Treasury

Cash Pooling : What You Need To Know Before Diving In

November 03, 2016

“183 bank accounts, 5 currencies, 30 entities! Where is all the cash in my company?”

This is a perennial challenge faced by treasurers all the time. In fact, I just had a yearly conference with regional CFOs, and one question that surfaced is ‘How can we improve cash optimization?’ When you have 183 bank accounts in 5 currencies spread over 30 entities, just finding out the total amount of cash you have at any point in time can be a headache, especially if the only technology you are relying on is Microsoft Excel. Don’t get me wrong… I am an Excel geek, and I love Excel! But imagine asking 30 entities one by one, collating data from 30 different Excel spreadsheets… I don’t even want to think about it.

Alright I know most people hate Excel, except geeks like me. There is a better way of doing things – a better and more efficient way to manage your cash stored in 183 bank accounts in 5 currencies over 30 entities.

It is the concept of cash pooling. (There are other methods of improving your cash management like in-house bank, but it won’t be discussed here.) Cash pooling is a very common way adopted by large companies (with many entities globally) to improve their cash management, simplify their bank account structures and reduce overall bank transaction costs. Ready to dive in?

Cash Pooling: Introduction

Before we talk about tax, regulatory and banking issues associated with cash pooling (yes, it is quite complicated), let’s start off with a basic understanding of cash pooling! As the name suggests, ’cash pooling’ basically means pooling cash from different bank accounts into one single cash pool.

The greatest advantage of pooling your cash together into a single cash pool is that you increase visibility and control over all your cash in different entities all around the world. Think about it..  if you don’t have visibility or control over your cash, how are you able to use cash at optimum efficiency? Centralizing your cash from all your entities will also allow you to better understand your cash and FX positions, i.e. how much cash do I have in currency A, B, C, D, etc.? Having the visibility and control over your cash will then allow you to think about improving your FX risk management and reducing the borrowing costs for your entities.

Okay cash pooling has its benefits, but it is difficult, or sometimes even impossible to achieve 100% cash visibility! Based on EY survey results ‘Reflecting on the future: a study of global corporate treasuries’, approximately one-third of treasury departments have daily visibility of more than 95% of cash in the company, and shockingly, about 10% have less than 50% visibility.

Efficient Cash Management is all about Streamlining and Centralization

Investing in technology (SWIFT, Treasury Management Systems) is one way to improve visibility, but a more fundamental solution to solve the problem of ‘having 183 bank accounts in 5 currencies over 30 entities’ is to first of all, improve your company’s global cash management structure!

Start thinking how can you streamline your bank accounts and build a global cash pool to consolidate the cash in all your entities. It may not be possible to consolidate 100% of your cash into one single pool due to various country restrictions, but I think if you can achieve visibility over 90% of cash in all your entities, it should be good enough for a start!

Okay ready to dive in deeper into the mechanics of cash pooling now?

If you speak to your friendly bankers about cash pooling, typically they will introduce you to two main types of cash pooling – Physical Cash Pool and Notional Cash Pool. Let me explain the difference between the two.

Physical cash pooling

As the name implies, physical cash pooling involves physical movement of cash (aka ‘sweeping’) from various bank sub-accounts into and out of a single central bank account (aka master or header account). The header account is usually under the name of the Group Treasury or Headquarters.

There are different variations of a physical cash pool.

The simplest form of physical cash pool is the zero-balancing pool. Let’s consider this cash pooling structure with 3 participating bank accounts and a header account.

At the end of the day, sub-account A has $100 credit balance, sub-account B has $80 credit balance, while sub-account C has $50 debit balance. The $100 and $80 credit balances will be swept automatically to the header account, while $50 will be swept from header account to offset the debit balance in sub-account C.

So, at the end of each working day, the participant banks’ accounts will be zero, thus the name ‘zero-balancing’. 

 

Another common variation is target balancing or conditional balancing. Basically, it is the same as zero-balancing except that sub-accounts are not zeroed, but rather left with a target balance after the sweep.

Let’s say target balances are set at $10 in each of the sub-accounts (note that different target balances can be set for different sub-accounts).

There are other variations of physical cash pooling structures that banks offer, but most are quite similar to the ones explained here.

The main advantage of a physical pooling arrangement is that treasurers gain access to cash in all accounts. They can choose the best way to manage the surplus cash, e.g. investing in short-term deposits or money market funds. [You can read more about choosing the right money-market fund for your excess funds here] However, there are two main considerations for physical pooling.

Consideration #1: Withholding Tax on Inter-company Loans

The main thing to take note of for a physical cash pool is that the physical movement of cash are treated as inter-company loans between the entities. As such, withholding tax on loan interest will apply if the cash pooling is cross-border.

Consideration #2: High Transaction Costs from Cash Sweeps

The second thing to consider is the transaction costs in physically sweeping cash between accounts, which can be substantial if number of transactions is large and cross-border transfers are involved. You will therefore need to negotiate well with your friendly bankers on the transaction costs if you decide to go ahead with the physical cash pool!

