type of cash pool in place.
Galia Elizondo, Global Product Manager, Cash Management at Finastra says companies looking to execute either physical or notional pooling first need to understand the types of liquidity management techniques available as well as the tax, regulatory and commercial issues that may come into play during pooling operations in different countries.
She explains physical cash pooling can be achieved on both a single-country and cross-border basis, using one bank or multibank, with the most common method for sweeping being where balances are physically moved in one currency at a time. In practice each company division or subsidiary maintains its own bank accounts – effectively sub-accounts of the header account. Assuming there is no regulatory restriction, these accounts can be held in location. At the close of each business day, all the balances from the accounts held in the subsidiary accounts are swept to the header account and this header account (which may or may not have an agreed overdraft for the use of the group of accounts) will send over the deficit balances.
Usually the main account is maintained in the name of another legal entity, such as the parent, a regional subsidiary, or a finance company – whatever best suits from both a practical and tax perspective.
Elizondo says: “The first thing to note about cash pooling is that nothing has really changed with the practice over the years. It remains what it always was, a way for companies to physically concentrate balances on a number of accounts into a single header account, in order to optimise interest and also invest the surplus concentrated in this header account.”
The other main type of pooling is notional pooling. This is primarily a tool for interest enhancement. Notional pooling structures are typically overlay structures. Debit and credit balances on a series of accounts owned by the same or different entities and domiciled in the same country are notionally netted for interest calculation purposes, without a physical movement of cash. Multicurrency notional pooling offers the ability to achieve a net notional position in a single currency without the need to perform traditional FX or swaps, and extends the benefit of further interest savings as a result of compensating balances in different currencies.
In addition to the two main types, hybrid solutions which combine notional and physical pooling are available for optimising liquidity. Elizondo says in her experience with multinationals, most first physically sweep balances from local accounts into a local master account (an account per currency). After centralising individual countries, the accounts are then centralised to a global structure and balances then notionally pooled, with cross-currency notional pooling a typical solution here.
In recent years there has been speculation over the relevance of notional pooling due to regulatory changes, for instance Basel III, making corporates perhaps unsure whether it will be useful to them in the future. But Elizondo assures that “notional pooling is very much alive and will continue to be on the agenda in the future for corporates wanting to optimise cash management”. “In fact, I think notional pooling will actually be more popular going forwards. It’s actually gaining in popularity now for cross-currency notional pooling in one country. That is particularly true here in the UK where we have so many currencies flowing through and, as a result, we see a lot of corporates want a multicurrency notional pooling scheme,” says Elizondo.
Let’s get physical
So, what are the pros and cons of physical cash and notional pooling? The concentration of all of a company’s surplus cash into one account, generally managed by the group treasury, will certainly help 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 and other short-term products. Companies with large treasuries often have dedicated staff managing these investments, with treasury accounts also likely to get better interest rates.
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. Establishing a physical cash pool also means that the treasurer need only negotiate one credit limit for the entire group, thus avoiding the need for separate credit arrangements to be set up for each subsidiary participating in the cash pool.
In this type of arrangement, the treasury has a high level of visibility over the balances of subsidiaries’ accounts and, as a result, can control the distribution 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 balance aggregation to arrange inter-company funding.
Disadvantages associated with the physical movement of cash between accounts include the creation of a series of inter-company loans between the master and participant accounts. This can have complex implications, particularly with regard to, for instance, withholding tax and, in some countries, ‘thin capitalisation’ rules which restrict the level of financing a subsidiary can receive from its parent or major shareholder.
The transfer of funds between a company’s subsidiaries can also create legal issues due to the co-mingling of funds, while 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.
Also, 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.
Variations on vanilla physical cash pooling include target balancing whereby 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. It is even possible for the treasurer to set negative target balances – an overdraft facility – on some of the participant accounts.
Let’s get notional
With notional pooling the main benefits include subsidiaries maintaining their autonomy over their bank accounts and retaining their cash balances as no physical concentration of cash occurs. The group however achieves similar economic benefits as it would with a physical cash pool.
Notional pooling also means less administration as balances remain with each legal entity and no inter-company loans are created – notional pooling requires far less administration than physical pooling. Notional pooling incurs lower fees than physical pooling as the bank operating the pool is not required to transfer cash between accounts.
The drawback with notional pooling is that 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.
Also, in some countries notional pooling is prohibited and the way in which net interest is calculated can vary from country to country. Furthermore, 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.
Variations of notional pooling include interest optimisation, a limited form of notional pooling whereby a bank offers a company preferential credit and debit rates – that is, 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.
