[stephenkhoo]

Cash Management: the In-house Bank - Part 1
Kelvin Walton, gtnews - 27 March 2014
gtnews’ series of articles on the practical application of technology in corporate treasury continues with a discussion of in-house banking. Part one of two articles on this topic outlines the business benefits, and analyses the nature and importance of strong technology support as well as the operation of in-house bank (IHB) accounts.

The essence of in-house banking may be defined as the use of internal treasury resources to replace services traditionally provided by external banks.

One may argue that any company that finances its subsidiaries’ commercial operations functions as an in-house bank (IHB). In practice, very many variations and sizes of IHB are found in treasury departments worldwide. The business driver for setting up an IHB is invariably cost effectiveness - if analysis shows that it is significantly cheaper to relocate the provision of a particular banking service in-house, that will drive the expansion of the IHB.

IHBs achieve cost efficiencies by creating a shared pool of resources and expertise to benefit the whole organisation. The cost of the operation is allocated proportionately across the corporate structure, enabling all operating units to share the benefits through the enhanced quality of cash and risk management operations. Superior price performance can be achieved by centrally negotiating advantageous fee structures with commercial banks, by netting and consolidating external dealing requirements, optimising liquidity via internal sources, minimising dealing costs and, potentially, commanding finer dealing rates for the foreign exchange (FX) and interest instrument transactions executed in the market.

Similarly, the costs of the IHB’s treasury management system (TMS) can be shared with other internal business units so the organisation affordably enjoys the benefits of powerful technology in managing cash accurately, identifying and hedging FX and interest rate risk, communicating and reporting, and generating the related treasury reporting and accounting results.

Strong Technology is Essential

Technology is central to the efficient and secure operation of an IHB of almost any degree of complexity. It is almost unthinkable to imagine an IHB functioning transparently and effectively without the support of a powerful treasury management system (TMS).The technology requirements may be summarised as treasury and cash management functionality and process support, control provision, generating timely, dependable operational and management reporting, and communications management across the organisation.

In multinational corporations (MNCs), the scope of the requirement may be global on a 24x7x365 basis, linking the finance and treasury functions of possibly hundreds of operating subsidiaries. Besides the functionality range, transaction volume management capacity will be an important consideration in technology selection, especially for organisations processing large numbers of payment flows (including payment factories) and for those managing complex webs of global FX risk exposures.

The application of technology is especially important in providing an effective solution for transfer pricing. IHBs can impose charges for their services through such activities as adjusting the rates of inter-company FX deals, increasing inter-company lending rates and reducing deposit rates by a pre-defined margin, and charging fees for operations such as payments and trade guarantees.

Depending on the organisation’s finance policy, the provision of these and other IHB services can be compensated and measured through internal charges. However, legislation prohibits corporations from artificially lending at sub-market rates to subsidiaries domiciled in high tax rate countries, and compensating this by borrowing at above market rates from subsidiaries situated in low tax regimes. TMS technology may be used to apply compliant pricing to IHB transactions, and to produce analytical reporting for auditors and regulators to verify that compliant policies are followed.

The technology that supports treasury operations with external counterparties (described elsewhere in this series) may be applied to the full range of IHB operations - with some subtle differences.

Subsidiary Communications

Among the key technology supports for in-house banking is establishing robust communications between a global network of operating subsidiaries and the IHB itself. Today, this is achieved by web based communications, either through native functionality for software as a service (SaaS), TMSs, or through the operation of specific web modules for client/server TMSs.

The key information flows from the subsidiaries to the IHB’s TMS are: cash transfer and payment instructions; hedge and investment transaction requests (FX, interest rate and commodity); trade finance requests and report requests.

The key information flows from the IHB TMS to the subsidiaries are message acknowledgements (for control and audit purposes) and reports, including inter-company deal confirmations and bank account balance and transaction statements, and in some cases, accounting reports.

In all cases, the system must be available 24/7, to accommodate global multinationals’ treasury and risk management requirements. The IHB business functions may be executed in a single, central treasury, or distributed among several regional treasury centres around the world. Both arrangements are found in practice.

The Starting Point: Internal Bank Accounts

Inter-company lending can be considered as the historical origin of in-house banking. Today however it is the operation of IHB accounts that forms the fundamental business basis of most IHBs - at least of those of any reasonable size and complexity. Such accounts are often used for subsidiary financing.

IHB accounts can replace most of the subsidiaries’ accounts held externally with commercial banks. Local accounts may be retained for such functions as payroll administration and operating income and expense management, depending on the organisation’s finance centralisation policies.

