Copyright © 2018 Euro Banking Association (EBA) All rights reserved. Brief excerpts may be reproduced for non-commercial purposes, with an acknowledgement of the source. The information contained in this document is provided for information purposes only and should not be construed as professional advice. This information paper is the result of an analysis carried out by the Euro Banking Association's Liquidity Management Working Group (LMWG). The Euro Banking Association does not accept any liability whatsoever arising from any alleged consequences or damages arising from the use or application of the information and gives no warranties of any kind in relation to the information provided. 2

CONTENT EXECUTIVE SUMMARY .........................................................................................................................7 1. INTRODUCTION ................................................................................................................................8 1.1 Relationship between corporate and bank balance sheets .......................................................8 1.2 The EBA liquidity management working group’s objectives .....................................................8 2. IDENTIFYING CORPORATE LIQUIDITY NEEDS .............................................................................10 2.1 Validation with corporate treasurers ........................................................................................10 2.1.1 Internal factors ...................................................................................................................... 10 2.1.2 External factors ..................................................................................................................... 11 2.2 Liquidity management: focus on corporate deposits and cash pooling .................................11 2.2.1 The central role of bank technology ................................................................................... 11 2.2.2 Investment of corporate cash .............................................................................................. 11 2.2.3 The importance of cash pooling ......................................................................................... 12 2.2.4 Core products affected by new regulation ........................................................................ 12 3. THE BASEL III RULES AND LIQUIDITY MANAGEMENT ...............................................................13 3.1 Ratios and definitions ...............................................................................................................13 3.1.1 Capital requirements ........................................................................................................... 13 3.1.2 Liquidity coverage ratio - LCR ............................................................................................. 14 3.1.3 Net stable funding ratio - NSFR .......................................................................................... 14 3.1.4 Operational vs non-operational deposits .......................................................................... 15 3.2 Basel III: differences in implementation ..................................................................................15 3.2.1 The banks' view: LMWG survey ........................................................................................... 16 Implications of survey results ............................................................................................... 17 3.2.2 4. HOW DOES REGULATION AFFECT CORPORATE LIQUIDITY MANAGEMENT? .........................18 4.1 Treatment of corporate deposits .............................................................................................18 Implications of LCR and NSFR ............................................................................................ 18 4.1.1 4.2 Availability of notional cash pooling ........................................................................................20 4.2.1 Regulation of notional pooling ........................................................................................... 20 4.2.2 The benefits of net position reporting ............................................................................... 21 4.2.3 Summary of existing notional pooling regulations ............................................................ 22 4.2.4 Possibility of a CRD V .......................................................................................................... 23 4.2.5 Ongoing uncertainty over notional pooling ...................................................................... 24 4

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1. INTRODUCTION Robust interbank payment infrastructure helps companies and individuals to exchange value and settle commercial transactions. At the end of each day, the effect of all these payments and collections are consolidated as net cash positions on bank accounts held with banks. These cash positions are simultaneously both an asset on the company’s balance sheet and a liability on the bank’s balance sheet. For a company, cash is crucial to fund its operations (as working capital) and meet its current and future financial obligations. The company must also manage the cash on the balance sheet: holding cash with a bank exposes the company to a counterparty risk and there is also a cost of carry1. The company uses balance information from banks and its own forecasts to identify its current and future liquidity needs. It then employs various techniques, including cash pooling, to utilise this liquidity as efficiently as possible. The company manages this process with the support of various technologies obtained from banks (balance reporting, cash pools) and specialist providers like Treasury Management System vendors, as well as by using Excel as an operational and reporting tool. Figure 1 explains the relationship between the two. The left-hand diagram represents a typical company’s balance sheet. Its assets include work-in-progress, inventory of raw material and finished goods as well as the receivables which customers have committed to pay (order to cash). The company’s assets also include any surplus cash (cash and cash equivalent) held on the balance sheet (which may be denominated in different currencies). The company’s liabilities are indicated in the right-hand side and include its commitments to pay its suppliers (purchase to pay) in a range of currencies. A company will hold its short-term cash/liquidity with banks, as well as potentially with asset managers, until it is needed elsewhere by the business (operating expenditure). The right-hand diagram represents a typical bank’s balance sheet. For banks, these corporate deposits are presented as liabilities as they are a commitment to pay in the future. Banks can manage these liabilities by changing the incentives for investors to place deposits with them. These deposits are crucial for the funding of the assets (loan book) of the bank. For a bank, having cash (in the form of deposits) allows it to fund its assets (loan book) on the balance sheet, while minimising counterparty and liquidity risk, and the cost of carry. 1.2 THE EBA LIQUIDITY MANAGEMENT WORKING GROUP’S OBJECTIVES 1.1 RELATIONSHIP BETWEEN CORPORATE AND BANK BALANCE SHEETS To put this into context, it is helpful to identify how a corporate deposit affects a bank’s balance sheet. 1 This is the cost of holding cash on the balance sheet, which is the difference between return/yield and the Weighted Average Cost of Capital (WACC). Recognising the link between corporate and bank cash, the EBA organised a corporate liquidity seminar in April 2017. This brought together both sides of the corporate liquidity management ecosystem from across Europe: corporates and banks. Both parties face similar challenges: as well as ongoing technical, operational, management control and regulatory issues, increased focus is being paid to risk mitigation and to upgrade the liquidity management practices for the digital era. 8

