Notional Pooling

The offsetting of balances is strictly notional. No funds are physically transferred, and notional pooling results in bank balances. This has important operational and regulatory and tax benefits.

The bank's interest spread comprises of:

1. The market spread between the bid and offer rates, for instance between LIBID and LIBOR
2. Regulatory capital costs (both the amount of capital required by regulators for different balances -which costs more than debt funding) and funds that must be deposited with the central bank
3. Equity funding costs (dividends to shareholder)
4. Profit margin (to cover the bank's costs, etc)

The regulatory capital cost is material, so the savings from notional pooling can be substantial.

To achieve those savings, the bank must prove to regulators that they have an effective right of offset. Most regulators require a cross guarantee arrangement (whereby each participant in the notional pool is jointly and severally liable for the debit balances of the other participants up to the amount of their credit balances). Regulations may vary and some allow other methods, for example a pledge of cash.

In practice, to achieve an effective right of offset, all the accounts must be held with the same bank entity, in a single jurisdiction (i.e. under a single regulator's governance). Banks also require a sophisticated regulatory environment to offer notional pooling, so it is most commonly practiced in major treasury centre locations such as Singapore, Hong Kong, London, and various European centres. The Office of the Comptroller of the Currency (OCC) does not allow notional pooling so it is not practiced in the USA, though most large US banks offer notional pooling in their offshore branches and subsidiaries.

Variations

Notional pooling comes in many variants. The two primary distinctions are multi-currency and multi entity.

Multi-currency notional pooling allows offset between bank balances in different currencies. Single currency notional pooling still exists but it is becoming less commonly used. Multi-currency notional pooling provides treasurers with an extremely efficient way to manage multi-currency balances while reducing external costs, and operational risks and costs.

Multi-entity notional pooling allows offset between bank balances belonging to different legal entities. This is very efficient for treasurers because it avoids the operational risks and costs associated with intercompany loans or ZBA (daily accounting entries and processing withholding tax). It is the multi-entity aspect of notional pooling that gives rise to the regulatory requirement for a cross guarantee or pledge of cash. Single entity notional pools do not need such support structures because all the accounts in the notional pool belong to the same entity.

How does it works?

Multi-entity multi-currency notional pooling is the default solution used these days. However, lack of clarity about how Basel III may affect the regulatory capital required for multi-entity notional pooling has led to an increase in the use of single entity multi-currency notional pooling as an overlay for ZBA structures and IHBs.

Because notional pooling must occur in in a single bank location, and most corporates require operating accounts across multiple geographies and even banks, in practice notional pooling is mainly used as an overlay.

Operating accounts, often at different banks, are swept at close of business to accounts at the notional pooling in a single bank location. In multi-entity notional pooling, each entity has its own account in the notional pool, so funds are not co-mingled across legal entities.

Other alternatives include using notional pooling as an overlay for a ZBA structure and using notional pooling as an overlay for IHBs.

Because ZBA is only effective in a single currency, many corporates run one ZBA per currency and then overlay that with a single entity multi-currency notional pool.

The end result of IHB is one account per currency for the whole group. The IHB then faces the problem of managing the resulting currency balances. Since the required overnight FX swaps present external costs and operation risks and costs, many IHBs choose to overlay their different currency accounts with a single entity multi-currency notional pool.

Notional pooling compared

Notional pooling is a balance management tool. Notional pooling results in bank balances.

Comparing notional pooling to interest optimisation, the key difference is in the regulatory capital required on the bank's side. Under notional pooling, the bank can (partially or wholly) offset the corporate's debit and credit balances thus reducing its regulatory capital costs. Under interest optimisation, the bank must allocate full regulatory capital against all the corporate's balances.

Regulations

Notional pooling is heavily dependent on a sophisticated regulatory environment. For this reason, it is normally only offered in the major financial centres listed above. Very few developing markets offer notional pooling.

The specifics of Basel III implementation remain unclear, and this has thrown doubt on the economic viability of notional pooling. Particularly in Europe, as a consequence of the legislation required to implement the Basel III recommendations, banks may have to hold capital against gross credit and debit positions, and therefore one approach being taken is to apply limits against individual participants to manage the gross positions with the notional pool. Banks may also require that debit positions in the pool are squared off on a periodic basis and not left indefinitely in a debit positon.

Tax

Because notional pooling results in bank balances, it is a much simpler arrangement than balance tools which result in intercompany balances. However, there is still a general lack of understanding of notional pooling, and opinions can vary within internal tax teams.

In some countries, the specifics of the support wording (cross guarantee, pledge of cash, etc) can have a big impact on the tax effectiveness of notional pooling, i.e. whether notional pooling interest is considered bank interest or deemed to be intercompany interest. For this reason, treasurers should consult with their tax advisors before implementing notional pooling.

Any tax issues apply only to multi-entity notional pooling. Single entity notional pooling does not present any tax issues.

Accounting

From an operational perspective, notional pooling presents no accounting problems because notional pooling results in bank balances so accounts in a notional pool are no different operationally than normal bank accounts.

From a reporting perspective, corporates generally want to report net notional pool balances. IAS32 places limits on the offset of notional pool balances, mainly requiring a demonstration of the intent to physically offset balances. To satisfy this requirement, most banks offer a service to physically offset notional pool balances periodically to satisfy IAS32. There is no such problem with FAS.

Implementation

Since notional pooling remains  to be a complex concept even after 40 years, treasurers will need to gain buy in from operational, accounting, tax, and legal colleagues. It is important to understand the nuances of different bank offerings, since they can have big differences in all these respects.

The primary issue with notional pooling tend to be in the documentation, and meeting the operational, accounting, tax, and legal constraints. Operationally, since operating entities retain their bank balances and no funds are transferred, notional pooling is very simple.