The in-house banking (IHB) structure, long-established among leading US and western European corporations, is now becoming a hot topic in Asia. The global growth ambitions of many Asian companies, coupled with the region’s comparatively benign economic conditions, are driving rapid corporate expansion, so the need to fund growth through more efficient funding mechanisms is escalating.
The classic IHB operation typically consists of a dedicated function or entity which handles cash management, foreign exchange (FX) and funding operations on behalf of various business units within a corporation. In effect each unit maintains its own virtual ‘bank account’ with the IHB, rather than directly with an external commercial bank.
The IHB houses these virtual bank accounts in its own sub-ledger, which is then tied to a single set of physical bank accounts maintained by the IHB with one or more external banks. Payment and deposit transactions processed by the IHB on behalf of a business unit pass through the physical bank accounts and are then allocated to the virtual bank account belonging to that business unit. In effect, the sum of the virtual bank accounts maintained by different business units at the IHB equals its net position with its external banks.
The number of bank accounts that a corporate needs to maintain is consequently dramatically reduced, resulting in consolidation of liquidity, FX and investment positions and enabling the IHB to net-off or self-fund its own positions across different business units. Having visibility over all payment and deposit flows also enables the IHB to forecast its net funding or investment position more accurately, thereby improving funding and investment operations.
However, IHBs are not something corporates typically set up in the early days of their international expansion. The primary focus initially is on building out the core business; for example finding the best factory locations, building the customer base, and setting up basic accounting functions, as opposed to developing a sophisticated treasury operation.
Nevertheless, as the business grows so issues around the funding of working capital become more pressing. As maturing operations throw off excess cash, others will require significant injections of new funding to support growth. This often leads to a rapid expansion of the balance sheet, with some business units holding substantial cash balances while others borrow as the ability to efficiently move money between business units and countries is constrained by the lack of sufficient treasury resources and infrastructure. It is at this stage that many Asian corporations start to consider IHB as a means of optimising working capital and self-funding.
While IHB appeals to a broad spectrum of Asian corporates, some of the strongest interest comes from Chinese companies which have already established an international holding company or listed vehicle in Hong Kong.
In addition to self-funding a growing business, IHB structures also offer other compelling benefits. These include more efficient management of FX risk and enhanced returns on surplus cash. The actual cash value of these benefits varies from business to business, but they can be substantial. For example, several Asian corporations supported by JP Morgan have quantified savings in the range of US$5m-10m per annum.
While the savings to be made on FX costs are significant, in most cases they are comfortably exceeded by those arising from self-funding. The key point here is that if an IHB maximises self-funding, external loans required by one business unit can be replaced by excess cash generated by another. Hence, the corporation eliminates the interest rate spread between deposits rates on one hand and loans on the other. Furthermore, in the case of many Asian currencies the interest rate spread is often wider than for US dollar.
Apart from reducing funding costs, maximising self-funding through an efficient IHB model delivers two other important benefits:
- Improved financial performance: using surplus cash to replace external bank loans shrinks the balance sheet, thereby improving leverage ratios and increasing the return on assets and shareholder funds.
- Preserving credit lines: which are kept free for strategic acquisitions or capital expenditure rather than being used to support day-to-day working capital. This is particularly important given the likely impact of the Basel III capital adequacy rules on banks’ lending capacities.
Evolution and Models
The potential benefits of an IHB are attractive, but the extent to which they are actually realised depends heavily upon how well the IHB is implemented. The ideal is obviously for the IHB model to facilitate the optimisation of working capital across the business. This inevitably necessitates a significant investment of resources and customisation to the specific circumstances of each business.
Many successful US and European corporates have taken between 10 and 15 years to arrive at an optimal IHB set up, typically involving three generic stages along the way:
- Establishing a formalised treasury function: newly globalising corporations often have limited treasury operations within the broader finance function. The first step is recognising the need for a dedicated treasury function, which is then often established on a global and regional basis for key operations.
- Integration of treasury and shared service centres (SSCs): in tandem with developing the treasury function, many corporations also tend to establish regional SSCs to centralise processing of functions such as accounts payable and accounts receivable. However, the treasury and SSC often operate independently of one another. Over time, companies realise that closer cooperation can help drive further improvements in working capital management, frequently resulting in a degree of integration or co-operation between the treasury centre and the SSC for the region.
- The fully integrated model: this is the ‘true’ IHB model commonly used by major US and European multinationals. Under this model all collection and payment data flows via the treasury or IHB accounts. The SSC still handles the actual transaction processing but payment files are routed via the IHB, which has final and direct control over when they are released. In the same way, all collections data also passes through the IHB so that deposits can be applied to the virtual bank account each business unit maintains. The key here is that the IHB has full visibility of all payment and collection flows and can use this to optimise cash flows and working capital across the corporation. Under this fully integrated model, liquidity and funding needs are efficiently concentrated within the IHB while also facilitating netting of FX positions and other exposures.