2. IDENTIFYING CORPORATE LIQUIDITY NEEDS Each company has its own liquidity management objectives, which it seeks to achieve via the adoption of treasury processes, supported by technology infrastructure and banking services. These objectives as well as broader corporate liquidity management needs, are determined by multiple interrelated factors. 2.1 VALIDATION WITH CORPORATE TREASURERS To better understand the corporate liquidity needs, the LMWG invited eight corporates to share their objectives, challenges and daily liquidity management practices. Based on these discussions, the LMWG has identified a range of factors which influence the needs of corporate liquidity. 2.1.1 Internal factors the LMWG During the validation process with the corporate treasurers, identified a number of internal factors which affect a company’s approach to cash and treasury management, starting with the nature of its business. Other key factors include: Ξ Company structure Companies vary from small and medium-sized enterprises (SMEs), with a small number of legal entities, to regional or global multinationals, with complex legal structures. Ξ Organisation and management to responsibilities their Companies also vary according decision-making process and structure. In some, important business decisions, such as how to fulfil financing needs, are made centrally at headquarters; in others, these decisions are made locally, either by subsidiary or business unit management or by in-country organisations. A company’s business decision- making structure will determine its treasury organisation, i.e. from highly centralised, with all key decisions made by group treasury acting as an in-house bank, to decentralised, in alignment with local businesses or entities. In other organisations, treasury can act as an agent, coordinating treasury activities across the group. Ξ Geographic footprint and complexity of supply chain A group with a presence in multiple jurisdictions and a network of international suppliers will face different challenges to a company with a primarily domestic focus. These challenges will materialise in terms of the number of currencies used, the company’s exposure to counterparty risk and the complexity of collecting the sales value and making supplier and other payments. All these will make cash positions reporting more complex, and therefore more difficult. Ξ Cash position A company with net cash position will have different liquidity management requirements than a net borrower. The net borrower needs to constantly focus on liquidity, whereas a cash rich company has a safety cushion to absorb and mitigate any mismatches between cash forecasts and actuals. Ξ Maturity of treasury organisation The resources available to support decision making vary from well-resourced departments covering all activities to smaller teams focusing on key priorities. Ξ Approach to risk Companies have to manage a number of key risks in relation to liquidity management. These include 10

As with the other core services banks provide, any company that uses a bank’s cash pooling solution relies on that bank’s ability to manage this product through its own legacy technology, in a way that remains compliant with all relevant regulations. 2.2.4 Core products affected by new regulation corporates have multiple While liquidity management needs, a bank’s potential ability to accept deposits and to offer cash pooling products has been affected by recent regulation, notably Basel III. investment instruments, usually placed with relationship banks or with alternative including money market funds. If the cash flow forecasts indicate working capital cash can be invested for longer than a few days, the corporate treasury policy may permit a treasurer to sacrifice some liquidity to seek a return on that investment. 2.2.3 The importance of cash pooling Third, treasurers use cash pooling to help them achieve their liquidity management objectives (notably to maximise available short- and medium- term working capital funding), typically by seeking: Ξ A more efficient use of corporate liquidity Cash pooling enables companies to include previously ‘idle’ cash in their working capital balances, without for manual intervention in these accounts. the need Ξ Optimisation of credit lines to reduce reliance on external sources of funding By using internal surplus cash to finance group operations, treasurers can reduce their reliance on external borrowing for short-term working capital finance. Since the financial crisis, corporate treasurers and financial directors, especially those in SMEs, are more aware of the risk of short-term market liquidity not being available when needed. Ξ Interest optimisation Cash pools allow companies to reduce the interest on debit balances or increase opportunities to earn a return on credit balances. In its simplest form, this involves adopting some form of cash pooling. Corporate participants in the LMWG corporate panel sessions confirmed that cash pooling is an important tool for them. 12

