Cash & Liquidity Management

Question Answered: Cash pooling

Published: Mar 2022

“Is cash pooling still an effective and valuable strategy for companies aiming to maximise the availability of capital?”

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Portrait of Susan Hillman, Founder and Partner, Treasury Alliance Group

Susan Hillman

Founder and Partner
Treasury Alliance Group

Cash pooling has different flavours. Companies can pool in-country or cross-border. It is the latter that appeals to multinational corporations because it allows them to maximise their credit and offset positive and negative balances across different legal entities. There are two approaches: physical and notional.

Physical pooling allows funds in separate subaccounts – at the same bank – to be automatically swept to and from a header account. The participating entities’ bank accounts are either in surplus or deficit position on an end-of-day basis. The physical concentration to the designated header account effectively zero balances the subaccounts. Physical pooling can be used across multiple legal entities, located in the same or different countries – but on a currency-by-currency basis. The idea ensures that a company doesn’t have one entity overdrawn on the same day that another entity, in another jurisdiction, has excess cash. Everything is swept at the end of the day, and the next morning funds cover outgoing payments for the overdrawn entity.

Movements between accounts in this way are categorised as intercompany loans to and from the header entity and the participating subsidiaries. Specific loan documentation related to the pool structure is prepared in advance. The holding entity should be designated as an agent for the group which allows the interest paid and earned to be treated as bank interest and is not subject to withholding tax.

Notional pooling achieves a similar result but is accomplished by creating a shadow or notional position resulting from an aggregate of all the accounts, which can be held in multiple currencies. Interest is paid or charged on the consolidated position. There is no actual movement or commingling of funds. It is a seemingly simple, hands-off solution; but the opaque nature of the arrangement in terms of costs and minimal documentation between separate legal entities makes many tax directors uncomfortable.

Most multinationals prefer physical pooling as it is cleaner from a tax perspective because those movements to and from the header accounts are characterised as loans. Cash pooling is day-to-day cash management – if you have an operation that needs funding on an ongoing basis, either handle through a capital infusion or a direct intercompany loan with specific terms and conditions.

Physical pooling is typically done with one bank, and companies must decide which of their banks is going to manage the daily cash positions and liquidity. There are only five or six banks globally that can effectively offer this service and have the reach and reporting platform required.

Cash pooling can reduce costs as companies are not paying fees to multiple different banks or doing wire transfers to fund operations or move excess cash – however the real value for companies is in administrative saving and cash optimisation. Cash pooling also eliminates overdraft charges and in times when interest rates are higher, companies can get a return on their cash. Still, there is a cost to a pooling arrangement and pricing may differ between banks.

Can third-party vendors provide pooling services? Information and transaction tracking potentially, but I can’t see banks being pushed out of the picture. Banks hold the balances and provide the credit lines that are normally behind this type of service, so I’d advise companies to give this service to one of their credit banks that can offer cash pooling. It is good transactional business and can provide balances and liquidity for the banks which is required from a regulatory perspective.

Portrait of Manish Joshi, Director, Cash & Banking Operations, META, GE Corporate Treasury

Manish Joshi

Director, Cash & Banking Operations, META
GE Corporate Treasury

Cash pooling enables companies to efficiently use their own money, and drives working capital management. As a rule of thumb, companies would prefer to use their own money rather than borrow from financial institutions, so pooling also reduces the cost of capital. Cash pooling also helps ensure that funds are available when needed, helping to smooth the payments process.

As a structured approach, companies can focus on cash consolidation at a country level first. This works best for a country that has multiple entities and business lines enabling better use of cash within the country for the purpose of payments, efficient collection, and consolidation. The process also involves defining the optimum requirement for cash at a country level and determining the core surplus which can be utilised by the wider company for cash management around the globe.

Cash pooling drives efficiencies in terms of companies’ ability to use their own funds. For example, in emerging markets in places such as Africa, cash pooling and collections in local currencies are often used for local payments and expenses as soon as possible to reduce FX exposure and protect against the risk of currency devaluation.

Cash pooling is a strategy that can be used to manage FX exposure, excess liquidity, and country and bank counterparty risk. By extension, companies shouldn’t shy away from borrowing in local currencies either. If collections and expenses are in local currency, companies may think about borrowing locally to fund the business to protect against the risk of devaluation. Local currency borrowing costs are preferable to the implications of FX devaluation.

It is simplest for a company to use one bank for its pooling needs, but this isn’t always possible because banks have footprints in different countries. Different regulatory requirements and product development can also require companies use the services of multiple banks to pool. Companies need to set up cash pooling between these different paradigms. Many countries still prohibit cash pooling, particularly those with low dollar reserves or with economies that are import-dependent.

Portrait of Lori Schwartz, Global Head of Liquidity & Account Solutions, J.P. Morgan Chase & Co

Lori Schwartz

Global Head of Liquidity & Account Solutions
J.P. Morgan Chase & Co

All companies need cash to support their business and make payments. This liquidity is an important risk mitigant, but excess liquidity can also be inefficient when seen in the context of capital that the company hasn’t deployed to invest either in the company or the yield curve.

Solutions like physical cash pooling connects accounts and corridors of activity, moving cash in between accounts to ensure treasury has cash where it needs it and when, in the right currency, and able to cover short positions or aggregate long positions. Notional cash pooling is similar but doesn’t involve physically moving cash. It creates a fungibility across currencies and provides visibility, control, and optimisation. Companies can also integrate virtual account solutions that retain the integrity of data and information on that underlying position.

Cash pooling is vital for optimising cash on account. Take a multinational with decentralised operating entities running their own businesses. These subsidiaries will keep their own cash buffers to mitigate risk and ensure they can make their payments that when added together, combine to make a significant sum across a global company. Yet not every operating company needs their buffer every day. As companies go on a journey of centralisation, they will create a fungibility in those cash buffers. It means that different entities can have a cash injection according to their needs, creating a central buffer that is optimised – and reduced – at a treasury centre.

When companies migrate from a decentralised to centralised structure, they can reduce the need to keep cash on deposit by up to 50% from simple efficiencies. Treasury can see what cash it has and where it has it, giving real-time control that allows companies to take that surplus capital and invest it to accelerate the business growth.

Of course, the cost of capital fluctuates in any given economic cycle, but companies benefit from reducing the amount of capital whatever the cycle because reducing capital is a value add. We saw a huge demand for pooling in 2020 when the business cycle changed and companies realised they would benefit from a centralised structure, with visibility and control of their cash.

Technology and digitisation are also driving pooling demand. Digitisation has led to an acceleration in e-commerce, giving way to faster payments and causing money to move much more quickly, putting pressure on liquidity management. Corporate treasury needs to know where cash is and have access to it. For example, one of the biggest challenges within cash management is short-term forecasting. It has created a need for structures that can respond and allow treasury to put cash where it is needed and in the right currency.

In another example, the evolution in e-commerce means more companies are selling third party goods and need to manage third party monies (3PM). It means these companies are an intermediary in a cash exchange. We increasingly work with companies to structure liquidity and account solutions that support 3PM which often involves safeguarding cash and requires even more visibility and control.

Next question:

“What does ISO 20022 mean for the payments industry and how should treasury prepare?”

Please send your comments and responses to qa@treasurytoday.com

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