For practical reasons, the vast majority of corporates tend to work progressively through these stages. It is essential, however, to plan ahead so that processes or technology implemented at an earlier stage do not have to be completely replaced later on. The ideal situation is to start with a core treasury and enterprise resource planning (ERP) system and then add functionality progressively at each stage, rather than having to replace whole systems and processes.
Making it Happen in Practice
While IHB is clearly an attractive proposition a number of specific factors help determine the success, or otherwise of implementation.
The journey toward a full in-house banking model may appear straightforward, but as ever the devil is in the detail. Determining and implementing the best model for a specific corporation requires amassing a great deal of knowledge around detailed business requirements as well as the implications of moving to an IHB model from a legal, accounting, tax, regulatory and systems perspective. For most treasuries, attempting to acquire this knowledge on their own is just too time consuming to be practicable; few have the resources or specialists to cover these issues in any depth.
In practice this throws the onus on their business partners, and especially their banks, to provide the necessary information to answer key questions. For example, what are the practical steps for a corporation looking at a particular structure? Exactly which functions should be covered by the IHB? What are the technology options? What are other major corporations doing in this space and what results are they achieving?
Corporates need to work with a banking partner able to share comprehensive practical insight and experience into different treasury and cash management models, not just information on the basic banking products available.
A crucial subset of this knowledge sharing process is technology. This applies both in the planning and implementation phases and requires expertise from individuals experienced in connecting clients to multiple banking channels. While this involves matters such as file formats and encryption, a key element is integration between bank and corporate technology requiring extensive knowledge of major ERP and treasury systems. In addition, end-to-end workflows that may involve highly sophisticated processes cutting across the environment of both the corporation and the bank have to be accommodated.
A further aspect of technology expertise that in time will become increasingly important for IHB is the Society for Worldwide Interbank Financial Telecommunication (SWIFT). While corporate SWIFT adoption in Asia currently lags the US and Europe, there are signs of a shift among larger market-leading Japanese and Korean corporations. Again the need for niche expertise is important here, so that the corporate client can make an informed choice between SWIFT and multi bank connectivity rather than being constrained by their partner’s limitations.
Global banking platforms
While the ability to share technological expertise is important, what can make or break an IHB implementation is the consistency of a banking partner’s technology and services. Consider this: an implementation involves centralising formerly highly fragmented processes. At the simple level of issuing a payment, a corporation might previously have had many business units conducting this at a local level in dozens of locations and across hundreds of bank accounts. If the corporate now seeks to move to an IHB model, they need a bank that can offer a consistent set of payment services across multiple countries and payment types via a single communications channel, either via the SWIFT network directly or the bank’s own proprietary host-to-host link.
An IHB that leverages a banking partner with a globally consistent bank platform will benefit from efficiencies such as:
- A single payment file type for all payments and currencies.
- Consistent collections processes.
- Automated reconciliation services.
- Cross-border sweeping services.
- Regional pooling structures.
- Multibank reporting (where local banks are used).
The bottom line is that this degree of technology consistency delivers a substantial additional boost to the efficiencies and returns of an IHB, through lower integration costs, standardised operational processes and value added services.
While the self-funding benefits of an IHB tend to attract the greatest attention, there are also appreciable opportunities on the FX side. At a strategic level, an IHB enables a corporate to centralise and net-off its FX exposures, reducing the size and complexity of different positions that need to be managed. The IHB can, for example, offset existing and anticipated FX positions/transactions by currency among group companies and then transact in the market for just the net enterprise-wide FX value.
There is also an opportunity to achieve further efficiencies by differentiating between strategic hedging activities and transactional FX associated with more straightforward payment activity. In many organisations, there is a temptation in the interests of price transparency to route all FX transactions via an FX desk. However, in the case of high-volume/low-value payments in foreign currencies this is actually extremely inefficient and costly, once the administrative overhead associated with confirmation and settlement is taken into account.
A far more effective route is to segment FX activity so that only large-scale balance sheet hedging or other major FX transactions are executed by the FX desk, while low-value transactions are handled via automated transaction processing. A few banks already cater for this approach by providing an automated FX funding and payment execution service based on a pre-agreed rate card. An IHB can now automatically make multiple low-value payments in assorted currencies from the main currency account, without incurring the additional costs of going via the FX desk.
With headline annual savings potentially running into millions of dollars and the ability to better support fast-growing operations, Asian corporates are seriously considering IHB. While the processes and cost savings can be substantial, building an IHB is heavily dependent upon understanding the legal, accounting, tax and regulatory implications, as well as having the necessary systems and banking partner to make it all work.
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