Cash & Liquidity ManagementCash ManagementNetting/PoolingIntraday Cash Balancing: Time to Move Forward

Intraday Cash Balancing: Time to Move Forward

Note: This article is replublished courtesy of The Euromoney Foreign Exchange & Treasury Management Handbook 2005.

Woody Allen once said: “A relationship is like a shark. It has to keep moving or it dies. What we have here is a dead shark.” The same – or be it at a much less glamorous level – applies to cash management. To stay ahead you’ve got to think ahead. You’ve got to move forward and, in today’s modern international marketplace, the key to everything is speed. The arrival of the Euro and the introduction of pan-european payment structures have revolutionised the approach to cross-border, multi-currency cash pools. Transactions that might previously have taken days can now be processed within a couple of minutes, heightening the corporates’ demands on their partner banks. Conducting sweeping or cash balancing via an intraday cycle, rather than the regular overnight approach, enables the central treasury function to have its net balance available for investment that very same day. There is consequently less demand for overdraft limits, hidden bank charges are avoided and a day’s value of investment opportunity is opened up. In countries such as the Netherlands where banking regulations promote a favourable environment for cash pooling institutions, this form of sweeping is fast becoming an extremely attractive and popular cash management tool. Despite the challenges in establishing an effective intraday cash balancing facility, those banks that are either unwilling or unable to do so will quickly find themselves at a distinct competitive disadvantage compared to those that are. In short: they will become Woody’s shark.

What is Cash Balancing?

The purpose of this article is to examine the changing nature of ‘cash balancing’ or ‘sweeping’ and the advantages of the emergent intraday, as opposed to the traditional endof-day approach, with special consideration to the favourable conditions within the Netherlands. First of all, however, it’s important to establish what we mean by the term ‘cash balancing’. Most companies and institutions may refer to it as ‘sweeping’, but cash balancing can also be used to cover ‘target balancing’ or ‘trigger balancing’. For the purposes of this article, we shall refer to it as cash balancing. Whatever term you use, this is the process by which a corporate ‘sweeps’ the balances from his subsidiary and participating companies into the master account. A notional overlay pool is normally operated above this arrangement and most European banks will refer to sweeping – and market it – as part of their overall cash pooling solution. The fundamental objective of a sweeping arrangement is to capitalise on excess balance and gain a maximum benefit on working capital while, at the same time, maintaining liquidity.

The traditional end-of-day approach, and the one still favoured by the majority of banks, leaves the corporate open to a certain amount of value and opportunity loss due to the time lag between the sweeping and the result showing up on the balance of the master account. Currently, most banks will only look at the levels of the balances of the participating accounts at the end of the day and it is on that basis that the balance is swept to the pool leader or master account holder. The effect of this is that, generally, the bank will only start to initiate the balancing process after the close of business, meaning that the master account holder occasionally receives the information too late to take any real action. At the very least, the result of the whole process, on the value of the top account, will not be available until the next day. A day’s value loss is therefore an inevitable consequence of this traditional approach. It is for this reason that many corporates are actively seeking banks that can maximise the effect of their sweeping with an effective and viable intraday solution.

Intraday Cash Balancing

Cash balancing, like all banking solutions, is continually reacting to trends as well as using emerging technologies to evolve and develop. Most banks already offer automated overnight sweeping services for added convenience, so progressing to an intraday method is the logical next step. Intraday cash balancing is identical to the traditional approach, but in this case the whole process takes place via an ‘intraday cycle’ within the working day. The timing of the cycle can be altered depending on the payment demands of the corporate, but the benefits in terms of timing, accuracy and flexibility are immediate. It allows the central treasury function in a multinational company to invest or finance the aggregate cash position of a group of companies on the very same day as this position was created.

The creation of the single European market and the arrival of the Euro have encouraged companies to expand their business overseas into new markets. Most banks believe that an effective cash pooling facility is a vital tool in retaining customers while corporates, looking to expand internationally, are increasingly turning to cross-border pools to effectively manage their liquidity. If run efficiently, a cross-border pool should be an undeniable success. However, factors such as local regulations, transaction costs, taxes and so on, mean that if a pool is run inefficiently, it can soon become a liability. Intraday cash balancing helps to avoid many of the dangers involved in cross-border pooling while maximising the opportunities to capitalise upon its advantages.

