Selecting the Right Treasury System - Part 2: Solutions for Pooling
Cash pooling or concentration is a treasury process from which virtually every multi-entity corporation can get huge benefit. The basic concept is very simple. One legal entity has excess cash for a certain period and another is in need of temporary cash. The critical outcome of the process is to get an affirmative answer to the following question: “Are we using all of our cash internally before we borrow or invest externally?”
The implementation of a cash pooling structure is often more complex than the above example suggests. Each corporation must decide which entities in which countries are allowed to participate. Given tax and ownership issues, this is no easy task. Once the players have been decided, though, it boils down to straightforward decisions about transaction costs, and the timing of cash movements. In the case of multi-currency pools, currency risk management and reporting add some complexity, but this is usually outweighed by the benefit of getting all the corporations cash put to use.
Most, if not all, treasuries in the US do some level of pooling in the US. Barriers to the process (single currency, no cross-border issues, uniform tax code, etc) are low and benefits are high and obvious. A large number however, do nothing when it comes to non-US accounts. In fact, it is not uncommon for a company to do daily cash pooling in the US, but pool their cash balances only monthly in Europe. The prime objective being to collect data for monthly accounting reports
Why companies choose to leave this portion of cash unused or under utilized is a bit of a mystery. Some explanations offered include the growth history of the company (i.e. grew organically for decades in the US, but only recently acquired businesses in Europe), and about the focus of the company (i.e. 70% of the business is in the US, the other 30% is too small to worry about). It seems to suggest that there are a number of companies in the US that have yet to focus on running their foreign treasury operations as efficiently as they run their US based treasuries.
There is one main cost of doing nothing and a few corollary costs:
1. Interest costs for unused or under used cash
This is a relatively easy win for most treasuries, yet a substantial number do little or nothing to capitalize on it. Even pooling accounts within countries (thus avoiding the hassles of foreign exchange) can add substantial value. Why do nothing? The answers: Too much work, we’re not measured on it, more important things to do; we don’t understand our foreign operations that well, TOO DARN HARD. All understandable excuses, after all how many of us leave balances on our personal credit cards, or overdraft facilities when we have cash sitting in our savings account earning next to nothing?
This is a classic opportunity cost, and therefore, a completely hidden cost. One case epitomizes the lost opportunity and money. A multi-billion dollar US corporation has dozens of subsidiaries across Europe. 70% of its business is in the US and the US treasury is running a daily cash pool. US cash efficiency is very high. In Europe, however, the accounting group performs the only cash operation, and this is only to make sure that their bank accounts are at zero once a month. Once a month! At this company, one subsidiary receives royalties of EUR 20m on the third day of every month and pays a similar amount out in taxes at the end of the month. During the 25 days between the inflow and the outflow, the money sits in an account earning next to nothing. Meanwhile, a credit line was in constant use in London. To make a long story short, not pooling the money of this one subsidiary, cost the corporation about EUR 600,000 per year in unnecessary borrowing costs.
2. Corollary Costs
Having a regime in place that requires people to focus on a daily basis on the efficiency of the organization is inherently good.
A significant number of companies take for granted that their foreign operations are managing their treasury operations with the same care as the head office. Often independent treasury control is given through a decentralization initiative. In reality, overseas subsidiaries are very often so focused on the business of the business, that operational efficiency of the treasury is too far down on the list of priorities to matter much.
Corollary costs include excess bank fees, manual processing, and timeliness of data. “How much cash do I have?” is a common question CFOs ask. Without a daily pooling regime in place, it is a very costly and disruptive question to have to answer quickly.
B) Ask Your Bank to do it for You
All of the big global banks such as Citibank, JPMorgan Chase, Bank of America, ABN Amro etc. offer bank account cash pooling services. These banks can provide you with a service that, when compared to doing nothing, will easily pay for itself and give you a handsome return on the cost. Furthermore, since they all have extensive overseas infrastructures, they can virtually take over the whole process for you. Given the convenience, and compared to the cost of doing nothing, this is a very attractive option.
