Notional pooling has traditionally been popular amongst multinational companies as an effective liquidity management tool, allowing for “the right amount of cash to be in the right place, at the right time”. By offsetting debit and credit balances on a notional basis, corporate treasurers are able to manage regional and global cash positions without having to conduct intercompany lending or incur costs from foreign exchange (FX) conversions.
In recent years, evolving regulatory, tax and accounting issues have resulted in tightening requirements around notional pooling. This article explores the implications of these changing dynamics on banks and their corporate clients. Are banks changing their views on notional pooling? What evaluation criteria should corporate treasurers use when setting up notional pooling structures in the new regulatory environment? Are there other liquidity management techniques that enable treasurers to achieve similar objectives?
Understanding the impact of regulatory evolutions and accounting principles
Basel III Guidelines:
Basel III and its equivalent local variations – such as Europe’s Capital Requirements Directive (CRD) IV and implementations by the Australian Prudential Regulation Authority (APRA) and Hong Kong Monetary Authority (HKMA) – generally look to strengthen capital requirements by requiring banks to ensure sufficient liquidity and adequate capital to decrease bank leverage. With the implementation of Basel III imminent, banks are continuously reviewing the scope of services they provide in tandem with pricing and cost conditions under the new regime.
Notional pooling as a bank services product could have negative implications under the Basel III principles and its local variations in two key areas:
1. Interpretation that banks may not be able to net off loans with deposit positions.
Notional netting of the balance sheet for the benefit of intra-group liquidity concentration is the basic premise of notional pooling. There is less reliance on bank credit lines, since overdraft positions can be offset against surplus cash positions to alleviate short-term funding mismatches. Basel III is expected to impact how banks offer notional pooling structures to corporate and institutional clients, as it is now costly for them to set aside capital against overdrawn accounts.
Basel III’s implementation may also be stricter in certain jurisdictions, for example under the APRA’s guidelines, where there is a 100% liquidity coverage ratio (LCR) value requirement on banks.
What’s more, as notional pooling structures are typically overlay structures, excess cash buffers of entities that treasurers maintain in the pool may be deemed as ‘hot money’ alongside the capital costs attracted by the negative balances in the leverage ratio calculation of the pool. Overall, this may attract additional costs to the notional pooling structures.
2. Distinction between core operating deposits and non-operating deposits (i.e. liquidity value).
Basel III principles are designed to ensure banks have a sufficient cash buffer in place to cover numerous and sudden withdrawals. Consequently, operating deposits linked to transactional and payment activities have increasingly gained in value. Banks increased their pricing for operating deposits thus improving LCR, and introducing new deposit products to support a more than 30-day liquidity coverage requirement.
As illustrated in table 1 below,it is evident that notional pools integrated with operating activities have a more efficient balance sheet usage – and therefore less of a challenge for banks in substantiating LCR requirements – compared to overlay structures.
Consequently, there is a trend for banks which have typically supported pure overlay and FX solutions to start reviewing the costs structures of notional pooling solutions. This could result in increased costs, or legal reviews of existing structures.
Requirements of IFRS/ IAS 32 versus US GAAP principles
Under the International Financial Reporting Standards (IFRS) and International Accounting Standards (IAS) 32, bank account balances are deemed as financial instruments and therefore need to be disclosed and presented individually.
Applying the offsetting accounting requirements of IAS 32 can be complex as it represents the need for companies and banks alike to demonstrate the legal right and intentions to settle on a net basis.
Conversely, the US Generally Accepted Accounting Principles (GAAP) continue to support the ability for banks to net the balance sheet. So corporates may start to see distinctions on how notional pooling programmes are treated between European and US banks as they start to re-evaluate existing structures and incremental considerations for applying notional pooling structures. For corporates implementing these structures, this may mean further legal and administrative burdens.
Potential impact of BEPS actions
The Organisation of Economic Cooperation and Development (OECD) released its final Base Erosion and Profit Shifting (BEPS) Action Plan in 2015. BEPS aims to tackle tax planning strategies that exploit gaps and mismatches in tax rules to shift profits to low tax locations.
