Consequences of Basel III for Notional Pooling
Companies can use effective liquidity management as a means of searching for ‘hidden’ cash. Increasingly, companies choose for notional pooling because it provides them with more insight in their (global) financial position and enables them to optimise their interest income on their accounts. At the same time Basel III puts stronger requirements on the compensation of balances (credit and debit). As a result notional pooling becomes a less interesting service. The question is whether the introduction of Basel III has consequences for the offering of notional pooling services by banks.
Advantages of Notional Pooling
In recent years the use of notional pooling has increased enormously. Currently, it is a widely-used structure for concentrating balances and maximising interest income on bank accounts. It also provides companies with a better understanding of their financial position as well as the opportunity to better and effectively manage and use their liquidity.
An alternative pooling technique is physical pooling (zero balancing) whereby the balances on the participating accounts are transferred physically to an overarching (master) account. The difference between both pooling techniques is that with notional pooling the balances are ‘virtually’ booked for interest calculation and with physical pooling the balances are physically booked. However, with physical pooling internal debt positions arise through the physical transfer of balances. Notional pooling and physical pooling do not exclude each other. Both structures can be combined in an overlay structure.
Basel III introduces a number of new financial ratios, which aim to strengthen the capital base of banks. One of the most profound of these is the liquidity coverage ratio (LCR). This ratio compels banks to hold sufficient qualitative strong liquid means – cash or assets which can quickly be traded on the market – to be able to withhold a ‘crisis’ by withstanding a period of 30 days without cash. The new legislation enhances the capital requirements for banks and makes these requirements more risk-weighted than before. The requirements are also more anti-cyclical in order to push banks to build up more capital in economically good times.
Liquidity management is gaining interest by two concurrent developments. On the one hand credit is a less attractive source of profit for banks, which causes them to focus on activities with less capital requirements. On the other hand, companies have to use their internal liquidity more efficiently as obtaining bank financing has become increasingly difficult. The developments outlined above have created an uncertain future for notional pooling.
Basel III simply does not permit liquidity ratios to be calculated by the ‘netting’ of the debit and credit balances of the accounts in a notional pool. As a consequence banks have to calculate their ratios on the basis of the gross value of the individual accounts. To cover the negative balances in the notional pool banks have to retain extra liquidity. The negative balances are seen as ‘debt’, which introduces an unattractive risk weighted asset (RWA) for the bank. The conditions for the reduction of these RWAs vary per bank and are dependent on the involved central bank. To prevent banks from having to hold a higher amount of risk capital they have to have a legal right of off-set.
However, the process of getting the right of off-set is time consuming and therefore costly – both for the bank and the company – and requires the necessary legal and fiscal knowledge. Firstly, the legislation within the jurisdiction of every participant in the notional pool has to allow for compensation in the case of bankruptcy. Secondly, every participant in the notional pool has to sign agreements which enable them to guarantee the other participants in the pool. Finally, the company has to demonstrate that netting has taken place.
As far as the future of notional pooling is concerned, there are a handful of scenarios that would enable banks to continue offering this service:
If banks are going to raise the fees for notional pooling, companies will possibly look for other alternatives for their cash management activities, such as physical pooling. To avoid being caught by surprise, it is advisable to contact your bank with regard to notional pooling.