the way banks calculate their risk-weighted assets. Global systemically important banks (G-SIBs) and domestic systemically important banks (D-SIBs) are subject to additional capital requirements. additional qualifications to the different nature of flows and provides guidance, rather than a single, specified method, on how to run the forecasting exercise. As well as a stricter allocation of capital, Basel III also introduced a requirement for banks to comply with a minimum leverage ratio. The leverage ratio requires banks to maintain a minimum of 3% equity against its on- and off-balance sheet exposures. Some countries have set a higher minimum leverage ratio: as an example, the leverage ratio in the Netherlands is 4%. The potential Basel IV could include new recommendations which would further impact these capital and liquidity requirements. 3.1.2 Liquidity coverage ratio - LCR The LCR requires banks to hold sufficient, unencumbered high-quality liquid assets (HQLA)2 to compensate for any net cash outflows over a stress-modelled 30-day period. The HQLA must exceed 100% of these net outflows on an ongoing basis. By definition, HQLA are easily converted into cash. The required level of HQLA is determined by the following equation: Stock of HQLA Net Cash Outflows forecasted in the following 30 Calender Days ≥ 100% The denominator is critical, as it references the concepts of ‘net cash outflows’ (the difference between inflows and outflows in the 30-day period) and ‘forecasting’. The regulation includes ≥ 100% 2 HQLA are, for example, cash at central banks and low-risk liquid securities. These assets have a low return on assets (ROA). 3.1.3 Net stable funding ratio - NSFR The NSFR takes a longer-term view and requires banks to maintain a NSFR (the ratio between its available stable funding (ASF) and its required stable funding (RSF)3) above 100% on an ongoing basis. As a result, banks will have to align the maturities of their assets, liabilities and off-balance sheet activities more closely. In brief, the NSFR means that a bank will no longer be able to rely fully on short-term funding (deposits) to fund its long-term assets (lending portfolio). ≥ 100% Available Stable Funding Required Stable Funding ≥ 100% To summarise, as long as a bank meets a minimum requirement in terms of adequacy of its own capital, the combined LCR and NSFR should ensure a bank has: Ξ Prudent funding in relation to the obligations on the asset side to overcome any future period of market stress; and Ξ A broad match, in terms of duration, of both sides of its balance sheet. The bank should have considered how much funding is prudent and sustainable given its investments. 3 The RSF is determined by the composition of a bank’s loan book and is based on a number of variables, including tenor of loans, type of counterparty (corporate or retail) and bond holdings. The ASF includes capital market funding, preferred stock, customer deposits and long- term borrowings (defined as >1 year). 14

balances and a list of payments and collections book entry codes. Ξ Of the surveyed banks, those with a higher level of corporate deposits have a greater reliance on operational cash for the purposes of LCR and NSFR. Ξ There is strong support (80%) for the idea that operational deposits should be identified using client-specific data, rather than using groups of client data. Ξ There are strong indications that banks update their calculation methodology of the ratios consistently and on a regular basis, forming part of banks’ LCR calculation model, and thus keeping the door open to possible non- linear changes in the future. Ξ Based on the survey, it appears that banks’ application of Funds Transfer Pricing (see section 4.1 below) is not homogenous, although they are leaning towards differentiation from an operational versus non-operational perspective. The survey also suggests banks differ over the issue of whether to try to attract ‘operational’ deposits by offering tailored rates to those clients expected to provide them. Ξ Decisions on intra-day liquidity will have an impact on bank balance sheets and liquidity buffers. (Although part of the survey, the LMWG decided to address intra-day liquidity at a later date.) In addition, Basel III is being implemented in countries whose central banks are members of the BIS. Elsewhere, many regulators have not yet implemented Basel III for their local banks. In these markets, international banks require compliance with stricter regulations for their branches than locally regulated banks. Companies therefore face banks with two totally different approaches to deposit gathering in these locations. 3.2.1 The banks' view: LMWG survey Given the broad scope and interpretation of the regulation, the LMWG decided to survey peer working group banks on a voluntary basis using publicly available information. The survey focused on two key points: Ξ Whether the nature of a bank’s customer deposit base (composition of the balance sheet) and the proportion of retail versus corporate deposits influences how it is interpreting the rules; and Ξ Whether some banks are more reliant on operational cash, e.g. for metric enhancement purposes, than others. The main observations from respondent banks are: Ξ Banks have different interpretations of the regulatory definition of operational cash and how it should be calculated, albeit within the parameters set by the regulation. Ξ Banks also use different methodologies to forecast their net outflows for the next 30 days. Some use criteria based on balances only, others use criteria based on a combination of 16

