Chapter Nine

Cash Pooling and Efficiency

ONE OF THE TOPICS OF MOST discussion in recent financial and corporate times is the pooling of cash and the processes that make the availability of cash and its use a lot tighter. The liquidity events of 2008 highlighted the use of cash, as we will see in Part Three of this book. In this chapter, we focus on the cash concentration aspects of transactions management, looking at the implementation of various structures that would help to pool cash in together.

CASH CONCENTRATION STRUCTURES

The ability to concentrate cash into one location and preferably in one currency has been a challenge for Treasurers ever since company operations became physically dispersed. Concentration structures can be one of two broad methods—notional pooling and physical pooling—or combinations of these (see Figure 9.1).

FIGURE 9.1 Concentration Structure Types

Physical Pooling

Physical pooling is the simplest method to appreciate: Cash is moved from one account to the other through a physical transfer and then moved back in the morning if required. The actual transfer happens to a master “concentration” account, and the net position is managed centrally.

Physical pooling can be:

• Cross-border
• Cross-regional
• Cross-bank
• Zero balance in each of the pooling accounts, or a targeted minimum balance

The more automated the environment is, the easier it is to achieve efficiencies with physical pooling.

Zero-Balance Account Pooling

Let us assume, for simplicity’s sake, the end of day balances in accounts A, B, and C to be USD +120,000, −150,000, and +90,000 respectively (see Figure 9.2).

FIGURE 9.2 End-of-Day Scenario Without Pooling

If the deposit rates in each location were, say, 2% and the overdraft rate were 6%, the effective interest receivable (payable) in each location is around USD 13.33 payable (see Table 9.1).

TABLE 9.1 Effective Interest Receivable (Payable) in Each Location

In a scenario with a zero-balance account (ZBA), where all the funds are pooled into a central concentration account (see Figure 9.3), the effective interest rate receivable (payable) in each location A, B, and C is zero, owing to all the balances (both positive and negative) being pulled away.

FIGURE 9.3 End-of-Day Scenario with ZBA Pooling

The effective interest receivable (payable) at each location is shown in Table 9.2.

TABLE 9.2 Effective Interest Receivable (Payable) in the ZBA Structure

As can be seen in Figure 9.4, when operations begin the next day, the funds are swept back.

FIGURE 9.4 Beginning-of-Next-Working-Day Scenario When ZBA Funds Are Swept Back

A target balance account (TBA) is similar to a zero-balance account, except that there is a specifically predecided amount that is left behind as an end-of-day balance in each of the designated accounts. These target balances are arrived at based on different factors such as regulatory need, banking covenants, management comfort, and contingency cushion for unexpected withdrawals.

Apart from the optimisation on interest cost and potential savings on overdraft fees that could be avoided, the benefits of physical pooling are that the cash can be used centrally for investment or funding purposes and entities not at the centre need not focus on managing their cash optimally. Pooling enables all possible benefits of cash centralisation.

From a regulatory point of view, regulators in some emerging market countries do not view pooling activity favourably, ostensibly because it takes away liquidity from local markets, especially if foreign currency resources are scarce and the potential conversion of local currency to foreign currency could impact currency rates. Also, since this process can be deemed to be a capital account conversion and the capital account is the one most scrutinised, easing restrictions on pooling transactions could force relaxations of far more important transactions as well.

Notional Pooling

Notional pooling, as mentioned earlier, retains the requisite balances in the respective accounts, while paying out (or debiting in case of overdrafts) the actual interest payable at the concentration centre. Notional pooling provides the interest benefit of the pooling exercise without providing the liquidity at the concentration account (see Figure 9.5). As can be seen, compared to the separate interests paid or charged in Figure 9.2 (base case), the net interest as payable in the physical pooling case (Table 9.2) is paid out centrally.

FIGURE 9.5 Notional Pooling

Notional pooling can also be:

• Cross-border
• Single entity
• Multi-entity

The “pool benefit” is the difference between the aggregate account level interest and the interest calculated on the notional pool balance. Since the operation is system intensive, the bank that does the notional pooling should have its entire systems piece well in place. Moreover, it is almost mandatory to have all accounts with the same banking entity in order to centralise the interest payment. Operationally, however, this becomes more convenient since the fewer physical transactions there are, the less chance of error there is.

From a government’s perspective, the disadvantage of notional pooling could be the lack of income being shown by the bank or the customer in the jurisdiction of the subsidiaries; in the example, no income is shown by the entities A and C and no income is shown by the bank in the case of overdraft payments of B.

Hybrid Structures

Hybrid structures, as the name suggests, combine physical and notional pooling across currencies and countries to create packaged solutions. For most companies with complex operations companies located across jurisdictions, the hybrid solution could be a good fit.

POOLING STRUCTURES

Next we explore some pooling structures that could be applied to a company’s cash management operations.

