“Reports of my death are greatly exaggerated,” quipped American writer Mark Twain on hearing that his obituary had been prematurely published in the New York Journal. Recently, a slew of articles and reports have prematurely rung the knell for notional pooling following Basel III’s implementation.
One might similarly wonder if these claims of the “death” of notional pooling are as premature as Twain’s obituary proved to be. While Basel III is certainly expected to impact on how banks offer certain cash management solutions to corporate and institutional clients, this is far from spelling the end of notional pooling.
Benefits of notional pooling
Notional pooling has always been about going back to basics and has proved an effective working capital tool for corporate treasurers who want to use the intra-group liquidity within their organisation. It has always been a solution meant to alleviate short-term funding mismatches, and is definitely not a long-term borrowing tool.
The solution enables a subsidiary that requires funding to easily obtain cash without a physical transfer from the group entity which holds surplus cash. Overdraft positions are offset against surplus cash positions, to minimise overdraft costs and maximise returns. All foreign exchange (FX) conversions are purely notional and therefore there are no FX costs. This means there is less reliance on bank credit lines, which makes notional pooling arrangements immensely attractive for corporate treasurers.
Enter Basel III, notional pooling exit stage left?
Some proponents have likened Basel III to the rise of the phoenix from the ashes of the 2008-09 global financial crisis, with promises to stabilise the banking system. To this end, Basel III lays down guidelines on how much capital banks must set aside to provide for potential losses when providing lending facilities (capital adequacy), the “quality” of capital the bank must have, its utility in withstanding stress (liquidity risk) and an overall cap on exposure and risk taking (leverage ratio).
Nonetheless, there are good reasons to believe that it is premature to ring the death knell of notional pooling just yet. Fundamentally, it is important to note that Basel III does not directly address, or bar notional pooling solutions although the regime does impact the costs associated with such an offering.
1. Right of Admission Reserved
An immediate impact is that banks are likely to become more selective and offer notional pools only to their top tier clients. To profitably offer notional pools, banks need to ensure that they do not have to set aside capital against overdrawn accounts. Setting aside capital is expensive, because capital could be deployed elsewhere earning higher returns. Cross guarantees and setoff-rights are therefore critical – as long as the corporate provides the bank with “legally enforceable” cross guarantees, banks generally do not have to set aside capital.
However, cross guarantees are not legally enforceable in all jurisdictions or for every type of institutions. Fiduciaries are a good example: think of the ill-fated MF Global. In case of an insolvency of a fiduciary, a cross guarantee provided by the fiduciary in favour of the bank may not withstand legal scrutiny.
Banks may therefore look to limit their notional pool offering to selected top tier clients, which are incorporated in legally-friendly jurisdictions and are willing to provide the requisite cross-guarantees and right of setoff. Notional pools – in which participating accounts are located in different jurisdictions (cross-border notional pooling) – may also be under pressure due to the legal ambiguity in being able to successfully enforce setoff.
2. Only Operational Balances Please
Another factor for banks to consider is the “quality” of deposits. Under the Basel III liquidity framework, “operational” deposits from corporate clients are considered to be of higher quality than non-operational deposits. The concept is fairly straightforward – when a particular bank is under stress, deposits which are a lower flight risk (“lower outflow factor” in Basel III parlance) are more valuable. Deposits which a client uses for its day-to-day business activities fall under the “operational” category, because it will take a period of time before a corporate can completely change its treasury processes and request its buyers to pay into different accounts. These operational balances are accorded a lower outflow factor.
How does this affect notional pooling?
Notional pooling, already a low margin product for banks, could become a loss leader if the underlying deposits are “non-operational”.
Banks are likely to restrict their notional pooling offering only to clients who use the bank for their day-to-day transactions.
Cross border notional pooling providers will be more severely impacted, as they essentially provide an “overlay” structure in which the real operational business is sitting with the local banks.
An interesting point to note – the American implementation of Basel III may not have an express provision (the equivalent of Article 26 of EU Delegated Act #7232) permitting the netting of notional pool deposits against overdrafts for outflow computation purposes As a result, US banks may need to hold more liquidity and therefore be at a disadvantage.
3 Short Term Funding Mismatch. Long Term lending
Finally, banks may look to limit the occurrence of perpetually overdrawn accounts, as these result in increased balance sheet costs due to Basel III leverage limits (and raise risk concerns for the bank). Banks may elect to periodically effect a physical transfer to close out perpetually overdrawn accounts. If offered with enough flexibility, this practise could end up being mutually beneficial, as it has the potential to help corporates optimise their own balance sheet reporting.
Bottom Line
In a post-Basel III world, notional pooling is likely to remain a viable liquidity management tool for corporates. However, banks may become more selective in their offering and certain structures – which might have been attractive once – may be less so now. The implementation of Basel III may also be stricter in certain jurisdictions, resulting in a certain amount of regulatory arbitrage that banks domiciled certain regions can take advantage of.