In-house Banks (IHB)
In-house banking is a form of financing that uses the company's own resources for a range of treasury functions including cash management, foreign exchange and funding. Additionally, they may be able to conduct payments and collections in a range of currencies, both inter-company and externally - on behalf of various entities within a corporate group, replacing external bank providers for corporate group entities across many, though not all, banking functions. Establishing an in-house bank for most companies means having an internal capability to perform the services that are typically provided by banks. This gives the treasury team a greater degree of control over the business.
What is an IHB?
The in-house Bank (IHB) has become an increasingly popular concept with treasurers because it addresses many cash management issues. In summary, IHB centralises both flows and balances by executing all flows through the operating companies’ internal multi-currency current accounts with the designated IHB entity.
IHB is typically used in two different ways; the first refers to using a treasury centre to execute internal loans, deposits, and foreign exchange with operating companies; the second refers to using an IHB entity to execute operating company flows on their behalf such as payables on behalf of (POBO) and receivables on behalf of (ROBO). In this article, we will focus on the latter concept.
How does an IHB work?
The IHB is able to centralise all flows through the designated IHB entity. Payments are executed by the IHB entity from its own bank account on behalf of operating companies, and debited to the operating companies' inter-company current account. Collections are received into the IHB’s bank account on behalf of the operating companies, and credited to the operating companies' inter-company current account.
This arrangement will result in the operating companies holding balances with the IHB entity (via their inter-company current accounts), rather than maintaining balances in bank accounts.
In effect, the IHB replaces bank accounts and acts as the correspondent for the operating companies.
Many corporates are running IHBs wherein its operating companies across multiple countries do not have operating company bank accounts at all. With the IHB arrangement, the group can possibly have just one bank account per currency, streamlining its account management.
Inter-company payments do not require any flows through the banking system – they are simply book transfers between two inter-company current accounts. This method of payment reduces cost and operational risk for the company.
The IHB can further reduce costs by aggregating third party payments. For example, when five operating companies need to pay a common vendor, the IHB will make one payment to the vendor on their behalf. IHBs commonly increase payment aggregation efficiency by making only one payment round per week.
Inhouse Banking Benefits
IHBs can further reduce costs by using lowest cost routing for payments. Lowest cost routing refers to using the lowest cost instrument to execute payments. Most obviously, this means using domestic electronic payments rather than cross-border payments which are typically more expensive. Often, IHB involves moving from cheques to electronic payments (although IHB can also execute electronic cheque initiation if required).
Operationally, IHBs can help the vendors by first alerting the vendor of its incoming payment so that it can get good value for its funds, and secondly, enable the vendor to auto-reconcile the incoming payment so that the vendor achieves higher processing efficiency.\
Typically, the IHB is integrated with the group's ERP system to maximise process efficiency. This arrangement is further optimised when the group has a single-instance ERP. Payments that are approved and due for payment are read automatically from the accounts payable ledger and executed by the IHB on behalf of the operating companies. Collections are reconciled using the IHB’s access to the operating companies accounts receivable ledgers and posted directly by the IHB on behalf of the operating companies. In a similar way, inter-company flows are executed and posted directly to the operating companies inter-company ledgers on their behalf by the IHB.
Cash visibility is no longer an issue because the operating company bank accounts have been replaced by inter-company current accounts. The IHB has direct visibility on the operating company's foreign exchange positions and it can hedge on their behalf according to group foreign exchange policies. Inter-company funding is automated through the inter-company current account, which can have positive (credit) or negative (debit / overdraft) balances. Cash is intrinsically concentrated at the IHB because the group will typically have only one bank account per currency.
However, IHB does not specifically address foreign exchange risk on currency balances. With IHB, all currency balances are in one place. Most IHBs either manage the foreign exchange risk themselves by using foreign exchange swaps and outrights or they can use a single entity multi-currency notional pool to automate the foreign exchange risk management.
How to engage with it?
IHB eliminates the need for operating company bank accounts in most developed countries, but in regulated countries a hybrid approach is often used. In this context, it is important to separate the operational benefits of IHB from its legal form.
In terms of legal form, IHB involves replacing bank accounts with inter-company current accounts and executing payments and collections on behalf of operating companies. This brings many efficiencies and big cost savings, but most IHBs report greater value from IHB’s operational benefits.
The operational benefits of IHB come from centralising payment and collection processing, streamlining foreign exchange risk management, and efficient balance management. In practice, it is common in regulated countries to capture IHB operational benefits by making the IHB operate more like a payment factory, with some netting process features to optimise inter-company payments.
There exists a wide variety of regulatory constraints to operate an IHB. Different countries require different solutions. As an illustration of how IHB can be adapted to country regulatory constraints, consider a country with exchange controls, restricted inter-company lending, and tight regulations. In such a country, IHB can be implemented using the operating companies bank accounts under control of the IHB (via e-banking or SWIFT connectivity).
In some countries, exchange controls mandate the documentation of cross-border flows. In this case, local colleagues will need to provide documentation to banks or regulators, but the payment initiation and processing can still be delegated to the IHB. Most banks will accept electronic payment instructions even if they need to sight the documentation before releasing payments.
It is also worthwhile to note that some regulatory environments prohibit payment netting. In this case, IHB can use gross in, gross out – aggregating payments in one flow into the regulated country and one flow out of the regulated country. Where regulations prohibit payment aggregation, IHBs are obliged to execute each payment flow individually. This arrangement will reduce cost efficiency, but other factors like internal process efficiencies and reduction of operational risk are preserved.
The IHB does all the payment and collection processing, and this delivers significant operational benefits to the operating companies. The IHB can use intercompany loans where permitted or bank loans to manage onshore balances. The IHB can also execute onshore foreign exchange hedges with onshore banks in the name of the operating companies where possible. Operating companies may need to provide supporting documentation to the foreign exchange counterparty banks.
IHB is both a balance management tool and a flow management tool. A ZBA results in an intercompany balance rather than a bank balance.
Of the balance management tools, interest optimisation and notional pooling result in bank balances, whereas intercompany loans, IHB and ZBA result in intercompany balances. This has important tax and regulatory consequences – notably withholding tax on interest.
Comparing IHB to intercompany loans, one can say that IHB is automating intercompany with IHB software (normally an ERP or TMS). Being automated, IHB provides real time balance management, whereas intercompany loans are typically monthly.
Compared with other flow management tools, IHB combines the benefits of payment factory and netting, (IHB is strictly balance netting as opposed to payment netting, but the functional result is similar). IHB normally helps improve reconciliation as well.
Tax is also a consideration in using IHB. From a balance and tax perspective, the result of IHB is intercompany loans (when the operating company has a debit balance in its inter-company current account with the IHB) and intercompany deposits (when the operating company has a credit balance in its intercompany current account with the IHB).
Intercompany loans may attract withholding tax, and even non-deductibility of interest when thin capitalisation debt to equity ratios are breached. DBS Treasury Prism helps treasurers to compute the net after tax benefits of various cash management arrangements.
Some IHBs use multi-entity notional pooling to optimise tax in their IHB balance management. This application somewhat reduces the IHB's operational efficiency because it requires one bank account for each operating company concerned.
It will be apparent from the foregoing that IHB is a big change from traditional decentralised flow and balance management. IHB is normally rolled out across a group in steps by Country or Region, and the implementation process requires proper project management.
Technically, IHB is a high volume, critical processing system that requires strong controls to manage its operational risk. IHBs solutions are available from ERP and TMS vendors, both installed and available on the cloud. IHB can integrate with single-instance ERPs as well as with heterogeneous accounting systems.
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