Cash Management: the In-house Bank – Part 1

The essence of in-house banking may be defined as the use of internal treasury resources to replace services traditionally provided by external banks.

One may argue that any company that finances its subsidiaries’ commercial operations functions as an in-house bank (IHB). In practice, very many variations and sizes of IHB are found in treasury departments worldwide. The business driver for setting up an IHB is invariably cost effectiveness – if analysis shows that it is significantly cheaper to relocate the provision of a particular banking service in-house, that will drive the expansion of the IHB.

IHBs achieve cost efficiencies by creating a shared pool of resources and expertise to benefit the whole organisation. The cost of the operation is allocated proportionately across the corporate structure, enabling all operating units to share the benefits through the enhanced quality of cash and risk management operations. Superior price performance can be achieved by centrally negotiating advantageous fee structures with commercial banks, by netting and consolidating external dealing requirements, optimising liquidity via internal sources, minimising dealing costs and, potentially, commanding finer dealing rates for the foreign exchange (FX) and interest instrument transactions executed in the market.

Similarly, the costs of the IHB’s treasury management system (TMS) can be shared with other internal business units so the organisation affordably enjoys the benefits of powerful technology in managing cash accurately, identifying and hedging FX and interest rate risk, communicating and reporting, and generating the related treasury reporting and accounting results.

Strong Technology is Essential

Technology is central to the efficient and secure operation of an IHB of almost any degree of complexity. It is almost unthinkable to imagine an IHB functioning transparently and effectively without the support of a powerful treasury management system (TMS).The technology requirements may be summarised as treasury and cash management functionality and process support, control provision, generating timely, dependable operational and management reporting, and communications management across the organisation.

In multinational corporations (MNCs), the scope of the requirement may be global on a 24x7x365 basis, linking the finance and treasury functions of possibly hundreds of operating subsidiaries. Besides the functionality range, transaction volume management capacity will be an important consideration in technology selection, especially for organisations processing large numbers of payment flows (including payment factories) and for those managing complex webs of global FX risk exposures.

The application of technology is especially important in providing an effective solution for transfer pricing. IHBs can impose charges for their services through such activities as adjusting the rates of inter-company FX deals, increasing inter-company lending rates and reducing deposit rates by a pre-defined margin, and charging fees for operations such as payments and trade guarantees.

Depending on the organisation’s finance policy, the provision of these and other IHB services can be compensated and measured through internal charges. However, legislation prohibits corporations from artificially lending at sub-market rates to subsidiaries domiciled in high tax rate countries, and compensating this by borrowing at above market rates from subsidiaries situated in low tax regimes. TMS technology may be used to apply compliant pricing to IHB transactions, and to produce analytical reporting for auditors and regulators to verify that compliant policies are followed.

The technology that supports treasury operations with external counterparties (described elsewhere in this series) may be applied to the full range of IHB operations – with some subtle differences.

Subsidiary Communications

Among the key technology supports for in-house banking is establishing robust communications between a global network of operating subsidiaries and the IHB itself. Today, this is achieved by web based communications, either through native functionality for software as a service (SaaS), TMSs, or through the operation of specific web modules for client/server TMSs.

The key information flows from the subsidiaries to the IHB’s TMS are: cash transfer and payment instructions; hedge and investment transaction requests (FX, interest rate and commodity); trade finance requests and report requests.

The key information flows from the IHB TMS to the subsidiaries are message acknowledgements (for control and audit purposes) and reports, including inter-company deal confirmations and bank account balance and transaction statements, and in some cases, accounting reports.

In all cases, the system must be available 24/7, to accommodate global multinationals’ treasury and risk management requirements. The IHB business functions may be executed in a single, central treasury, or distributed among several regional treasury centres around the world. Both arrangements are found in practice.

The Starting Point: Internal Bank Accounts

Inter-company lending can be considered as the historical origin of in-house banking. Today however it is the operation of IHB accounts that forms the fundamental business basis of most IHBs – at least of those of any reasonable size and complexity. Such accounts are often used for subsidiary financing.

IHB accounts can replace most of the subsidiaries’ accounts held externally with commercial banks. Local accounts may be retained for such functions as payroll administration and operating income and expense management, depending on the organisation’s finance centralisation policies.

The IHB accounts will be used for settlement of all the subsidiaries’ inter-company transactions, and, naturally, for all transactions with the IHB itself. From a cash management perspective, the IHB takes over operation and management of most of the external bank accounts. Implementing this arrangement often leads to significant bank charge savings by consolidating banking relationships and bank accounts, with the closing of accounts no longer needed under the new in-house banking arrangement. The IHB can construct a revenue stream for itself via interest calculations and applying transaction and other fees, as permitted by policy.

Establishing a network of IHB accounts enables the organisation to improve performance through consolidating much of the enterprise’s cash, so that it can be mobilised to optimise interest income/expense performance across the corporate infrastructure. The IHB accounts allow both the centre and subsidiaries’ finance operations to keep track of each subsidiary’s correct cash position, regardless of the fact that surplus cash in real accounts may have been mobilised to fund shortfalls internally.

It follows that a key technology support for effective in-house banking is the calculation of debit and credit interest, so that it can be accurately allocated across the organization. This is achieved in the static data set-up: each IHB account has an associated rate of debit and of credit interest, sometimes expressed positive and negative margins that will be applied to a nominated index such as a particular London Interbank Offered Rate (Libor) rate to calculate the interest to be applied automatically by the TMS based on the closing balance.

The look, feel and functional performance of IHB accounts is often a critical point in the internal selling of an IHB to its clients: the subsidiaries’ finance managers. The internal accounts need to operate with all the responsiveness and transparency of commercial bank accounts if clients are to enthusiastically support IHB implementations; and this may have serious consequences in organisations where IHB participation is voluntary.

Conclusion

IHB accounts provide an elegant means of executing internal funding transactions via a debit to the central IHB account, and simultaneously generating a matching credit to the subsidiary’s account. TMS transfer pricing functionality can automatically create compensation for the IHB by calculating an interest adjustment on the deal, or by applying a transaction fee according to pre-defined rules.

IHB account management functionality, as seen, includes the automated calculation and application of interest. The mechanism of bank account inflows and outflows suits the control of inter-company transactions where the requirements change day to day; most treasurers will use this approach for internal funding and short term investment where this is permitted by regulation, and where this conforms to internal policy.

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