Treasury as a Service Centre

Treasury departments have a visibility problem. The value of their operations is not seen to have a direct impact on EBITDA and so they fall under the radar, lacking senior management attention. The result? It’s treated as a cost centre, with all the attendant pressure on minimising expenses and resources. Under these conditions, a treasury cannot give optimal service and just does the minimum required. Is there a different way to organise treasuries in order to get the best from them?

A profit centre may not be the answer. Normally, the core business of a corporate is not making money on financial transactions, whether investments, speculations or trading. This is what financial services companies do. If a corporate wants to be in financial services, it would mean re-focusing its core business, investing in qualified personnel, system support and appropriate processes – especially with regard to risk. Then it is no longer a normal corporate, but has become, at least partly, a financial institution.

The middle ground is the service centre. In this model, treasury charges for the services it supplies to the members of the group. This not only places a value on treasury activities, but also generates an income for the department, giving it a higher budget for investment in human resources and proper system support. As long as treasury adds value to a subsidiary’s business processes, the subsidiary will be prepared to pay for the services it receives.

There are, of course, some exceptions. A profit centre model makes sense if the funds raised are used to generate sales. It is often used for the sale of high value goods such as cars, where the manufacturer helps the purchaser with financing either through loans secured in the product or through leasing. The funds are usually raised using various types of bonds issued in the market with security in the cash flow from the loans or leasing arrangements. This gives the bonds an investment grade rating (often Aaa) so it is a cheap form of financing. The financing department, therefore, often makes a significant contribution to the overall profit of the company through its activities.

The main services that treasury can offer are described below, with an explanation of how they add value to the company – and how treasury could charge for them in a service centre operation.

Bank communication

Many subsidiaries have their own connections to local banks that service them. It is much more efficient for treasury to centralise this task. The subsidiaries are no longer required to create, maintain and pay for local bank connections. Today, the centralised bank connectivity can be done even more efficiently using SWIFT for corporates. All the major banks are able to communicate electronically via SWIFT. Treasury can then charge the subsidiaries a fee for each bank they connect. The total cost for the central connectivity will be less than the individual connections due to the elimination of duplicate interfaces. Thus, treasury can earn more from the subsidiaries than the cost they have for the central connection.

Payments

The next step in this effort is to centralise payment processing. This can reduce the overall cost of payments in several ways:

• Routing: Payments are routed to the accounts from where it is least expensive to make payments. For example, when a European subsidiary has to make a payment to a Japanese company in Japanese yen, it is more cost effective if the payment order is routed to a Japanese bank account, as this will then be considered a local payment. If the payment instruction is executed from an European account, it will be treated as a cross border payment and will incur larger charges.
• Netting: Payments between subsidiaries can be netted internally, saving on external bank fees and reducing the loss of float when monies are being transferred between bank accounts.
• Volume discounts: Treasury is presented with a more accurate view of the cost of making payments, along with overall banking costs and relationships, and can therefore better negotiate going forward.
• Fewer FX transactions: Expensive FX transactions – due to payments in other currencies than the bank account currency – can be avoided or pooled, resulting in fewer, larger FX transactions with reduced spread.

Treasury should charge the subsidiaries a fee based on the number of transactions and the number of banks the subsidiary deals with. It becomes a straightforward exercise for the subsidiary to compare treasury’s charges with the local costs of making payments on their own behalf.

Cash Management

By establishing an in-house bank, a company can centralise the liquid funds and excess cash available across all subsidiaries and use it to fund other subsidiaries, rather than encouraging subsidiaries to invest cash in low yielding money market instruments, when at the same time other subsidiaries borrow money at significantly higher rates. The subsidiaries no longer need to manage their daily cash levels to make sure that there is sufficient cash to pay invoices and salaries, but instead they can rely on treasury to manage the cash levels for the whole group optimally.

Treasury can generate profits by taking deposits from the subsidiaries with surplus cash and then lending it to subsidiaries with deficits. Treasury can then place or borrow the net position at better rates than the individual subsidiaries as they have economies of scale. Furthermore, treasury can hold less spare cash than the sum of each subsidiary, allowing it to free up cash that can be invested in other parts of the company at a superior rate of return.

However, the subsidiaries still have to help by providing accurate cash flow forecasts, so that the central treasury can optimally manage the cash levels for the group. The more accurate these forecasts are the better treasury will be able to manage cash levels.

Often the total number of bank accounts held by the corporation is reduced when centralising the cash management activities and establishing an in-house bank. This in turn leads to a permanent reduction in bank fees.

Risk Management for FX and Commodity Risks

Many operating subsidiaries will be exposed to risks due to foreign exchange rates and commodity prices. These exposures are best known by the operating subsidiaries, but centralising the management of these risks provides the following advantages:

• Netting: Offsetting risks in different subsidiaries can be netted. For example, if two subsidiaries have opposite exposure to Swiss francs, they can be netted internally rather than allowing the two subsidiaries to hedge their own positions externally. This netting reduces costs due to differences in bid and ask prices.
• Pricing: Centralising the positions increases volumes, giving better rates.
• More effective hedging: A centralised treasury, with skilled staff and appropriate system support, can use the best derivative instruments to hedge risk at a lower price than subsidiaries without such support would be able to achieve.

This centralisation can be established in different ways. Some prefer to have treasury collect subsidiary exposure forecasts, while others might allow local subsidiaries to deal with treasury. In any case, treasury would enter into inter-company deals with the subsidiaries at rates that are better than the subsidiaries could achieve in the market place themselves. Treasury would have hedged the risk in the market at a more favourable rate, earning a profit for this particular service.

Many companies are now required to apply hedge accounting to hedging transactions, but this can be very complex and require sophisticated systems to support this process effectively. Documentation of the hedge relationships, the effectiveness calculations for hedge accounting and generation of the accounting entries can best be done centrally as part of treasury’s service and then distributed to the subsidiaries, which can load the results into their accounting systems as required.

Funding

Raising long-term funds for financing the operations and management of the interest rate risks can also be done better by a centralised treasury service centre rather than by the individual subsidiaries. Treasury can go to the market and borrow on behalf of the group and therefore achieve a better rating and lower risk than a typical subsidiary. Furthermore, treasury can also build up expertise in the area and use structured products and exotic derivatives to lower total funding costs.

The funds raised can then be lent to subsidiaries either by providing the subsidiaries with overdraft limits or longer-term loans. Treasury earns revenue for the company by providing more cost-efficient financing than the individual subsidiaries can find themselves. If a company is relying heavily on debt for financing, then using advanced financing instruments supported by a sophisticated treasury system can add tremendous value.

As for FX and commodity hedging transactions, the accounting processes for structured products and exotic interest derivatives can be complicated. A centralised treasury service centre with the appropriate systems will reduce the workload and ensure that all processes are fully auditable and compliant with industry regulations.

Conclusion

By organising treasury as a centralised service centre, it can provide substantial value-added services to subsidiaries at a profit. By charging the subsidiaries for services incurred, treasury moves away from being a cost centre and becomes a revenue-generating service centre. But this can only be achieved with senior level backing, along with investment in appropriate resources and technology to support the new processes and the volume such a new treasury service centre would have to handle.