4. HOW DOES REGULATION AFFECT CORPORATE LIQUIDITY MANAGEMENT? Given the lack of corporate awareness of the implications of Basel III, it is useful to identify the precise impact of the regulations on the two elements of corporate liquidity management: the investment of corporate cash and the availability of notional cash pooling. 4.1 TREATMENT OF CORPORATE DEPOSITS While banks have always had to keep a certain level of liquid assets in the past, Basel III has formalised this by requiring a minimum level of HQLA as a buffer. By tightening the requirements, the new regulations have a significant impact on both banks and their corporate clients. To fully understand the implications, it is helpful to view them in the context of the impact the regulations have on a bank’s funds transfer pricing (FTP)5 policy. Each bank develops its own internal FTP policy, which is the pricing that the bank’s internal treasury applies to bank business units on all loans (assets) and deposits (liabilities) that the business arranges with its clients. 5 As an example, consider a relationship manager (RM), who ‘sells’ a loan product to a customer. In effect, the RM will be buying funds from the bank treasury at a certain price (the FTP) and then reselling those funds to the customer, adding a certain ‘spread’ as a gross profit mark-up. The process is the reverse for deposit products. In this case, the RM buys effectively funds from the customer at a certain interest rate and sells them to the bank treasury. The price paid by the bank treasury is the FTP, with the gross profit the difference between the FTP and the interest rate granted to the customer (in theory, the rate paid to the customer will be lower than the FTP). 18 4.1.1 Implications of LCR and NSFR As discussed, banks have to hold sufficient HQLA against cash deposits to cover forecast net outflows for the next 30 days to mitigate liquidity risk. They are also required to distinguish between ‘operational’ and ‘non-operational’ deposits and hold HQLA at a minimum of 25% of operational cash deposits and 40% of non-operational cash deposits6. Figure 2 shows how different deposits from corporates and financial institutions are treated for the purposes of both the LCR and the NSFR ratios. Note that non-operational deposits from non-bank financial institutions are assumed to have a 100% run-off rate. Whether a deposit is classified as operational or non-operational has consequences for a bank treasury and its policy (Figure 2). Ξ First, any deposit classified as non-operational partially restricts the bank’s freedom when deciding its asset allocation. Ξ Second, as a result, a bank should identify which commercial initiatives generate ‘non- operational’ deposits and then manage them consistently with bank treasury. The effect of this is that deposits are valued differently by banks from a long-term funding perspective, with the nature of the depositor (corporate versus financial institution) and whether they are considered to be ‘operational’ or ‘non-operational’ both having an impact. This consideration becomes more complex where companies and banks manage multiple buckets of cash denominated in different currencies. 6 These figures are the minimum assumed ‘run-off’ rates, or the proportion of operational and non-operational cash that will flow out over a 30-day period.

Figure 3 – Notional pooling & regulatory drivers NOTIONAL POOLING Regulatory Framework CAPITAL RULES BASEL III Liquidity, Leverage, Capital ACCOUNTING STANDARDS Netting, off-setting US BASEL III EU CRR/ CRD IV US GAAP EU IFRS 4.2 AVAILABILITY OF NOTIONAL 4.2.1 Regulation of notional pooling CASH POOLING7 The availability of notional cash pooling depends on the approach by the regulators in all relevant jurisdictions. This applies to both the banks providing the solution and the corporate client seeking to benefit from it. As well as bank-specific capital and liquidity rules, the recognition of any legal documents underpinning the cash pool (including set off or cross-guarantee clauses), the treatment of intercompany loans and the ability to account for positions on a net, rather than gross, basis will all have an impact on the availability and efficiency of a notional cash pool. Collectively, these rules and standards determine how banks are permitted to net or off-set credit and debit balances for reporting purposes and, then, how much capital and liquidity a bank must set aside to support pooling positions. 7 Definitions of the different forms of cash pooling are provided in an appendix to this paper. Evolving capital and liquidity regulations and accounting standards affect the way banks offer notional pooling. Banks need to ensure the balance sheet treatment of clients’ notional pooling structures is compliant with the applicable capital and liquidity rules and accounting standards in the relevant jurisdictions where the product is offered. For the purposes of European notional cash pooling, the regulatory environment is summarised in Figure 3. While most banks in the EU are subject to EU regulation (CRD IV) and report to International Financial Reporting Standards (IFRS), some are subject to other regulation (notably, US banks have to meet US Basel III rules and report to US GAAP). Whichever regulatory regime is relevant, the rules should establish whether cash positions in a notional cash pool can be netted and the difference between the capital treatment of a gross and net position. This, together with the extent to which the rules are clear or open to interpretation, 20