The IHB accounts will be used for settlement of all the subsidiaries’ inter-company transactions, and, naturally, for all transactions with the IHB itself. From a cash management perspective, the IHB takes over operation and management of most of the external bank accounts. Implementing this arrangement often leads to significant bank charge savings by consolidating banking relationships and bank accounts, with the closing of accounts no longer needed under the new in-house banking arrangement. The IHB can construct a revenue stream for itself via interest calculations and applying transaction and other fees, as permitted by policy.

Establishing a network of IHB accounts enables the organisation to improve performance through consolidating much of the enterprise’s cash, so that it can be mobilised to optimise interest income/expense performance across the corporate infrastructure. The IHB accounts allow both the centre and subsidiaries’ finance operations to keep track of each subsidiary’s correct cash position, regardless of the fact that surplus cash in real accounts may have been mobilised to fund shortfalls internally.

It follows that a key technology support for effective in-house banking is the calculation of debit and credit interest, so that it can be accurately allocated across the organization. This is achieved in the static data set-up: each IHB account has an associated rate of debit and of credit interest, sometimes expressed positive and negative margins that will be applied to a nominated index such as a particular London Interbank Offered Rate (Libor) rate to calculate the interest to be applied automatically by the TMS based on the closing balance.

The look, feel and functional performance of IHB accounts is often a critical point in the internal selling of an IHB to its clients: the subsidiaries’ finance managers. The internal accounts need to operate with all the responsiveness and transparency of commercial bank accounts if clients are to enthusiastically support IHB implementations; and this may have serious consequences in organisations where IHB participation is voluntary.

Conclusion

IHB accounts provide an elegant means of executing internal funding transactions via a debit to the central IHB account, and simultaneously generating a matching credit to the subsidiary’s account. TMS transfer pricing functionality can automatically create compensation for the IHB by calculating an interest adjustment on the deal, or by applying a transaction fee according to pre-defined rules.

IHB account management functionality, as seen, includes the automated calculation and application of interest. The mechanism of bank account inflows and outflows suits the control of inter-company transactions where the requirements change day to day; most treasurers will use this approach for internal funding and short term investment where this is permitted by regulation, and where this conforms to internal policy.

[stephenkhoo]

Cash Management: the In-house Bank - Part 2
Kelvin Walton, gtnews - 10 April 2014
gtnews’ series of articles on the practical application of technology in corporate treasury continues with the second and concluding article about in-house banking (IHB). It addresses key IHB business operations including support for cash pooling, the management of inter-company lending and depositing, inter-company dealing, treasury accounting and payments management - including payment factory operations.

Cash pooling interest optimisation solutions are commonly offered by banks in most geographical regions. Subject to the bank’s technical capabilities and to local tax and related regulations, two forms of cash pooling are generally available: notional pooling and zero-balancing.

Notional pooling involves the calculation of notional amounts of debit and credit interest on a group of physical bank accounts. The interest amounts are then netted together to calculate one amount that is then debited or credited centrally. In zero-balancing, debit and credit account balances are physically swept into a ‘header’ account; a single amount of debit or credit interest is calculated and applied to the header account balance.
In-house banking (IHB) technology plays an important role in managing both kinds of cash pooling. With notional pooling, the critical role is the reproduction of the bank’s interest calculations, and its allocation - in debits and credits - to the accounts of pool members. The IHB acts as a check and control on the bank’s operations, helping to detect and eliminate error.

IHBs play a major role in support of zero-balancing. Firstly, they can calculate and check - and even drive - the calculation and execution of the zero-balancing account sweeps. They can also accommodate leaving any required target or peg balances in swept accounts. Subsequently, the IHB will update internal accounts with reconstructions of each subsidiary’s pre-sweep positions, so that it can calculate and apply debit and credit interest accurately across the entire pool. Finally, the IHB can set up and execute the reverse sweeps, enabling the pool’s component accounts to be accurately reconstructed at the start of the next business day. In this case, the IHB technology has either managed the cash pooling sweeping process itself, or has validated it; and it has performed the required interest allocations among pool members.

In both cases, IHB technology enables the organisation to validate and enjoy the benefits of interest optimisation through cash pooling, and to allocate debit or credit interest accurately.

Inter-company Lending

An alternative approach to using IHB accounts for inter-company financing transactions is the use of inter-company loans. This method may be mandated in some cases by the dictates of regulation or policy.

This approach is less flexible than the use of IHB accounts; but may be facilitated by automated features, such as the generation of the mirrored side of a transaction: the IHB simply defines the loan issued to the subsidiary as a transaction, and the treasury management system (TMS) automatically creates the mirrored transaction and applies any transaction fee.

