The future of pooling

Cash management
Authors
Stephen Everett	MD, Client Proposition, Global Transaction Banking
John Salter	MD, Global Corporate and Financial Institutions, Global Transaction Banking Lloyds Bank Commercial Banking

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Introduction

Notional pooling has earned its place in the liquidity management armouries of companies around the world. Regulatory change now presents a challenge – but change can be a driver of innovation. As Basel III comes into effect, the implications of the new regulation are becoming increasingly clear. While detailed analysis has focused on what Basel III means for corporate deposits, commentary on the impact to notional pooling has been more general. As a solution, notional pooling is fundamentally different from cash-pooling structures, where balances are physically swept to and from a header account. In a notional pooling arrangement, credit and debit balances are notionally offset against each other – without the movement of funds – in order to ‘self-fund’ and reduce the cost of overdrafts across the relevant accounts. This can be useful for treasuries that are more decentralised or prefer to avoid the co-mingling of funds associated with physical pooling structures. This is also one of the preferred solutions that is currently used for the ongoing management of balances across a number of different currencies.

While notional pooling has been available for many years, regulatory change could threaten the viability of this type of solution – at least to some extent. With some global banks reportedly now reviewing their notional pooling offerings or marketing, many corporate treasurers are rightly asking their banks what the future of pooling looks like.

In with the new

This shift has been caused by a number of different factors relating to Basel III. For one thing, under the new regulation, balances that are classified as operational are more attractive to banks, while non-operational balances are less attractive.

As a result, there is a greater incentive for banks to seek balances that are linked to their clients’ core banking, such as payments and collections. Of course, this will not be uniform, since the drivers will depend on a number of factors relating to each bank’s funding mix.

This has implications for a specific type of pooling structure: the liquidity overlay. Under this model, which operates as a standalone structure, the provider sweeps money from a number of different banks on behalf of a corporate, and then overlays a notional pooling solution on top. From the company’s point of view, this solution achieves the desired goal of reducing funding costs without requiring a more rigorous project to centralise its treasury function.

From the bank’s point of view, however, there is a lot of potentially more costly cash on the balance sheet, with little operational tie-in. This type of solution is less attractive under Basel III, and some historic providers are likely to move away from these solutions or seek ancillary business from their clients, while new entrants may see an opportunity.

The challenge in context

This issue is specific to liquidity overlay solutions, but other factors affect the viability of notional pooling more generally. In order to viably offer notional pooling, banks need to be able to report the balances in a pool on a net basis for both financial and regulatory reporting to avoid capital costs. Under Basel III, for example, banks may be permitted to report notional pooling structures to the regulator on a net basis for capital reporting, as long as the company uses a credit risk mitigation technique.

These techniques historically included joint and several liability in the UK, or a pledge in the Netherlands. The Dutch central bank, however, issued a flag note in July 2013, challenging net reporting for multiple legal entities based on historical credit risk mitigation. This raised a number of questions about how ongoing structures in the Netherlands would look. There is also concern that other European regulators could decide to follow suit.

That’s not all. The most significant hurdle facing notional pooling is Basel III’s leverage ratio, which aims to limit the total amount of risk that a bank can take on. Article 429 of the EU’s Capital Requirements Regulation states that assets and liabilities cannot be reported on a net basis for the leverage ratio, and that credit risk mitigation cannot be used:

• “…(b) physical or financial collateral, guarantees or credit risk mitigation purchased shall not be used to reduce exposure values of assets;

• (c) loans shall not be netted with deposits.”

This stipulation may have a significant impact on the scalability of notional pooling structures. Essentially, net reporting becomes a finite resource limited by capital under the leverage ratio. While banks may already have the capital they need for their existing pools, they could find that new structures or larger netted positions will incur an additional capital cost. Significantly, there are some differences between the European and US interpretations of Basel III. At this stage, banks in the US may have a little more leeway, since the relevant clause is less defined in the US interpretation of Basel III. Nevertheless, it is likely that there will be further harmonisation between the US and Europe as the leverage ratio is embedded.

Implications for corporates

What does all this mean for corporate treasurers? While notional pooling may present greater challenges under Basel III, opportunities for treasurers still exist and it would be premature to believe that banks will stop offering this type of product altogether. It is clear, however, that significant challenges are emerging – and treasurers need to be aware.

The main point to note is the likelihood that notional pools may incur additional capital costs in the future, which could translate into a more limited offering from banks, or greater selectivity in terms of which clients are offered this solution. Treasurers using notional pooling will need to understand that there is an element of risk as the impact of regulation flows through, so they should engage with their banks in order to understand this point as clearly as possible, while taking a risk-based approach.

Opportunities ahead

This is not an insurmountable issue. In reality, many corporate treasurers do not use notional pooling as a standalone product. Notional pooling is often used in combination with physical sweeping, which is undertaken to move the relevant balances into a single country. By concentrating balances in this way, into a single legal entity, such as a treasury entity, a degree of centralisation can be achieved, thereby reducing the complexity of any notional pooling and associated risk – meaning that, if the notional pooling element has to be reduced or settled more regularly, the company will still retain some of the benefits of automated pooling.

Furthermore, these developments may have a very positive impact on companies looking to move to a more centralised structure. The question mark over this solution could help such companies to build a business case for the greater centralisation of their cash and treasury policies, which could lead to further long-term benefits in efficiency and control. At the same time, with the high level of competition and investment in this space, it is likely that banks will step up innovation in liquidity management, leading to new opportunities in areas such as cross-currency sweeping and multi-currency accounts, as alternative or complementary solutions for multi-currency notional pooling. Payments and receivables ‘on behalf of’ structures in the Single Euro Payments Area can also simplify liquidity structures, reducing cash pooling altogether. Change drives innovation, in this sector as in any other, and the results are often incredibly positive.

What now?

For treasurers currently using notional pooling – or considering using notional pooling – the most important next step is to work closely with existing and prospective banks in order to understand the nature of these challenges and their bank’s response as regulation evolves. In this way, they can incorporate any risks into solution or treasury planning, and remain on the front foot. As some banks adjust their markets and offerings, a number of companies are likely to be exploring liquidity management solutions with new banks. Treasurers in this position should avoid the temptation to replicate solutions they have had in the past: the landscape is fundamentally changing, and it is important to gain an accurate understanding of these issues in order to make an informed choice, and tap into innovation in this area as it continues to evolve.