The Benefits

Intraday cash balancing is a faster, more efficient and more affordable way of doing business. Its fundamental benefits are:

  • Enhanced investment opportunities.
  • Less recourse to overdraft limits for the subsidiaries.
  • Compensation advantage the same day.
  • Efficient use of credit facilities. An intraday limit on the level of the participating account is sufficient since no (or hardly any) overnight overdrafts occur.

The advantages of sweeping processes conducted via an intraday cycle create a trickle effect that pays substantial dividends both in terms of savings and investment opportunity. When a corporate uses intraday balancing to sweep cash out of the overlay pool he can, from a central point of view, dispose of his net cash position before the market closes. The treasurer is therefore able to process a number of functions on a same day basis: the offset between credit and debit occurs the same day and excess credit is also available the same day. Naturally, this maximises investment opportunities which, within an endof-day structure, might otherwise have been missed. Additionally, as a side benefit, the corporate’s bank will come under pressure to process payments made into the participating accounts more expediently.

So long as the intraday cycle is adequately harmonised with the corporate payment structure, intraday leads to a significant reduction of bank charges and the avoidance of any accounts running into overdrafts. If payments are made before the intraday moment the simple use of intraday limits to support the payment process is more efficient. Conversely, with cash pools based on end-of-day booking and processing the corporate runs the inevitable risk that credit limits will be required on participating accounts – with the resultant expense and inconvenience this can cause.

Practical Value

In action, the practical benefits of an intraday solution are clear. A corporate might have – to take a hypothetical example – cash pools in two countries: A and B. By the end of the day, the cash pool in country A shows a debit balance of 20,000,000. In country B there is a credit balance of 50,000,000, thereby showing a net investment opportunity of 30,000,000. If the corporate is working with a bank that still adheres to the regular end-of-day approach, there are a number of hidden costs and opportunity losses right down the line for which the company will have to pay in the end. All calculations take place with the following values in mind:

  • Capital adequacy ratio for the bank = 8 per cent of debit balance.
  • Minimum reserve requirement bank = 0 per cent of credit balance.
  • Interbank interest rate = 2 per cent
  • Credit interest rate = 1.75 per cent
  • Debit interest rate = 2.3 per cent
  • Investment opportunity in the money market is 2.1 per cent

When working through the traditional end-of-day approach, the net balance will only be available for money market investment the next day. The resultant opportunity loss (2.1 per cent – 1.75 per cent) amounts to 0.35 per cent. On an annual basis, by multiplying this figure by the daily net balance of 30,000,000, it would equate to 105,000.

There now follow a number of hidden regulatory and interest costs which will sooner or later be passed down to the customer. The bank or branches where the balances are maintained have to report to the central bank for capital adequacy purposes. Country A’s debit position of 20,000,000 requires the bank to retain 8 per cent of 20,000,000 equating to 1,600,000. This amount can then only be invested in risk free assets. To calculate the annual cost you multiply 1,600,000 x 2 per cent to get 32,000. This cost, generally referred to as capital adequacy costs, would, in the end, inevitably be passed down to the customer.

Equally, as long as the balances are sitting in their own countries, they will generate their own interest leading to further hidden interest costs. The 50,000,000 credit balance in country B (50,000,000 x 1.75 per cent/360) would yield a 2,430 credit while the 20,000,000 debit sitting in country A would lead to a debit (20,000,000 x 2.3 per cent/360) of 1,277. Therefore the net result created by the interest conditions applicable in each country would be a credit of 1,153.

Transpose that to a situation in which 100 per cent of the balances in both country A and B are swept up. The interest result on the aggregate balance (30,000,000 x 1.75 per cent/360) is 1,458. On a daily basis the advantage (1,458 – 1,153) is 305. Carry that forward to an annual basis(calculated on an average number of banking days per year of 290) and the advantage (205 x 290) becomes 88,450. The annual advantage does of course depend on the amount in each cash pool. However, if we assume that the single day position described above repeats itself every day during the year, the final total benefit of intraday pooling (105,000 + 32,000 + 88,450) amounts to 225,450 annually.

 

Challenges

However, intraday balancing is not without its drawbacks. Despite the obvious advantages many banks remain tentative about committing themselves wholeheartedly to intraday solutions. Like any new development, intraday balancing must be handled carefully with plenty of forward planning and foresight. Discipline of the master account holder, relationships with third party banks and local regulations can all influence the effectiveness of an intraday solution. Failure to address these issues in advance can negate the hard won advantages explained previously.