This use of automation is efficient, and eliminates the potential sources of error in a manual process. Its workflow logically and naturally extends to back-to-back transactions: in the case of a loan, the central treasury draws down from an external facility, and then allocates the proceeds to subsidiaries via a series of automated and mirrored internal transactions. The TMS controls this process, and will automatically generate the cross-referenced strings of transactions, which can be subsequently researched and reported. Such solutions have the additional merit of high audit quality. The IHB may, if permitted by treasury policy, take a spread on the internal allocation of borrowed funds.

The in-house TMS bank will automatically issue confirmations to the internal counterparties of the loan, and will automate subsequent interest management and rollover/maturity operations.

Inter-company Deposit Taking

Similarly, IHBs can replace commercial banks in taking deposits from subsidiaries. These funds naturally form the basis for the subsequent financing of inter-company lending transactions. The IHB may receive compensation for their operations by taking a spread on the interest credited to subsidiaries’ IHB accounts compared with their cost of internal or external borrowing.

As with inter-company lending, the IHB will confirm its deposit transactions with all internal and external counterparties. It will additionally perform the subsequent interest and principal management operations. The TMS will allocate, generate and link external deposits placed with the IHB’s transactions with subsidiaries from both parties’ perspectives - namely deposits taken and placed.
Inter-company FX and Commodity Dealing

Among the IHB’s primary functions is to receive and act on subsidiaries’ requests for executing foreign exchange (FX) and commodity hedging transactions. Requests to the IHB for cover are communicated to the centre via the web. Receipt should be automatically acknowledged by the TMS, in line with best practice.

Several areas of added value can be achieved by an IHB in this area, especially with strong technology support. The TMS can consolidate similar requests for cover, allowing dealing to plan and time market operations to optimise intra-day pricing. Consolidating amounts into ‘round lots’ of a suitable size commands the tightest market quotations, and the IHB’s expert dealers will be accordingly equipped to seek the best results for the enterprise in their market operations.

As with other types of dealing, the TMS will generate and manage confirmation and settlement of the external and internal transactions - providing a secure, transparent platform for hedging operations.

Other Deal Types

These same principles extend to all other types of in-house bank dealing in any permitted instrument, including trade finance letters of credit (L/Cs) and guarantees, internal allocation of the proceeds from capital markets issuances via term internal loans, and the transaction of all kinds of derivative - especially interest rate swaps. The TMS will organise settlement of internal transactions through the IHB and across its network of accounts, achieving a cost- effective and low risk result compared with external settlements.

Treasury Accounting

An IHB can assume the central functions of treasury accounting for its clients, the finance subsidiaries. This service can extend to the generation and export of accounting journals, and the preparation of accounting reports such as the subsidiaries’ balance sheet, profit and loss (P/L) and trial balance reports by the TMS. It can provide substantial added value by centralising a demanding technical treasury and finance function; for example as part of a shared services centre’s (SSC) operations. The provision of timely and accurate treasury accounting is achieved through the application of concentrated expertise and specialist technology.

Payments Management

All TMSs include the facility to export payments to banks, using bank workstations, file transfer and SWIFT messaging, or a combination of these. At the level of the IHB organisation, this function tends to overlap with the organisation’s management of payments on behalf of (POBO) and commercial bulk payments, through a payments hub or payments factory.

As a general rule, treasury is concerned with low volumes of high value transactions, and finance departments with high volumes of low-value commercial bulk payments. Treasury simply requires summary information about payment outflows, for cash positioning and forecasting purposes. On the other hand, in many organisations a payments factory must function efficiently with very large volumes of payments, and deal with cyclical volume peaks. In this area, the IHB bridges the disciplines of treasury and finance.

If a company needs a high volume payments factory solution, many TMS solutions are simply not designed to accommodate this. In outline, their database management process will not have been designed to manage high volume effectively, and performance may degrade geometrically as volume increases. Such requirements demand properly scalable solutions; and if such usage is projected for a TMS, it is imperative that effective volume testing and benchmarking form central parts of the system evaluation and selection process. One size does not fit all in this case.

Not all IHBs have bulk payments management as a central feature of their terms of reference; but those that do should make this requirement influences their technology selection project.

Conclusion

The deployment of IHBs continues to grow in corporate treasury around the world. Organisations are looking to benefit from the centralisation of resource and expertise that can be gained from an IHB. Additionally, they are seeking the costing and pricing advantages that be gained by concentrating cash management, hedging and other treasury operations in-house.

These developments minimise the needs for external dealing, enabling internal sources of cash to be detected and put to work, reducing demands for expensive external liquidity, and hence optimising interest income/expense performance. In-house banks support efficient cash pooling, and provide the means for radically reducing bank fees and overhead. The use of effective TMS technology - selected according to the specific business requirements of a particular IHB - is central to securing the many business benefits offered by a well-implemented IHB.