Figure 5 – Gross vs. net treatment of notional pools - impact GROSS TREATMENT NET TREATMENT ASSETS LIABILITIES ASSETS LIABILITIES Leverage ratio* 3% OVERDRAFT = 90 HQLA = 44 ROE = 10% / 12% Equity = 4 DEPOSIT = 110 Leverage ratio* 3% OVERDRAFT = 90 0 HQLA = 8 ROE = 10% / 12% Equity = 0,24 DEPOSIT = 110 20 ROA ≈ 0 LCR 40% / 25% ROA ≈ 0 LCR 40% / 25% Higher capital and liquidity requirement * Leverage ratio differs per jurisdiction 3% > Netherlands 4% > Switzerland 4,5% Lower capital and liquidity requirement * As balances are netted (-90+110) the dynamics of balance sheet changes With net treatment, the balance sheet changes. The bank will only have to hold 8 of HQLA against the deposit of 20. From a leverage perspective, the position is transformed. The netted balance sheet is smaller, requiring the bank to only hold 0.24 of equity against the lower HQLA, making it much easier to satisfy shareholders too. The LMWG has not calculated the impact of the overdraft facility on LCR and NSFR, so the benefit of net treatment is not as simple as illustrated. The overdraft facility of 90 will have an additional impact on the bank’s LCR and, consequently, the level of HQLA it has to hold. The precise treatment will vary according to the terms of the overdraft including, for example, whether it has a maturity date. In addition, banks may also apply some form of capital cost, depending on the nature of the notional pooling structure itself. 4.2.3 Summary of existing notional pooling regulations As discussed above, the ability of banks to offer notional pooling is determined by both bank capital rules (including Basel III) and accounting treatment. Although regulations and accounting standards are open to interpretation (notional pooling is not a defined term in US GAAP or IFRS), it is possible to summarise the main rules: these Capital rules Ξ Deposits within a notional pool need to be evaluated against LCR tests. If the notional pool is linked to operating accounts, the LCR treatment may be favourable, reducing the level of HQLA a bank must hold. Ξ For the purposes of the leverage ratio, US-regulated institutions may report loans and deposits on a net basis; EU-regulated 22

Under CRD V, the treatment of netting in the EU is expected to be more aligned with the current US interpretation. As a result, the LMWG expects a higher level of consistency between the two regulatory regimes over time. 4.2.5 Ongoing uncertainty over notional pooling to understand In summary, the LMWG has found that there is no consistent approach to notional pooling, making it difficult for banks and their corporate clients liquidity management options. Each bank operates within its own context, notably its specific balance sheet structure, with the result that differences exist between banks cross-region, within region or even within the same country. the potential Given this uncertainty, the LMWG discussed whether banks could do more to educate their corporate clients about the impact of existing and future regulations. 24

