The classic in-house banking operation typically consists of a dedicated function or entity which handles cash management, FX and funding operations on behalf of different business units within a corporation. In effect, each business unit maintains its own virtual 'bank account' with the in-house bank rather than directly with an external commercial bank.
The in-house bank houses these virtual bank accounts in its own sub-ledger which is then tied to a single set of physical bank accounts maintained by the in-house bank with one or more external banks. Payment and deposit transactions processed by the in-house bank on behalf of a business unit pass through the physical bank accounts and are then allocated to the virtual bank account belonging to that business unit. In effect, the sum of the virtual bank accounts maintained by different business units at the in-house bank equals the in-house bank's net position with its external banks.
In this way, the number of bank accounts a corporate needs to maintain is dramatically reduced, resulting in consolidation of liquidity, FX and investment positions, and thereby enabling the in-house bank to net-off or self-fund its own positions across different business units. Having visibility over all payment and deposit flows also enables the in-house bank to forecast its net funding or investment position more accurately, thereby improving funding and investment operations.
However, in-house banks are not something corporates typically set up in the early days of their international expansion. Rather, their primary focus is on building out the core business (e.g. finding the best factory locations, building the customer base, and setting up basic accounting functions) as opposed to developing a sophisticated treasury operation.
Nevertheless, as the business grows, issues around the funding of working capital become more pressing as maturing operations throw off excess cash, whilst others require significant injections of new funding to support growth. This often leads to rapid expansion of the balance sheet, with some business units holding substantial cash balances whilst others borrow because the ability to efficiently move money between business units and countries is constrained by the lack of sufficient treasury resources and infrastructure. It is at this stage that many Asian corporations start to consider in-house banking as a means of optimizing working capital and self funding.
It is interesting to observe that while in-house banking appeals to a broad spectrum of Asian corporates, some of the strongest interest is currently coming from Chinese companies that have already established an international holding company or listed vehicle in Hong Kong.
In addition to self funding a growing business, in-house banking structures offer a number of other compelling benefits including more efficient management of foreign exchange risk and enhanced returns on surplus cash. The actual cash value of these benefits obviously varies from business to business, but can be very substantial. For example, several Asian corporations supported by J.P. Morgan have quantified savings in the range of US$5-10 million per annum.
While the savings to be made on foreign exchange costs are significant, in most cases they are comfortably exceeded by those arising from self-funding. The key point here is that if an in-house bank maximizes self funding, external loans required by one business unit can be replaced by excess cash generated by another business unit. Hence, the corporation eliminates the interest rate spread between deposits rates on one hand and loans on the other. Furthermore, in the case of many Asian currencies the interest rate spread is often wider than for US dollar.
Apart from reducing funding costs, maximizing self funding through an efficient in-house banking model delivers two other important benefits:
Evolution and Models
These potential benefits are obviously attractive, but the extent to which they are actually realized depends heavily upon how well the in-house bank is implemented. The ideal is obviously for the in-house banking model to facilitate the optimization of working capital across the business, which inevitably necessitates a significant investment of resources and customization to the specific circumstances of each business.
Many successful US and European corporates have taken 10-15 years to arrive at an optimal in-house banking set up, typically in three generic stages along this journey:
For practical reasons, the vast majority of corporates tend to work progressively through these stages. It is essential, however, to plan ahead, so that processes or technology implemented in an earlier stage do not have to be completely replaced in a later one. The ideal situation is to start with a core treasury and ERP system and then add functionality progressively at each stage, rather than having to replace whole systems and processes.
Making it happen in practice
While in-house banking is clearly an attractive proposition, there are a number of specific areas that have a major influence on the success (or otherwise) of an implementation.
Although the journey toward a full in-house banking model may appear straightforward, the devil is very much in the detail. Determining and implementing the best model for a specific corporation requires amassing a great deal of knowledge around detailed business requirements as well as the implications of moving to an in-house banking model from a legal, accounting, tax, regulatory and systems perspective. For the vast majority of treasuries, attempting to acquire this knowledge on their own is just too time consuming to be practicable; most treasuries simply do not have the resources or specialists to cover these issues in any depth.
In practice, this throws the onus on their business partners (and especially their banks) to provide the necessary information to answer key questions. What are the practical steps for a corporation looking at a particular structure? Exactly which functions should be covered by the in-house bank? What are the technology options? What are other major corporations doing in this space and what results are they achieving?
Corporates need to work with a banking partner that is able to share comprehensive practical insight and experience into different treasury and cash management models – not just information on the basic banking products available.
A subset of this knowledge sharing process that is particularly crucial is technology. This applies both in the planning and implementation phases and requires expertise from individuals with long experience of connecting clients to multiple banking channels. While this involves matters such as file formats and encryption, a particularly important element is integration between bank and corporate technology, which requires extensive knowledge of major ERP and treasury systems. In addition, end-to-end workflows that may involve highly sophisticated processes that cut across the environment of both the corporation and the bank have to be accommodated.
Another aspect of technology expertise that in time will become increasingly important for in-house banking is SWIFT. While corporate SWIFT adoption in Asia currently lags the US and Europe, there are signs of a shift among larger market-leading Japanese and Korean corporations. Again, the need for niche expertise is important here so that the corporate client can make an informed choice between SWIFT and bank connectivity, rather than being constrained by their partner's limitations.
Global Banking Platforms
While the ability to share technological expertise is important, the thing that can make or break an in-house banking implementation is the consistency of a banking partner's technology and services. Consider this: an implementation involves centralizing formerly highly fragmented processes. At the simple level of issuing a payment, a corporation might previously have had many business units conducting this at a local level in dozens of locations and across literally hundreds of bank accounts. If the corporate now wants to move to an in-house banking model, they need a bank that can offer a consistent set of payment services across multiple countries and payment types via a single communications channel, whether that be via the SWIFT network directly or the bank's own proprietary host-to-host link.
An in-house bank that leverages a banking partner with a globally consistent bank platform will benefit from efficiencies such as:
The bottom line is that this degree of technology consistency delivers a substantial additional boost to the efficiencies and returns of an in-house bank through lower integration costs, standardized operational processes, and value added services.
Foreign Exchange Management
While the self-funding benefits of an in-house bank tend to attract the greatest attention, there are also appreciable opportunities on the FX side. At a strategic level, an in-house bank enables a corporate to centralize and net-off its FX exposures, reducing the size and complexity of different positions that need to be managed. The in-house bank can for example offset existing/anticipated FX positions/transactions by currency amongst group companies and then transact in the market for just the net enterprise-wide FX value.
There is also an opportunity to achieve further efficiencies by differentiating between strategic hedging activities and transactional FX associated with more straightforward payment activity. In many organizations, there is a temptation in the interests of price transparency to route all FX transactions via an FX desk. However, in the case of high volume/low value payments in foreign currencies, this is actually extremely inefficient and costly once the administrative overhead associated with confirmation and settlement is taken into account.
A far more effective route is to segment FX activity so that only large-scale balance sheet hedging or other major FX transactions are executed by the FX desk, while low value transactions are handled via automated transaction processing. A few banks already cater for this approach by providing an automated FX funding and payment execution service based on a pre-agreed rate card. An in-house bank can now automatically make multiple low value payments in assorted currencies from the main currency account, without incurring the additional costs of going via the FX desk.
With headline savings running into potentially millions of dollars a year and the ability to better support fast growing operations, it is little surprise that Asian corporates are seriously considering in-house banking. Whilst the processes and cost savings can be substantial, building an in-house bank is heavily dependent upon understanding the legal, accounting, tax and regulatory implications — as well as having the necessary systems and banking partner to make it all work.