Importance of location

Location, location, location. This seems to be one of the latest catch-phrases of the moment, but what works for house-hunters also holds true – perhaps even more so – for corporate treasurers. Despite repeated statements to the contrary, the creation of the Euro has yet to create the desired single market in the truest sense. Different regulations, in different countries, mean the choice of location is as vital as ever:

  • tax on interest payments;
  • a lack of interest remuneration on current accounts; and
  • prohibition of notional pooling between separate legal entities and restriction of pooling between resident and non-resident accounts are just some of the possible obstacles to a cash pool.

The Netherlands, on the other hand, offers a number of particular banking regulations and tax treaties that help facilitate the successful establishment of an effective cash balancing arrangement.

Attracting cross-border cash pools has obvious benefits for the local economy and the Netherlands is keen to establish itself as one of the most attractive cash pool locations in Europe. By locating a pool in the Netherlands, the corporate can avoid certain obstacles and benefit from a generally favourable taxation environment.

  • First and foremost, the Netherlands permits the compensation of the balances of different legal entities. While some countries will restrict or forbid the establishment of cash pools between separate legal entities, the Netherlands allows accounts held in the names of different legal entities to partake in the cash pool. This has a number of valuable benefits, the most important of which being the avoidance of intercompany loans.
  • Secondly, there is no withholding tax on interest in the Netherlands. In some countries withholding tax is levied on the interest payments generated by cash concentration and pooling schemes, which have a negative effect on cash pooling arrangements. Countries such as the Netherlands, that do not impose withholding tax on interest will have advantages as locations. Furthermore, the Netherlands has an extensive double tax treaty network, which is particularly useful for (financing) companies resident in the Netherlands. Dutch tax treaties generally result in the reduction of withholding tax on cross-border payments to the Netherlands. Also most Dutch tax treaties allow to partially credit any remaining withholding tax against the Dutch corporate income tax liability.
  • Finally, the Dutch central bank permits the reporting of the balances of corporates on a net basis. It does not impose capital requirements on a Dutch bank as long as it meets certain requirements, one of which being a firm pooling agreement including a guarantee of the different participants.

The one cloud on the horizon of Dutch legislation comes in the form of thin capitalisation legislation, i.e. rules designed to limit the deductibility of interest cost on ‘excessive’ related-party debt financing. The required debt-to-equity ratio is 3:1 under the Dutch thin capitalisationrules. These rules were introduced as per January 1, 2004. Various European countries have thin capitalisation rules which vary per country. Thin capitalisation rules may have an effect on pooling agreements.

Intercompany loans could arise during the pooling cycle if more than one legal entity is involved. This may result in a high debt to equity ratio on a temporary but recurring basis between the participating companies. As mentioned earlier, when discussing the problems of intraday balancing, if the master account and participating accounts belong to the same legal entity, these problems can be avoided.

In Exhibit 1, the intraday cash balancing mechanism is used to sweep the balances from the participating accounts (P) to the cash pool accounts held by the same legal entities, so that no Intercompany loans are created. The pool leader account is held by Treasury. The pool leader can dispose of his net aggregate position the same day. This structure requires cross guarantees between the pooling participants.

In Exhibit 2, like in Exhibit 1, intraday sweeps to and from the notional cash pool, but now the accounts in the notional cash pool are all held by the pool leader. The “re”-accounts in Exhibit 2 are used for the Intercompany loan administration.

Who Will Benefit?

What kinds of companies are likely to benefit most? Basically the answer reads the same as for pooling in general; if cash pooling is for you then – as long as it is managed effectively – intraday cash balancing cannot fail to be anything but a benefit, at least on some level. However, the companies which will be especially suited will be those whose requirements most closely match the core benefits of intraday balancing as listed previously in the article. In simple terms they can be typified by the three following statements:

  1. Companies that regularly have excess cash in several countries, with a centralised cash management/ treasury function.
  2. Companies whose policy of central function is in short-term investments and short-term financing.
  3. Companies with a certain turnover. As with any cash management solution, the key is to weigh up and consider the key requirements of your business and relate them to the balancing solutions available.

In the end it all comes down to the impulse of corporations to grow and expand their business. Cash balancing is now recognised as an excellent method of concentrating funds in order to maximise liquidity, interest expense and investment opportunity. What’s more, its popularity is growing as companies come to terms with the advantages it can offer and, as the market develops, corporates step up the search for more effective tools. Banks, for their part, are scrambling to keep pace with the market.

Overlay cash pool with IC loans

Source: ING

 

Overlay cash pool with IC loans

Source: ING

 

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