In coming years, banks need to prepare themselves for compliance with the new rules imposed on financial institutions by Basel III. Both the financial crisis and the advent of Basel III represent a reduction of available resources for companies. The result is that companies need to find liquid assets. Effective liquidity management is a way of identifying “hidden” liquidities within one’s own organisation. Companies are therefore increasingly opting for notional pooling, because it gives them a better insight into their (global) financial situation and the ability to optimise interest revenue on their accounts. At the same time, Basel III imposes more stringent requirements for offsetting balances (credit and debit) and this could pose a risk to notional pooling. The issue is what consequences the introduction of Basel III will have on the offering of notional pooling services from banks.
Benefits of notional pooling
The use of notional pooling has increased exponentially in recent years. At present, it is a widely used mechanism for concentrating balances and maximising the interest revenue on bank accounts. Besides, it gives businesses a better insight into their financial situation and the business is therefore able to manage and utilise funds productively.
Another widely used pooling technique is physical pooling (zero balancing) whereby funds from participating accounts are transferred to an umbrella bank account via physical transfer. The difference between the two is that with notional pooling, the sums are only transferred virtually, while a physical transfer of funds takes place with physical pooling. With physical pooling, internal negative balances arise because of the physical transfer. Moreover, notional pooling and physical pooling are not mutually exclusive. Both structures can be combined in an overlay structure.
Basel III is introducing a number of new financial ratios for the purpose of strengthening the capital base of banks. One of the most significant ratios is the liquidity coverage ratio, which obliges banks to hold sufficient high-quality liquid assets (cash or assets that can be traded on the market quickly) to withstand a ‘crisis’ that could put cash flows under pressure for a period of thirty days. Moreover, the new legislation increases capital requirements for banks and makes these more risk weighted than before. These conditions will be countercyclical to encourage banks to build up more capital when the economy is good.
Liquidity management is gaining popularity because of two simultaneous developments. On one hand, credit is becoming a less appealing source of revenue for banks, as a result of which they are switching their focus to activities without capital requirements. On the other hand, companies need to make optimal use of their internal liquid assets, given that bank financing is becoming increasingly difficult. Notional pooling offers the option of combining the balances of different (international) accounts and optimising interest.
Uncertain future for notional pooling
Basel III does not permit liquidity ratios to be calculated by means of ‘netting’ the outstanding balances of accounts in the notional pool. This means banks must calculate their ratios based on the gross value of individual accounts. Banks must increase their liquidity to offset negative balances in the notional pool. The negative balance is regarded as an overdraft, which is associated with an unattractive Risk Weighted Asset (RWA) for the bank. The conditions for reducing this RWA vary by bank and depend on the central bank in question. Banks must have a statutory right to offset to avoid having to hold a higher amount of risk capital.
However, the process of gaining this right is very time consuming and expensive (for both the bank and the business) and requires the necessary legal and taxation expertise. Firstly, the law in the jurisdiction of each participant of the notional pool must allow compensation in the event of bankruptcy. In addition, each participant in the notional pool must sign documents that enable them to act as guarantors for other participants. Finally, the business must demonstrate that netting has taken place periodically.
As far as the future of notional pooling, there are a number of possible scenarios when it comes to continuation of this service by banks:
- Banks only allow entities into the notional pool if there is an enforceable right of compensation;
- Banks pass the higher costs of notional pooling on to companies;
- Banks offer notional pooling selectively depending on a company’s creditworthiness.
If banks proceed to increase the costs of notional pooling, it is likely that companies will seek alternatives for their cash management activities (physical pooling, for example). For that reason, it is advisable to contact your bank about notional pooling, so you are not confronted with unpleasant surprises.
Enigma Consulting is monitoring the developments of the Basel III framework closely and is combining its expertise in the areas of Payments, Treasury and Risk to provide its clients with solid advice. The Treasury Scan enables Enigma Consulting to analyse the impact of Basel III on your existing cash pools and to offer advice on the way in which this should be managed in future.