John F Kennedy, the late president of the United States made a compelling observation about the nature of crisis and the inherent predicament it brings forward. In a speech given in 1959 at Indianapolis, he mentioned in what became an often-repeated quote: “The Chinese use two brush strokes to write the word ‘crisis’. One brush stroke stands for danger; the other for opportunity.”
Drawing this analogy to the European transaction banking landscape, the current ‘danger’ is palpable. Over recent years, the formidable forces of a post-2008 weak global economy, negative interest rates and regulatory pressures have resulted into reduced margins and falling return on equity (RoE). At the same time, new market entrants are disrupting the traditional banking relationships and challenging the status quo.
It is amid this crisis, that the European incumbent banks are looking for new sources of value and innovative cash management offerings such as ‘virtual accounts’ are providing the much-needed opportunity to reinvent their services.
This opportunity, to dispel any doubt, is not entirely supply driven. As corporate clients mature in their cash management journey, European treasurers are looking to streamline processing and centralise operations. The single euro payment area (SEPA) initiative – finally launched in August 2014 after much delay – promised some of these results, but a fragmented implementation left much of them undone. Buoyed by cost reduction goals and digitisation programs, the appetite for treasury centralisation has increased; and it is in this perspective there is an emerging demand for virtual accounts in the market.
Introducing virtual accounts
In essence, virtual accounts are a series of dummy sub-accounts linked to a physical current account, which can be used by treasurers to manage working capital processes. From a user’s perspective, these dummy accounts offer the same capabilities as a bank account, but without the associated administrative workload and costs so therefore drastically reduce the need for real physical accounts.
While the concept comes across as new, virtual accounts have been prevalent in Asian markets for over a decade and in the Nordics via a similar liquidity management offering. The re-emergence of virtual accounts in European markets is largely due to the sophistication the product offers today and the variety of business propositions it can support.
Virtual account propositions
From a European context, two different product propositions are predominant – virtual IBANs and virtual account solutions.
Virtual IBANs are a series of dummy International Bank Account Numbers (IBANs) that reroute payments to a real physical account. This creates an opportunity for corporates to issue dummy accounts on a large scale; for example assigning each virtual IBAN to a client, or each to an invoice. When a client makes a corresponding payment, these are automatically routed to the physical account. The virtual IBANs are also captured in the account information, thus allowing corporates to identify the originators, match them with invoices and thereby enabling straight through reconciliation.
While virtual IBANs streamline the account receivables (AR) process, virtual account solutions on the other hand have a wider scope. These solutions allow treasurers to create dummy account hierarchies for a real physical account and distribute these structures as per the business need (across subsidiaries, entities, regions).
Treasury users also get the flexibility to self-administer accounts using virtual account management tools. With these hierarchies in place, virtual accounts can be used for liquidity management (replacing traditional cash pooling arrangements) and for creating payment on behalf of (POBO) or collections on behalf of (COBO) constructs.
Strategic capabilities are all encompassing and address needs beyond regulations
It has been widely argued that virtual accounts will be a convenient solution to address some of the regulatory pressures currently in the market. In particular, under the Basel III capital adequacy regime, banks will not be able to compute liquidity coverage ratios by means of netting the outstanding balances of accounts. This will imply that traditional liquidity management products like notional pooling will become more expensive for banks and corporates. Virtual accounts will provide a viable alternative to notional pooling and allow banks to save on regulatory capital costs.
While this cost saving will vary depending on the size of the bank and its balance sheet exposure, it should be emphasised at this point that the applicability and benefits of virtual accounts are much wider than addressing regulatory needs. These benefits vary as per the client segments and the idiosyncrasies of the business operations; however there are sizable opportunities for all.
For instance, for a mid-sized utility company, the efficient reconciliation of collections using virtual accounts can drastically streamline the AR process, deliver reduced days sales outstanding (DSO) and improve working capital. At the same time, for small-sized clients such as investment fund managers, solicitors or attorneys who traditionally hold their customer’s funds in separate bank accounts, a virtual account offers the benefits of opening a series of dummy accounts, without any comingling of their customer funds.
The opportunities of virtual accounts are perhaps the most pronounced for large corporations, such as financial institutions. As these firms mature in their cash management journey, virtual accounts can support in-house banking (IHB) structures using POBO/COBO constructs, perform netting, interest rate management, allow self-servicing from single group treasury and thereby enable centralised processing.
As an illustration, Swiss pharmaceutical company, Roche worked with Deutsche Bank to implement a virtual account solution that would enhance their existing payment factory and enable payments on behalf of local entities (POBO).
Such capabilities can help corporates rationalise bank accounts, reduce administrative costs, improve reporting and provide better cash forecasting. In addition, it is through these solutions that the full potential of virtual accounts can be realised and the goal of centralised treasury can be achieved.
Complement the digital agenda for transaction banking
Across Europe two big themes – real time payments and the Revised Payment Services Directive (PSD2) – are dominating the digital agenda for transaction banks.
While real time payments will result into instant clearing and availability of funds for corporates, the full benefits of real time propositions cannot be utilised without an instant reconciliation mechanism. Virtual account solutions (typically V-IBAN proposition discussed earlier) are well positioned to address this challenge.
Simultaneously, open application programming interfaces APIs (mandated by PSD2) allowing third party access to account information, will enable the creation of multi bank virtual account platforms and support creation of data driven centralised treasury functions.
It must be the strategic imperative for transaction banks to prioritise virtual accounts in their digital roadmap and create propositions that complement existing initiatives.
Also, the very notional nature of virtual accounts imply that transaction banks can support their growth ambitions by competing in local markets without building a physical presence and realisation of these digital agendas will be key in achieving that.
While much has been said about the promises and benefits of virtual account solutions, transaction banks should have a steady focus on the corporate client requirements to accelerate its adoption.
There is no ‘one-size-fits all’ rule for such offerings and the solution uptake will depend on the specific characteristics of the client’s business model and local market considerations.
At the same time, there are clear ‘known-unknowns’ regarding tax, KYC, data privacy rules that must be further explored and their implications on the bank’s operating model must be analysed.
Notwithstanding the complicacies, with the right approach virtual accounts provide immense opportunities to transaction banks and corporate treasurers and can drive the brave new world of cash management.
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