The cost of asking a bank to run your cash pool is primarily one of removal of competition. Put differently you become dependent on your bank to manage all the moving pieces and to provide all of the financial instruments to make it happen. Apart from any set-up, management, and or transaction fees that they may charge, there are two main costs that can get overlooked:
1. FX Spreads
A company recently presented its European notional cash pooling arrangements at a trade show. The crowd was duly impressed when the treasurer declared that it took them ten minutes each day to manage a pool with six currencies and 12 countries. The bank did the rest. They really liked the convenience of that. Everything rolled up into EUR and yet, there was no currency risk to manage or report. Brilliant.
Compared to doing nothing, it is, indeed, good value. However, it is important to recognize that even if the company doesn’t have the hassle of managing the currency risk it is still getting done (and they are still paying for it). In this particular arrangement, the bank manages the risk every day. From a practical perspective this means that the bank is executing hedging transactions every day which have the effect of rolling six currencies into the EUR. Each of these deals is done at the bank’s internal rate. The spread on this rate varies, but it is certainly much larger than an open market deal. The spread is potentially big enough to eat up half of the benefit of pooling the money in the first place.
2. Interest Rates
The biggest financial benefit to pooling structures is to consolidate excess cash to pay down short-term debt or credit lines. This works very well with banking structures. There is, once again, some cost to giving all your money to one bank. Excess is usually kept at the bank, and at a rate that is probably less than what could be had in an open market situation. How big is this cost? It is probably not too large and, frankly, not too painful (especially when they just saved you millions in borrowing costs). Additionally, a low interest rate is a lot more transparent to the client than the currency charges in the background.
C) Buy a Treasury System, and do it yourself
Cash Pooling is a treasury service can very easily be managed in house using a treasury management system. From a practical perspective, you need to decide who can participate in the pool, you need to know what is in your bank accounts (see the article on Balance and Transaction Reporting), and then you just set-up the system to automatically generate the appropriate money movements. Additionally Cash Pooling is often part of an in house bank structure where internal borrowers are “charged” interest and internal pool contributors “earn” interest.
There is an extra layer of complexity in managing and reporting the currency transactions necessary to run a multi-currency pool, but that is also where the biggest savings versus a bank come. The better treasury systems are design to help manage those processes.
As usual, this tends to be the “least cost” solution, but it is also the “most difficult to get budget for” solution. It also requires a corporate philosophy of managing these kinds of tasks in house. That said, if the corporation is focused on wringing our every last efficiency out of its treasury processes, cash pooling provides a very big bang for the buck.
Additionally, you gain a high level of control over what moves where and when. If you own your own system, you can change the parameters of the pool at will. Bank pooling structures are much more rigid in this regard. (Software purchases and installations are long-term nature, and therefore, IT costs get a correspondingly large amount of profile and attention. As such, technology driven projects typically require a special capital expenditure budget and are almost always subject to the scrutiny of the Purchasing Department.)
Technology related costs can easily be $200-$400,000 plus ongoing costs. That is a very high cultural hurdle for most treasuries. Take as an example one treasurer that was taking the do nothing approach. He calculated that his first year and annual savings from pooling would easily be more than $1 million. Unfortunately, this treasurer was not being measured on working capital efficiency. In his company, that translated into having to ask for a large capital expenditure in order to save money on a corporate operation that senior management wasn’t focused on. Politically, that is not an easy task.
People are needed to operate systems. However, there is rarely an incremental position required. In fact, most software ROI’s includ a reduction in staffing costs.
In the case of pooling, however, it is necessary to have some currency management expertise in house. To the extent that this doesn’t exist in the company, extra resource is likely to be needed.
Shipping money around costs money. Real money. When a treasury manages this in house, the costs are very transparent. Fortunately, the better treasury management systems have threshold settings that prevent small balances from being pooled. This prevents situations where $1.57 is being moved using a $10.00 wire.