5.2 UNDERSTANDING HOW COMPANIES USE TECHNOLOGY Technology is a critical tool that companies deploy to achieve their liquidity management objectives. At a base level, companies use a combination of their general ledger and spreadsheets to manage liquidity. They may also rely heavily on bank technology for core services, including balance and transaction reporting and payment processing, although it is easy for banks to underestimate the value of these services to their corporate and other clients. A number of other services commonly used by corporates, including cash pooling, are similarly important for companies to achieve their liquidity management objectives. It is fair to conclude that companies rely heavily on solutions provided by banks, all of which are driven by each bank’s internal technology. As companies evolve into more sophisticated organisations, they employ a wider range of more specialised solutions and activities, all of which rely on technology. Provided by banks and/or specialist technology companies, these solutions offer: access to bank systems (single and multibank) to gather real-time information, visibility of company liquidity, account aggregation for multibank reporting, support for cash flow forecasting, access to foreign exchange and money market trading systems (both proprietary and independent), and the ability to support in-house banking and virtual account management. For some companies, these solutions are delivered through an integrated treasury system provided by specialist treasury system vendors. Because of the central role bank technology already plays in supporting corporate liquidity management, there is potential for banks to extend this provision and access new revenue streams. As an example, there may be potential for banks to attract corporate deposits of operating cash via the provision of additional cash pooling products and/or other targeted technology solutions. 5.3 OUTLOOK: EMERGING LIQUIDITY MANAGEMENT TECHNOLOGIES This paper examined how current regulations are developing and impacting the current liquidity management solutions offered by banks. Other factors are liquidity solutions used by corporate treasurers, including: influencing the potential Ξ The need to understand the detail of CRD V/ Basel IV and its implications for cash pooling; Ξ New and emerging liquidity management technologies and solutions developed by technology companies; and Ξ The introduction of instant payments, which may release liquidity currently trapped during the day, increases the potential for intraday liquidity (for both banks and companies). This may impact the way companies manage their liquidity and cause banks to redefine their value proposition. issues to arise While treasury management systems have been developed by specialist providers to support corporate treasurers in managing liquidity more efficiently, banks could consider offering similar technology services to their corporate clients in the future in order to: Ξ Retain client relationships by providing valuable services to their clients – corporate participants in LMWG panel sessions want banks to become more than just a financial partner; 26

6. CONCLUSION The LMWG’s recommendations are based on the following conclusions: 1. Bank development of technology corporate customers for Ξ Corporates already rely to a significant extent on bank-provided technology when managing cash, notably receive balance and transaction reports and to use cash pooling solutions. to Ξ Banks could extend the range of technology solutions they provide to corporate customers for a number of reasons including to enhance the client relationship, to increase revenue (tap into new wallets) and to gain and retain more valuable corporate cash deposits. The LMWG proposes to assess the potential for banks to provide technology solutions to corporate clients and to identify appropriate collaboration models for banks and technology companies to do so. The findings will be published in a future paper. 2. The implications of Basel III for investment of corporate cash Ξ Banks with a higher level of corporate deposits rely more on operational cash for the purposes of LCR and NSFR than banks with higher levels of retail deposits. Ξ Banks are currently interpreting the guidelines differently, in terms of both their distinction between operational and non-operational deposits and how they execute their FTP policy in light of the new regime. Ξ Corporates are not generally aware of the ways banks view and treat their current accounts and demand deposits. The LMWG recommends that each bank takes steps to educate its clients on how the bank views corporate deposits and, in particular, show how the bank balance sheet benefits from operational rather than non-operational cash. This will help corporate treasurers to make an informed investment decision, when seeking to deposit cash with different banks. 3. The future of notional cash pooling Ξ There is no consistent regulatory approach to notional pooling, making it difficult for banks and their corporate clients to understand the potential liquidity management options. Differences between banks exist cross-region, within region or even within the same country. Ξ Basel III, particularly the leverage ratio, may affect banks’ commercial ability to offer certain products to their corporate clients. While the Basel Committee issued a clarification on notional pooling in December 2017, it is still uncertain how this will develop within the EU as the guidelines need to be implemented into local legislation, potentially via a new EU directive (CRD V). Even if CRD V does relax the framework, the final treatment will not be clear until it is implemented by all member states. The LMWG recommends that banks enhance their client education initiatives about the impact of existing and future regulations on the solutions banks provide to their clients. 28

