Acarate’s David Blair has written an article on pooling for GTNews (09 Sep 2013)
A Premature Death Knell for Notional Pooling
David Blair, Acarate Consulting - 9 Sep 2013
The trio of regulation, tax and accounting issues are, it is claimed, combining to spell the demise of notional pooling. However this article suggests that the argument is largely a self-serving one promoted by the banks and that notional pooling remains an efficient corporate solution for cash concentration and other treasury activities.
I disagree. Notional pooling remains the most elegant and cost effective way to concentrate cash for most corporate. Before explaining why, let’s clarify some terminology.
Sweeping – also known as zero balancing (ZBA) and physical pooling – involves moving money from sub accounts to a designated master account. Basically, treasurers outsource to banks the daily money transfers that they might otherwise carry out manually.
Just like manual money transfers, sweeping creates intercompany loans which, in turn create accounting requirements (they must be booked in the general ledger (G/L)) and tax consequences (such as withholding tax and thin cap rules).
By contrast, notional pooling, as its name implies, is purely notional. No money moves, each participant’s bank balance remains untouched and there are no intercompany loans.
Notional pooling is basically an agreement that your bank will not charge interest on gross debit balances, nor pay interest on gross credit balances. Instead the bank agrees to pay interest on the net credit balance only (notional pools are normally run in a net credit balance). This saves the spread between the bank’s debit and credit interest rates, which is normally the sum of market spreads plus the bank’s cost of capital plus the corporate’s credit spread.
Of course the bank needs to be able to avoid the cost of capital on the gross balances, which means that regulators who decide capital allocation drive the rules of notional pooling. In many countries regulators require banks to obtain a cross guarantee, whereby each notional pool participant is liable to the extent of its credit balances for the debit balances of its fellow participants. Other techniques, such as pledges, are also possible.
Sweeping and notional pooling are not mutually exclusive. They can be – and often are – combined in an overlay structure. A cash concentration or liquidity management overlay structure normally sweeps from operating accounts at different banks and different locations to an account owned by the same legal entity (so no intercompany loans) with the notional pooling bank.
There are some things that simply don’t work with sweeping. For example, the plethora of overnight currency swaps required to conduct multi-currency cash concentration with sweeping are not cost effective. Multi-currency notional pools (MCNP), on the other hand, provide an elegant and easy to operate solution by allowing cross currency balance offset without conversion.
Regulation, Tax and Accounting Rules
So what is driving the alleged demise of notional pooling? The first issue is the wave of regulation hitting banks, notably the US Dodd-Frank Act and the Basel III capital adequacy regime. Regulators in some countries are tightening their requirements for allowing banks to report net balances rather than gross balances (which is required to make notional pooling cost effective). In some cases, they require sweeping cross-guarantees and will not accept guarantees limited to participants’ credit balances. Some regulators are also asking for parent company guarantees. The topic extends beyond bank regulation per se to, for example, bankruptcy law (i.e. what is the liability of a participant in a bankruptcy situation?).
The situation is compounded by regulatory vagueness in many countries. To avoid liability, some regulators refuse to specify exactly what is permitted. This places bank compliance departments in a difficult position and often makes them choose differing and conservative interpretations, to avoid regulatory liability to the bank.
But ‘some regulators’ is not the same as ‘all regulators’. Some regulators allow non-guarantee support for notional pooling arrangements, are willing to be explicit and even give written opinions on capital arrangements. As a result, the old maxim that all global banks offer pretty much the same cash management services is no longer true. So it is crucial that treasurers understand the nuances of different notional pooling techniques and dive deeply into bank capabilities with appropriate legal and tax support.
A second issue driving the alleged demise of notional pooling is tax. The logic runs as follows: since many tax authorities deem third party loans covered by related party guarantees as intercompany, and since notional pools need cross-guarantees, notional pooling is not tax-effective.
The error here lies in the second statement. As treasurers now know, notional pools do not need cross-guarantees, or any guarantees at all. Some banks need cross-guarantees to meet their regulatory requirements, while others can use other techniques such as pledges.
A knock-on issue here is that few tax advisers really understand notional pooling. They therefore tend to take a conservative view and pronounce it tax ineffective. I have seen tax partners within the same office disagree on this point. So it is critical to have good advice and robust support for your case – and even to find tax advisers who have already OK’d notional pooling to explain to their peers.
The bottom line is that hundreds of multinational corporations (MNCs) are happily using notional pooling for cash concentration and tax effective subsidiary funding – although as the author is not himself a tax adviser, treasurers need to carry out their own due diligence on this.
A third issue driving the alleged demise of notional pooling is accounting rules. The idea here is that International Financial Reporting Standards (IFRS) – specifically IAS32 – requires periodic physical offset of balances if you want to net pool balances in your financial reporting. Again it is a matter of choosing the right bank and market leaders provide a service to physically offset balances (with a two way sweep) whenever required by your auditors. The requirement varies because this is another issue on which individual auditors differ.
In summary, on closer inspection all three issues are not intrinsic with notional pooling. Rather they are issues that specific banks may have because of the regulatory and/or system limitations.
The first problem, of regulation, is specific to banks whose regulator requires cross guarantees or more.
The second problem, of tax, is specific to banks whose regulator requires cross-guarantees.
The third problem, of accounting, is specific to banks whose systems do not support periodic physical offset by two way sweep.
Therefore, I maintain my opinion that notional pooling remains an elegant and effective solution for cash concentration, subsidiary funding, and in the case of multi-currency notional poolings (MCNPs) for foreign exchange (FX) risk management.
In summary, treasurers should beware bankers who sound the death knell for notional pooling. Their arguments might be based more on their own constraints than on what works best for their corporate customers.