Single-Entity Pooling

Single-entity pooling is one of the simplest concentration techniques, where different accounts across subsidiaries, locations, or countries may be owned by the same legal entity. The bank effectively provides the company with an opportunity to use the funds without specific movement of funds within the central pool (see Figure 9.6). An end-of-day sweep keeps the money in the central pool, and any funds required by the other locations are sent through in the form of an intercompany loan. This effectively keeps interest payments within the group rather than to a bank. In some cases, the accounting view could also allow for setoff to prevent balance sheet bloating. This method also provides the Treasurer with clear visibility on the balances of each entity.

FIGURE 9.6 Single-Entity Pooling

One drawback of this structure is potential thin capitalisation issues in some locations. Also, while third-party payments can also be captured, the physical nature of the transfer process ensures that third-party payments have to be made well in advance.

In some circumstances, issues and consequences of thin capitalisation may arise. Physical transfers in the case of third-party accounts have to be done well before the actual deadline to facilitate ease of payments.

Multiple-Entity Pooling

Multiple-entity pooling structures provide a concentration account for each subsidiary at the concentration centre; these accounts are then pooled notionally with the main parent concentration account (see Figure 9.7).

FIGURE 9.7 Multiple-Entity Pooling

This method removes the need to have intercompany loans and allows for easy passing of entries to each account. Visibility is also high, as in the single-entity pooling case. However, owing to the lack of physical movement of cash to the concentration account, this method is unlikely to receive setoff treatment from an accounting standpoint. Tax and documentation aspects could also be cumbersome.

Multi-Currency Notional Pooling

Multi-currency notional pooling (see Figure 9.8) uses one concentration account (either single or multiple entity) across currencies for seamless pooling benefits. The amounts for each entity are swept into a specific concentration account in the centralised location; however, these accounts are denominated in the currency (CCY) of the original amounts. At the centralised location, the bank allows for these amounts to be transferred notionally to the parent concentration account in a currency of choice, which could be totally different from any of the other currencies in which a balance has been hitherto maintained. A notional buy-sell swap is done (to convert the currencies to the master account currency and then convert it back the next day). There is no physical foreign exchange transaction, only an economic calculation by the bank.

FIGURE 9.8 Multi-Currency Notional Pooling

The benefits are obvious: Multi-currency notional pooling allows for effective use of funds in the location (albeit in different currencies) while still providing the economic interest benefit of notional pooling. It potentially saves a lot of Treasury employee time due to the ease of using of process and automation. This method does, however, require a lot of documentation and exploration from the tax perspectives, plus from stringent reporting and control norms.

IMPLEMENTATION ASPECTS OF CONCENTRATION STRUCTURES

It is widely acknowledged that speaking about or describing pooling structures in two-dimensional box flow diagrams is the easy part that ignores the actual nitty-gritty of transacting and setup for pooling. We now explore some of the aspects of implementation, rolling up our sleeves and getting our hands dirty as we explore the practical aspects of the pooling setup and implementation.

Locational Considerations

The decision of the location of pooling or concentration is very different from the decision on the location of the Treasury centre or the shared service centre. The employees could be located anywhere, but the location of the concentration accounts is what matters from a tax, cost, banking, investment, capital treatment, and hence profitability perspective.

These elements play a key role in determining the location of concentration:

• Tax treatment of pooling flows including notional pooling
• Tax treaties with countries from where flows are expected
• Regulatory environment
• Financial investment opportunities
• Accessibility of liquidity and banking solutions
• Business and economic climate and environment
• Account restrictions (especially nonresident accounts)
• Any statutory requirements on funds stored in accounts
• Reporting requirements
• Access to liquidity and banking services
• Banking support across all time zones
• Any incentives from the local government
• Documentation requirements, both local and banking

Of these, the tax and documentation aspect could be potentially the most involved and also the most complicated. For that reason, we discuss these aspects in more detail next.

Tax Aspects

The primary issue with increasing intercompany flows is the possible treatment as dividend. Pricing, especially for interest and capital, has to be at arm’s length, and there has to be a justified business purpose or economic substance for the flow. As mentioned earlier as well, any incremental, such as withholding tax or other taxes, could be a detriment to potential benefits of implementation.

Tax authorities in all countries are fairly cognisant of the pitfalls of pooling and hence keep a wary eye out for issues that could be sensitive from a regulatory standpoint. Attractive though concentration may sound, it is always a safe practice to get a seasoned tax opinion prior to starting the implementation.

Documentation Aspects

There are many documents required (apart from any specific local requirements) for purposes of executing cash concentration. Some of these are:

• General accounting documentation
• Intercompany agreements
• Pooling agreement
• Sweep agreement
• Cross guarantees or indemnities
• Legal right of setoff
• Tax indemnities if required
• Tax opinions
• International Swaps and Derivatives Association (ISDA) membership, if required

The example below shows one way to quantify the effects of a pooling solution.

SUMMARY

This chapter introduced many concepts and practices relevant for the next part of the book (balance sheet and liquidity management) and some basic concepts of physical and notional pooling. Three different pooling structures were discussed with their benefits and potential issues. Implementation aspects of pooling were examined, and the chapter concluded with a simple example on calculating the benefits of implementation of a simple global concentration structure.