APPENDIX 1: CASH POOLING A.1 DEFINITIONS OF DIFFERENT CASH POOLING METHODS that underlying accounts hold a pre-set level of cash (target balancing). This allows liquidity to be consolidated from participating business units as well as from different banks. Interest is then calculated on the balance after concentration, whether credit or debit. Using the principles outlined in Section 2.2 above, the LMWG has defined the different cash pooling methods for the purpose of this paper, not least because the terms are sometimes used slightly differently in the market. These definitions help to identify the benefits of specific techniques for corporate treasury departments as well as some of the issues which can arise. Figure 6 – Cash concentration/target balancing CONCENTRATION ACCOUNT LEGAL ACCOUNT ACCOUNT ACCOUNT A.1.1 Cash concentration/zero balancing Company benefits: Cash concentration is the physical transfer of funds from a number of accounts into a single central master (target or consolidation) account. All accounts are real legal accounts and can thus be held in the name of a single legal entity or across multiple legal entities. Cash can also be concentrated from accounts held across a number of relationship banks, using a process sometimes referred to as sweeping or topping. End-of-day (or intraday) balances are automatically concentrated from participating accounts to the master account. Cash concentration can be structured so that all cash is concentrated from the underlying accounts (zero balancing) or so Ξ Cash concentration allows a company to move all balances to one central location, in the name and ownership of central treasury. Automation is critical as this process would be impractical and error-prone using manual transfers. Ξ It has the effect of shortening the company’s group balance sheet, as all participating positive and negative balances are physically offset. Ξ As long as the sweeps are administered well, it provides certainty over ownership of consolidated funds, as the sweeps are legally intercompany loans. 30

The differences are: 1. A real notional pool offers full balance and interest compensation. 2. Although interest enhancement/set off may be considered to be a notional cash pool, it is technically only a reduction of the interest margin. The credit and debit balances are not offset. 3. With balance netting, the balances are offset against each other for risk management and credit management purposes. However, interest is still calculated on each individual balance, rather than on the pooled balance. The difficulty for corporate treasurers is that the term ‘notional pooling’ is used to describe all three products. Because of the different treatment of each product, the implications for both company and bank balance sheets vary, affecting the potential benefits for the corporate treasurer. Company benefits: Ξ All accounts participating in a notional cash pool are legal accounts held with the bank. Therefore, each balance reflects a debt/claim toward the bank, simplifying the intercompany liabilities. Ξ All balances from the real accounts are netted against each other, as long as they sit on the pooling bank’s balance sheet. Banks typically enforce limits on both a net (aggregated position of all accounts) and a gross (aggregation of all debit positions) basis. Ξ The lack of physical movement of cash reduces a group’s transaction fees and banking costs. Ξ A notional pooling structure enables a company to use the bank’s balance sheet to centralise liquidity. Because there is no mingling of funds, cash is owned and held in the name of the pooling participants, retaining local independence. Considerations: Ξ Notional cash pooling is heavily regulated and not permitted in some jurisdictions. Ξ Alternative products (referred to as interest optimisation, interest enhancement or interest compensation) are sometimes used to achieve the interest netting. Ξ As there are no physical sweeps of funds, there is potential for the bank´s and the group’s balance sheet to become enlarged. Ξ The method of allocating the pool or interest benefits to participants can be complex. A.1.3 Balance netting/single legal account Balance netting is also referred to as single legal account and/or Nordic cash pooling, as it is the most commonly used method across the Nordic countries. The master or top account is the only legal account held with the bank, so it holds the net balance representing the claim between the company and the bank. All other accounts are internal ledgers set up by the bank, rather than legal accounts. Balances on underlying ledgers automatically reflect the group’s internal debt/claim for each participant. Internal terms and conditions can be applied to underlying accounts for the automatic calculation of group internal interest, which banks will normally administer. This structure is used by both centralised and decentralised corporate 32

Figure 9 – Virtual accounts LEGAL ACCOUNT LEDGER ACCOUNT to balance netting where the non-physical or ledger accounts are established by the bank, virtual accounts are set up and managed by the company. Company benefits: Ξ Corporate treasurers view this concept as a way to significantly reduce the number of physical bank accounts. Ξ A virtual account management structure gives treasurers the ability to open and close virtual bank accounts, providing flexibility in internal account design. However, any new virtual account will be treated as a real account from an anti-money-laundering and know-your- customer perspective. Ξ In the virtual account structure, there is only one legal account with the bank, so it always holds the legal net balance for the group. The virtual account structure is effectively the company’s in-house bank. Ξ On top of this many other added value services can be attached to a virtual account, for example: › It can be used as a reconciliation tool to increase straight-through processing and automation in invoice matching. › It can run flexible pooling structures. › Some companies use a centralised structure, such as shared services or a treasury centre, to process payments on behalf of (POBO) and/or collections on behalf of (COBO) group entities. Such structures give treasury greater visibility and control over group payments and liquidity. Considerations: Ξ The balances on virtual accounts reflect a debt/claim between the virtual account holder and the owner of the bank accounts and so the implications of the resultant internal loans must be considered. 34

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