In-house Banks Come of Age in Latin America

Structure promises financial and strategic transformation

by Martin Barrios, Latin America Large Corporate and Multinationals Sales Executive, Global Transaction Services and Luiz Carlos Couto, Latin America Financial Institutions Sales Executive, Bank of America Merrill Lynch

Corporates with operations around the world are facing numerous challenges today. The geopolitical and economic environment – both regionally and globally – is creating uncertainty and hindering growth, while interest rates remain at record lows. Within Latin America, foreign exchange (FX) volatility has increased, prompting companies to reconsider how they manage FX risk and seek more effective ways to move funds between entities and reduce their exposures.

At the same time, new bank regulations are being introduced – most notably Basel III, which is expected to increase banks’ costs of holding high quality liquid assets required for certain types of deposits under Basel III’s liquidity coverage ratio. As a result, it will change banks’ appetite for certain types of deposits, and impact the rate of return on long-term deposits.

Companies are responding to the challenges they face in a number of ways, and starting to strongly consider the use of in-house banks (IHBs) to improve visibility and control over FX and funding, help mitigate some of the risks presented by economic uncertainty, and improve operational efficiency, enabling better use of internal balances.

How they work

IHB structures are designed to manage 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. With an IHB, each subsidiary’s account is credited or debited according to receivables and payables flows. In addition, IHBs may enable corporates to aggregate surplus cash to take advantage of investment and/or business opportunities.

Interest in in-house banks grows

Historically, Latin America has lagged other regions when it comes to using IHBs. Unlike Europe, for example, which has common standards, such as the Single Euro Payments Area (SEPA) that facilitate in-house banking, Latin America remains an extremely diverse region, with different fiscal structures in each country and widely varying regulations and FX controls.

The region’s largest markets – Mexico and Brazil – both have complex fiscal environments, while Brazil also has rigid FX controls. Similarly, countries such as Chile, Peru and Colombia all present specific challenges (as do smaller markets such as Panama and Costa Rica) while Ecuador, Bolivia and especially Argentina and Venezuela have extremely restrictive regulatory environments.

Although the regulatory and legal hurdles facing companies have changed little in recent years, there is a gradual trend towards liberalisation that has spurred corporates in Latin America to consider in-house banks. Just a few years ago, it might have been hard to overcome the challenges of using an IHB, but with technology advances, including greater use of SWIFT connectivity and advanced ERP systems, IHBs are easier to implement than in the past.

In-house bank benefits

IHBs offer multiple benefits, the importance of which depends on the company’s operational footprint and organisational model. For example, companies in the metals and mining sector are typically capital intensive and therefore benefit from the greater credit lines and flexibility that can be extended to an IHB. In contrast, retail companies, which generate lots of cash, may have little requirement for capital but might have significant trapped cash, due to regulations in the countries where they do business. Extremely large companies might deploy an IHB primarily to improve visibility and control across the organisation.[[[PAGE]]]

Some of the principal drivers of IHB adoption include:

1. Working capital and funding optimisation

An IHB structure facilitates optimisation of working capital by enabling positive and negative balances to offset each other. It, therefore, removes the need to access funding from third parties for subsidiaries short of cash, and compensates those subsidiaries that are long with more attractive yields than might otherwise be available. An IHB requires local entities to set up an offshore account where funds are physically swept or – ideally – notionally pooled to avoid fiscal costs. Vehicles such as inter-company lending can be used to facilitate transfers (and also to streamline trade between separate entities within a corporate group). An IHB structure can take advantage of notional pooling to utilise cash trapped by FX or regulatory restrictions. By increasing scale, an IHB also potentially enables a company to gain access to increased credit lines or more cost-effective funding than might be available at subsidiary level.

2. Improved forecasting and visibility

An IHB requires a robust forecasting model to be effective. Central treasury must impose strict discipline on subsidiaries and other entities to require them to commit to accurate and timely forecasting. Otherwise, the structure risks unnecessary pulling or sending of funds, which increases costs and negates many of the benefits of an IHB. For large companies operating across multiple countries in Latin America, an IHB can act as an effective way to gain oversight of a complex regional structure.

3. Control and compliance

An IHB requires greater central control and is frequently implemented as part of a broader plan to centralise authority and reduce the autonomy of subsidiaries. Typically, following an IHB project, subsidiaries retain responsibility for cash management and forecasting at a local level while most other treasury tasks are centralised. Centralisation facilitates improved compliance through standardisation of processes, increased monitoring and the use of scorecards for key performance indicators, so that problems can be identify and tackled quickly. By internalising receivables and payment flows, balance statements and detailed transactional reports are easily accessible for all accounts, further enhancing compliance and accountability.

4. FX and risk management

Centralisation facilitates improved FX and risk management. By consolidating payments across the corporate group for efficient processing, FX can be aggregated to secure improved rates while reducing the number of trades required overall as inter-company transactions take place within the IHB rather than with an external bank, helping to lower costs. In addition, an IHB makes it easier to introduce risk management structures, including hedging using derivatives, designed to address FX, interest rate and other exposures.

5. Operational efficiency

The standardisation of processes required by an IHB structure ensures that subsidiaries operate in a similar, streamlined way, improving efficiency. Moreover, centralisation of tasks increases volumes and creates an opportunity to lower costs and improve efficiency through automation. Centralisation significantly improves treasury productivity, streamlines bank communication and relationship management through the use of a single point of contact at a bank. By reducing the number of tasks that take place at a country level, staff can be freed up for more valued-added activities.

A model for today’s environment

While the drivers for adoption of an IHB vary for each company, corporates across a wide variety of sectors in Latin America are recognising the financial and strategic logic of moving to such a model. The financial cost savings of an IHB are significant, resulting from the automation of processes and reduction of manual intervention. Depending on the company structure, an IHB can act as either a cost centre or a profit centre. Companies that continue to give local entities considerable autonomy may opt to run an IHB as a cost centre and distribute profits to subsidiaries, helping to gain support for the model. Alternatively, strongly centralised companies can operate an IHB as a profit centre and use profits to incorporate payment factories or shared services centres, add processes to the IHB or invest in new technology.

While the financial benefits of an IHB may be clear, the strategic rationale for an IHB has grown as a result of changes in the economic and regulatory environment. IHBs require centralisation and significant discipline at the subsidiary level. As a result of the structural change required to implement an IHB effectively, companies find an IHB improves their competitiveness. The enhanced diligence and professionalism of treasury functions that results from centralisation enables the company to become more strategic in how funding is used and resources are allocated. Consequently, business decision-making is improved and the company is able to mobilise to take advantage of new opportunities more effectively. Ultimately, by improving visibility and control and increasing efficiency, an IHB can be transformational and provide a foundation for strategic business growth.