Notional Pooling: a Worked Example

A group with several companies rarely has its cash where its borrowing is. A retail company collects cash every day; its importing sister company pays for a container before the stock is sold. Banked separately, the group pays an overdraft rate on one account while earning a deposit rate on the other, and the difference is interest paid on money the group already has.

There are three ways to close the gap. The companies can lend to each other, with loan documents and tax consequences. They can have the bank move the cash every night, which is zero-balancing. Or they can leave the cash where it is and ask the bank to calculate interest as though it had moved, which is the notional pool. The last suits a group whose companies need to keep their own funds, or whose owners would rather not create balances between the companies at all. Most pools are in one currency; multi-currency pools exist but fewer banks offer them.

Each day the bank adds the participants' balances together and applies its credit or debit rate to the net figure. The pool agreement then says how the interest is shared back among the companies. That allocation is the group's choice, but because it moves value between separate companies, it can raise tax questions, most sharply when the companies sit in different countries.

The bank's protection has three parts. Each participant guarantees the debit balances of the others, often up to the amount of its own credit balance. The bank takes a contractual right to combine the accounts. And it sets limits: on the pool's net debit and on each company's overdraft. The guarantee matters because insolvency set-off generally works only between debts running both ways between the same two parties. The bank owes the deposit to one company; the guarantee makes that same company owe the bank the other's overdraft, and the two can then be set against each other.

Netting the interest does not net the bank's balance sheet. Under the Basel leverage ratio, which in the UK applies to the largest banks and in Australia to banks accredited to use their own credit risk models (New Zealand's Reserve Bank has not adopted one), loans and deposits in a notional pool are counted gross, so the overdrafts count in full in the exposure the bank must hold capital against. In the group's own consolidated accounts the deposits and overdrafts are usually shown gross too. IFRS, and the New Zealand and Australian standards based on it, allow offset only where the group has a legally enforceable right of set-off and intends to settle net, and FRS 102, which most UK mid-market groups use, sets the same two-part test.

A family group, constructed for this page, owns an outdoor-clothing retailer, the company that imports its stock and a company that holds the freehold of two stores. Their average balances over the year, and the bank's rates, are the example's, not market rates.

Two years later, with balances as above, the import company fails owing the bank US$3.0m. The bank does not wait for its liquidator.

The loss has not disappeared. It has moved to the retail company, which now has US$1.2m in the bank instead of US$4.2m and a claim for US$3.0m against an insolvent sister company. The cash a reader of the retailer's accounts might have counted as free was, for as long as the pool ran, standing behind the importer's overdraft.

In a zero-balancing structure the cash really moves. Each night the bank sweeps every account to nil into a header account, so the bank faces one balance, and each sweep creates a loan between the subsidiary and the header company. The Basel Committee treats that physical settlement differently from netting: the single balance left after the sweep can be the starting point for the bank's leverage exposure, provided the bank cannot be held liable for a participant's failure. Notional pooling avoids loans between the companies but depends on the cross-guarantees; zero-balancing creates the loans, and the bank's end-of-day exposure narrows to the header account. Some groups run both: a sweep within each currency, and a notional pool across them.

DEFINED IN ONE PARAGRAPH → · ZERO-BALANCING, WORKED → · CROSS-GUARANTEE →

A credit officer reads a pool by its gross limits, not by its net balance, because the overdrafts are the exposure and the deposits are protection only as far as the guarantees and set-off rights hold. The file asks which companies are in the pool and whether each one is a guarantor; whether each guarantee has corporate benefit for the company giving it; what happens when a participant is sold, since it has to leave the pool and be released; and whether the group's net debt definition counts cash that is standing behind another company's overdraft. The price follows: a bank that holds capital against the gross balances recovers it through a fee or a narrower rate, and may offer the pool only to groups whose credit it is comfortable with.

CORPORATE BENEFIT → · THE EXAM HALL · TRANSACTION BANKING →