Although not legally binding unless adopted at the local level, the BEPS Action Plan gives countries the tools to ensure that profits are taxed in the location where economic activities generating the profits are performed. In this regard, corporates that have implemented global or regional liquidity and funding structures – including notional pooling – may be impacted by the adoption of BEPS actions in the countries where such structures operate.
For instance, corporates may be subject to a greater level of business substance to enjoy a local tax incentive and/or double tax treaty benefits, as well as higher transfer pricing and reporting requirements. While there appears to be no reason why the BEPS Actions should prevent corporates from setting up efficient liquidity structures, they may lead to incremental implementation complexities.
Considerations for corporate treasurers
While the various guidelines seem to spell the end of effective liquidity management practices, and in particular notional pooling, we do not believe this to be case. Here, we review some of the considerations and best practices to ensure long term sustainability of an efficient liquidity programme:
Leverage alternative liquidity programmes to achieve the same centralisation objectives:
As some banks re-evaluate the costs and feasibility of supporting a notional pooling programme, corporates can also consider putting in place a physical cash concentration programme where intercompany loans are created in order to centralise cash positions, or payment-on-behalf-of (POBO) and receipt-on-behalf-of (ROBO) programmes which act to optimise cash efficiency within the in-house bank (IHB) or treasury centre.
While these programmes may demand additional elements of reporting and reconciliation – as they involve physical accounting entries and require arms-length transfer pricing on intercompany loans – they serve as viable alternatives to corporates in light of incremental costs with notional pooling programmes,
Citi has worked with companies in Asia either looking to replace their notional pooling programmes with physical cash concentration structures; and/or restructuring current solutions from multi-entity programmes to single entity notional pools, which would face a lesser challenge. POBO structures are also being reviewed as regulations turn in favour of supporting these structures, which underlie commercial transactions.
Select the most suitable header company and location:
Driven by Basel III, IFRS/US GAAP requirements and BEPS Action Plan, our recommendation is that the header company selected should have sufficient economic activities to justify the profits earned – either by way of treasury activities or via the pooling benefits. Additionally, there will be increasing requirements from banks in ensuring a ‘clean pool’ – one with clear rights to set off between the positions. The header company should be incorporated in a location where clear rules support the right to set off, to show legality and intention to net the balances.
Asia, Singapore and Hong Kong are regarded as the most suited locations for header companies within a notional pooling programme, due to the availability of favourable treasury centre tax incentives.
Apply additional due diligence on jurisdictions to be included for notional pooling:
A general commonality among the various guidelines and regulations is that there should be a clear legal right and intent present in order to net balances within the notional pooling structure. As banks start to impose these requirements on corporates, it is important for treasurers to ensure there are clear legal rules supporting the right of set off of balances within their company’s notional pool.
Likewise, while some banks already apply these practices, expect all banks offering notional pooling services to start to limit the product offering to jurisdictions where they have sought comfort on the legality of the right to set off.
Use one bank as a holistic cash and liquidity management provider:
In alignment with the Basel III principles, some banks may start to apply incremental charges on negative balances in addition to reducing payout on excess balances within the notional pool structure. This would increase the cost of having a pool in place, which may start to outweigh the efficient liquidity management benefits that corporates enjoy today.
Alternatively, corporates which have integrated the notional pool structure with the underlying operating business under one global or regional bank may not have these incremental costs under the Basel III framework. We encourage treasurers to ask their notional pooling bank how Basel III would impact their existing notional pooling arrangements.
In summary, many guidelines that vary across regulations, tax and accounting principles could potentially impact the effectiveness of notional pooling structures as a liquidity management tool. While many treasurers may choose to use other liquidity management techniques – such as physical cash concentration to centralise their cash positions – notional pooling remains a viable solution.
As banks look to reassess the conditions under which the product is offered, it is important that treasurers are aware of the cascading implications to them, and act in a timely manner to apply appropriate measures to ensure a sustainable liquidity programme.
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