Notional pooling

The second type of cash pool is the notional pool. Unlike physical pooling, there is no physical movement of cash for a notional cash pool. The bank basically offsets the debit and credit balances, and calculates the interest to be paid or charged on a net basis. (basically, the bank does the work for you)

Let’s return to our example of entities A, B and C again and this time, we want to create a notional cash pool!

 

The bank will offset the debit and credit balances of A, B and C, and calculate interest to be paid on the net amount of $130.  The interest on the net amount of $130 will then be paid to a master account (you will need to decide whether A, B or C should be the master account in this notional pool), which can then be allocated accordingly to sub-account A, B and C.

Remember that there is no physical movement of cash in the notional pool! In other words, entities A, B and C have full control over their bank balances and excess cash. And there will be no fees charged with physical movement of cash.

The main issue with a notional cash pool is that banks typically require cross-guarantees in place for all cash pool participants, and full legal right of set-off over pool accounts. Basically, a cross-guarantee is a promise by an entity to cover any loss of funds from another entity. For example, if a cross-guarantee is signed between Tom, Dick and Harry, they will be liable to cover each other’s losses should any one of them becomes bankrupt!  A cross-guarantee gives the bank assurance that it can reclaim funds from the Group, if an entity becomes insolvent.

Why do banks require a cross-guarantee for notional pools?

The reason why the cross-guarantees or set-off clause is required by banks is that a deficit balance in any of the sub-accounts will appear as an asset on the bank’s balance sheet. However, the bank does not earn interest on these assets (or deficits in the sub-accounts of the cash pools) as these are offset in the notional cash pools, and could be considered non-performing loans unless the bank has a right to offset. Therefore, banks will often require cross-guarantees to be signed by pool participants.

The problem with cross-guarantees is that (1) they are costly to implement, especially if there are many different jurisdictions (think of all the legal costs), and (2) they may affect the entity’s ability to raise funds in the future.

(Let’s say Tom signed a guarantee to cover Dick, who is always in debt and has poor credit rating. The bank will now consider Dick’s poor credit rating, and is less likely to lend Tom money in the future!)

IMPORTANT: Restrictions on Cash Pooling Structures in Different Jurisdictions

If your company has entities in countries all over the world, you might be disappointed to hear that there are many restrictions with respect to notional and physical pooling in different countries.

Central banks tend to be less receptive to the idea of notional cash pool, as compared to physical cash pool. Some of the countries that prohibit notional cash pool are Argentina, Brazil, Chile, India, Mexico, Sweden, Turkey and Venezuela. Physical cash pooling also has many restrictions in different jurisdictions too. For example, some jurisdictions like India has exchange controls and restrict cross-border physical pooling.

The MILLION Dollar Question: Physical pool or Notional Pool?

You should consider both physical and notional pools, depending on your requirements, jurisdictions (where your entities lie) and cost of pooling. Most big MNCs will use a hybrid of both to create a global cross-border cash pool.

It is very difficult to create a global cash pool that covers 100% of all cash. The best way to start is to think of some of these questions before diving into the cash pool!

– I have 5 different currencies. Which currencies do I want to pool? Do I want to create a multi-currency cash pool, or am I okay with individual single-currency cash pools? There is no one right answer. It all depends on the costs and benefits of different arrangements.

– I have 183 bank accounts. Which banks do I want to use for my cash pool? This can be a sensitive topic, as you need to take care of the needs of local entities who might want to retain control of their banking relationships. If all your entities are currently serviced by different banks, it won’t be possible to use only one bank for your cash pool. It might also be important to consider maintaining various in-country bank relationships to diversify funding for the group, even though raising funds centrally is generally cheaper due to higher bargaining power of the Group.

– I have cash in 30 countries. Is physical pooling or notional pooling allowed in the countries? What are the regulations and restrictions in these countries? Where is the best place to locate my header accounts?

As you think through these questions, always look back at your objectives of doing a cash pool. Is your objective to have greater visibility and control over all your cash? Is your purpose of the cash pool to centralize management of cash globally? Do you want a multi-currency cash pool or individual cash pools in different currencies?

What next after you have created your cash pool?

When you have finally achieved these objectives of visibility and control over your cash and foreign exchange positions, you definitely deserve a pat on your back and you should really go on a vacation at Hawaii or Maldives.

And when you are back, you can start thinking about other issues like how to improve cash forecasting or how to manage risks faced by the group. 

 

about author

Lee is currently pursuing a Master’s degree in Finance at INSEAD. Prior to his Master’s, he has worked for about five years in the treasury and accounting space. He graduated from SMU with a double degree in Accountancy and Finance, and is also a Chartered Accountant (Singapore). Other than building Excel spreadsheets and poring through annual reports, he spends his time reading and watching sci-fi movies.