More broadly, there is the overlay cash pool, which isn’t necessarily distinct from notional, conventional target or zero balancing but can contain components of all three. It is a cash management service that facilitates the aggregation of liquidity from a series of multiple underlying banks or accounts into a single bank or banking structure. This could be within a single bank, but typically an overlay structure refers to a multi-bank structure.
Where balances are held at two different banks, the cash has to physically move from the local bank to the overlay bank. This can be done by the corporate instructing its local bank to push the funds to the overlay bank – where every day at a particular time the bank pushes excess cash into the overlay bank account structure. The alternative is for the overlay bank to pull the cash from the local bank at a predefined time and within certain parameters.
Horses for courses
The key difference between the two main types of pooling is that notional is favoured by companies that want their subsidiaries to maintain their autonomy, while physical pooling enables budgetary assistance to be actioned across subsidiaries with surpluses being invested in a money market fund or a short-term financial product – the transfer of funds results in a transparent or clean pooling structure.
Elizondo says that one thing notional pooling allows that is very advantageous is that no intercompany loans are generated and cross border transfers are not necessary. However, one major disadvantage of notional pooling schemes is that they generate the need for cross guarantees, cross indemnity agreements or pledge guarantees. This is because the bank requires each participant to indemnify the bank, or provide a guarantee to like effect, against any other participant’s default. That means there is much more documentation generated and it needs experts to basically read all the documentation and small print that banks will give to the corporates.
She adds: “Any legal entity that wants to participate in a notional pool must give the bank the right to offset the pooled debit and credit balances and record the net position only on its balance sheet. Usually the participating subsidiaries sign a cross guarantee agreement. This cross-guarantee agreement implies that in case of default, the risk should be borne by the credit account balance legal entities of the notional pooling account structure, and it will be equivalent to the sum of debit account balances in the structure.”
Based on her many years of experience in pooling – she spent several years at Banco Santander as a global liquidity manager with a focus on sweeping and pooling before joining Finastra – Elizondo reckons around 75% of corporations favour physical pooling. Of the rest around 15% implement notional pooling and 10% will plump for a hybrid solution.
It is vital companies consider country specific regulations when considering notional and physical pooling. In general, notional pooling tends to be implemented more in Asia and in Europe, which is also the most mature region globally for hybrid solutions. Physical pooling tends to find favour in Latin America and the US. She cautions that in some countries, like China and India, which do not allow unrestricted cross border movement of funds, pooling solutions are very difficult to implement, with the cost of doing so likely to outweigh the benefits.
Optional routes
Jelle Goossens, Head of Group Treasury at Barry Callebaut Group, Singapore, says that aside from pooling structures involving third-party (usually banking) partners, corporates can also look to in-source these activities by deploying an inhouse bank ledger-based solution. “Inter-company flows related to commercial, lending, and hedging activities can be settled completely virtually in a transparent and cost-effective manner. Moreover, if executed within the same ERP platform, this will help to create efficiencies by avoiding inter-company reconciliation differences; a job which can become quite cumbersome in companies that have a global footprint and global supply chain, resulting in a matrix of possibilities of inter-company relationships,” he says.
Furthermore, Goossens says, in a more advanced set-up, one could implement daily inter-company swaps of cash/debt positions in currencies different from the home currency of the operational entity. The FX swaps serve to align the mismatch between the cash flows – for example the underlying commercial risk as hedged item versus the hedging instrument which, when best-practice, is also an inter-company hedge traded with the inhouse bank – mitigating the risk of changing interest rate differentials. As a result, the operational entity shows a clean net cash or debt position at the end of the day, resulting in a clear-cut financial expense or income.
“Ultimately, all of these virtual flows and associated financial risks are centralised, create transparency and hence allow risk management within a single financial vehicle. Granted, as with external pooling structures, such virtualisation also faces challenges including regulatory, compliance and fiscal and across emerging Asia they are especially pronounced. However, the efficiency gains should not be underestimated.”
Goossens says such integration within a group-wide ERP system can be a key enabler when it comes down to forecasting cash flows, which in turn drives more efficient and effective liquidity management. “In the third-party bank linked solutions, forecasting is done based on what could be labelled as first-order derivative pieces of historical information, such as cash collections and payments, which are extrapolated to forecast the future.
“However, especially for corporates in the B2B-space, access to the underlying sources of the cash flows – commercial contracts, purchase orders, sales orders and ultimately invoices – provides insight in what to expect well in advance – before the bank statement indicates what cash flow took place.”
