This is the fourth article in a series on leading practices in corporate treasury.

Liquidity management is of paramount importance for corporate treasurers and refers to a set of strategies, processes and tools that enable a corporation to access cash when and where it is needed to meet their short-term financial obligations.

To access cash quickly and easily and to make the best use of it require current reporting and comprehensive visibility (including daily and timely visibility) of global account balances and transactional activity, and control over cash so that treasurers have a complete picture of their company’s financial health. This is made possible by establishing an effective liquidity structure.

In this uncertain, yet competitive market environment, inefficient liquidity structures can keep corporate treasurers from achieving optimal liquidity management, both domestically and across currencies and borders. At a minimum, inefficiencies lead to extra borrowing, additional transactional costs, and greater expenses than necessary.

Here are our recommendations on how corporations can optimize liquidity by implementing these leading practices in liquidity structure to achieve their strategic objectives and enable the movement of idle cash when and where it’s needed. Optimizing liquidity structure by establishment of pooling arrangements – physical pooling, notional pooling, and insurance short-term investment pooling (STIP) – also helps improve working capital management and reduces foreign exchange conversion spreads and transaction fees.

• Physical pooling: Also referred to as zero balancing, target balancing, or sweeping, allows corporations to centralize their cash from all their bank accounts automatically to create full visibility and control of their overall cash position and cash flow.

Physical pooling constitutes the transfer of all funds or pooling (sweeping) of cash funds from different bank accounts into a master, concentration, single or target account, usually at the end of the day (and in some cases on an intra-day basis). This allows liquidity to be consolidated from participating business units as well as from different banks. Movement of funds in physical pooling structures are invariably treated as intercompany lending for tax and regulatory purposes.

Setting up an automated physical pooling structure not only alleviates risks for a company, but also helps them take advantage of economies of scale, maximize investment potential and reduce their transaction costs.

Physical pooling or cash concentration should be structured as per the specific requirements of the company. Treasurers can mobilize cash via zero balance accounts (ZBAs), whereby some bank accounts are completely zeroed out by moving the funds to another account, or they could be set up so that sweeps occur only when target balances (pre-set level of cash) have been achieved. Physical pooling is an important treasury tool to optimize a company’s cash flow.

“Adoption of an automated physical pooling structure makes it possible for the system to take over and move cash when required. This automatic cash movement presents to the corporate treasurer a consolidated view of a corporation’s cash position that aids in lowering borrowing costs, reducing the need for external debt, optimizing interest and working capital, and avoiding a liquidity crunch during uncertain market conditions,” said Craig Jeffery, managing partner at Strategic Treasurer, a leading treasury consulting firm. ⃰

Organizations with subsidiaries or operations in several countries and corporations with highly fragmented cash balances can repurpose the funds or concentrate the cash in one spot for improved visibility and availability, reduced fees, and debt paydown.

Modern physical pooling works best with companies that have a centralized cash management structure to balance the accounts of a group’s subsidiaries and efficiently pass down funds to those parts of the organization that need them.

• Notional pooling: This arrangement is ideal for corporations with decentralized treasury structures or highly autonomous subsidiaries that prefer cash to be in local control and not commingled in a central concentration account. Treasurers pool the cash value by expanding or deepening their relationship with a financial institution and establishing the structure and mechanisms that allow this pooling to be effectuated.

Notional pooling does not involve physical movement of funds, but account balances are notionally combined. This may be accomplished by having the organization’s accounts held at various banks be associated with the pooling bank’s accounts that are also held at these banks. This allows the pooling bank to have access to these funds. In essence, a corporation ends up combining its balances or all of its accounts through the arrangement with the pooling bank to arrive at an aggregate net balance globally. In many cases, the organization may be able to access the total pool of funds in any country whether or not the funds are physically located there. This minimizes or reduces corporate treasurers’ interest expenses (balance set-off or notionally offsetting debit and credit balances) or interest spreads (interest set-off or the difference between credit and debit interest rates). If the debit balances are fully or partially offset by credit balances, the corporation receives higher interest income.

An automated notional pooling structure lowers the costs of borrowing (and reduces total borrowing needs) for the company and helps address cyclical cash flow fluctuations and variations in cash balances and needs.

Notional pooling can be set up in a single or multi-currency and single or multi-entity basis. In the past, notional pooling structures were largely confined to same-currency accounts in a single location. However, multi-currency, cross-border notional pooling solutions now enable corporations to use the cash value globally without the need to move funds across borders. This enables them to better leverage the aggregated net balance in multiple currencies (sometimes done without converting currency that helps avoid foreign exchange costs) and optimize interest payments within the group.

Notional pooling is treated as a form of bank lending, and as a result, the pool-holding bank will require cross guarantees and full legal right of balance-set off and interest-set off over the pool accounts.

Notional pooling structure is more complicated than physical pooling and is practiced in major treasury centre locations such as Hong Kong, Singapore, London and various European countries. In the U.S., notional pooling is not allowed by the Office of the Comptroller of the Currency (OCC). 

• Insurance short-term investment pools (STIP): Setting up an automated STIP structure aids an insurance company treasury group combine their resources or mobilize liquid cash via various mechanisms to make more efficient use of cash and ensure adequate short-term liquidity for multiple portfolios and business lines.

Insurance companies have large investment holdings to support their various liabilities. These liabilities often cover different durations and are managed in different portfolios. Each portfolio has current liquidity needs, whether to cover operational insurance flows or to provide liquidity to support investment purchases. When each asset and liability stream is managed separately, a significantly larger amount of cash must be held overnight or close to maturities. This creates a lower yield on the investment portfolios, which is the key method insurance companies use to maintain the ‘spread’ required to operate at a profit.

The aggregated cash is typically pooled in one spot to facilitate the purchase of liquid and highly rated short-term investments or securities. The pooling of balances allows for larger purchases, greater liquidity on any given day, and higher quality investments for the same yield as would have been possible managing a large number of portfolios.

Associate entities with lower cash balances can leverage the financial strength of other related entities to access certain markets that require significant investments. “Grouping together resources and making fewer but more strategic or larger investments helps in reducing total transaction costs, increases the yield, and provides for simplified investing. This augments optimal use of cash resources and the margin sought by insurers,” observed Jeffery.

“An automated STIP process reduces investment transactions, increases the size of holdings and purchases, and improves liquidity management.”

Making time-sensitive and informed strategic decisions in this pandemic-induced challenging economic and operating environment requires the establishment of a robust liquidity structure that adapts and evolves in uncertain times.

It is as important as ever for treasurers to periodically review their liquidity structure to make sure that the processes and tools continue to suit the specific needs of the corporation, keeping in mind their treasury goals, location, size and complexity of business operations while supporting established accounting norms. Fortunately, these time-tested leading practices will help you optimize liquidity now and in the long-term as you put in place a globally efficient liquidity structure.

 

⃰⃰ Disclosure: Strategic Treasurer owns CTMfile.

 

Read more from this series:

Part 1: Bank account management

Part 2: Bank relationship management

Part 3: Cash concentration

Part 5: Treasury owns cash