The Corporate Bank

Among recent innovations in financial management, the concept of the corporate bank ranks high for a number of prominent companies that have changed their attitude toward finance from basically reactive to decidedly proactive. The corporate bank has altered the status of their finance teams from largely staff to nearly line and has facilitated a new and dynamic approach to managing financial assets, liabilities, and risk — one that actively strives to contribute to overall corporate performance.

But all managers do not understand the concept of the corporate bank. Some are deeply suspicious of active financial management, believing it to be the sure road to massive loss — a belief sustained by publicity about those that have failed. But these accounts, while newsworthy, represent only the rare and preventable exceptions. They should not be allowed to obscure a corporate bank’s purpose and its potential contributions.

What gave rise to the corporate bank? What exactly is it? What are its basic functions? What is its role in financial policy? How does it work with operating divisions? How should its performance be assessed? How is it controlled? What are the tradeoffs and costs in setting it up? These are the main questions I address in this article.

Growth of the Corporate Bank

The concept of the corporate bank has its roots in the late 1960s when the French automobile group, Renault, set up a finance subsidiary in Lausanne, primarily to avoid exchange controls. But the real impetus came with the floating of exchange rates in the early 1970s. Financial exposure began to take on real significance as currencies bobbed up and down unpredictably from one quarter to the next, giving rise to large, unexpected losses. Management, directors, and shareholders started to demand that exposure be better controlled and managed.

Most multinationals responded by organizing so that they could at least identify and forecast exposures on a consolidated basis. Some, like Chrysler, adopted a policy of centrally hedging all their exposures in the forward market. Others took a more decentralized approach and left this decision to each region or subsidiary, while a few saw floating as a golden opportunity to make money.

The opportunists invariably got burned. As for the others, their efforts can be described as quite modest, carried out for the most part by self-taught staff people who devoted only a small amount of time to the job. They generally felt satisfied if they got quotes from two banks at the same time for a modicum of competition.

Sophistication came slowly with experience. The first lesson managers learned was that markets do not wait for meetings to end. Managing exposure was not a part-time job or a job for amateurs. Not being alert to and on top of changing market conditions could result in major loss. Dealing with the wrong banks or at the wrong times was a quick way to give away money.

In the late 1970s and early 1980s, European multinationals like Peugeot and British Petroleum established full-time dealing rooms staffed with professionals. Since then, other European, U.S., and Japanese multinationals — such as ICI, BAT, Unilever, ABB, Fiat, Volkswagen, Daimler-Benz, Thompson, Elf-Aquitaine, Ford, 3M, Dow, SmithKline-Beecham, RJR Nabisco, Sony, Hitachi, and Toyota — have followed suit to varying degrees.

The process is continuing today. Not all multinationals face the same problems, so not all operate in exactly the same way. But their motivation is similar. One major multinational treasurer commented, “We know that our competitors are sophisticated in managing their international treasuries. We cannot afford to put our operations, our margins, and risk management at any disadvantage to them.”

What Is a Corporate Bank?

A corporate bank, unlike a commercial bank, confines its activities within the multinational and never involves the public at large. It does not, therefore, have to conform to the governmental laws and rules for commercial banks. Rather, it is an organizational concept that can take any number of different legal structures.

Many are simply the primary holding company or a major operating company. Some are set up specifically as in-house banks; some are finance companies incorporated under favorable fiscal regimes, such as in Belgium, the Netherlands, or Ireland. Some are formally authorized by banking authorities, as in Switzerland, to operate as near banks.

Each multinational’s fiscal position largely accounts for the diversity of legal structure. Differing tax regimes and group tax positions give rise to a wide range of legal structures. The corporate bank’s essential legal and fiscal requirements are that its operations are conducted from jurisdictions free from foreign exchange and capital controls and prohibitive withholding taxes. There must be cheap access to the Euromarkets.

But apart from this, there need be no dedicated legal entity, no plaque on the wall identifying the bank as such. In fact, for some multinationals, it is just a shorthand way of referring to finance team members who perform services that are so banklike there is no other way to describe them. So, rather than legal status or structure, what defines a corporate bank, sets it apart, and justifies its name is its operational substance: what it does, how it does it, and whom it employs.

Functions of a Corporate Bank

The corporate bank’s functions can be divided broadly into two types of activity: first, to conduct internal, intercompany banking among the group’s companies; and, second, to execute external financial transactions and manage group liabilities with the financial community. While not all corporate banks perform these two types of activity in exactly the same detail or in precisely the same way, there are some more or less common practices.

Internal Banking

Internal banking involves four activities. The first is to consolidate the cash and debt of operating subsidiaries. Subsidiaries put excess cash on deposit with the bank; subsidiaries requiring funds borrow from the bank. This pooling of cash eliminates borrowing by one entity while the other has excess cash. Taking into account that local banks charge margins of anywhere from 1/2 percent to 3 percent, companies can achieve substantial interest savings by employing excess cash to reduce borrowing.

The second internal banking activity is to consolidate intercompany accounts. The amount owed by one subsidiary to another is debited or credited on its account with the bank. Only the net amount is ever transferred and only when it is needed. Netting reduces the number and amount of intercompany cash transfers, eliminating unnecessary currency transactions, which would have cost from 1/16 percent to 1/8 percent in dealing spreads and bank charges.

Major multinationals have used the technique of netting intercompany accounts for many years. Companies pick a day each month on which to do the accounting and then purchase and transfer the currency to settle the net amounts owed. The corporate bank adds flexibility to this. By using the intercompany accounts at the bank, settlement can be made on the bank’s books, eliminating the need to make an immediate cash transfer to a cash-rich company or having to buy currency on a bad day in the markets.

The third activity is to take currency exposures on board via internal contracts with the operating units. The internal contract is no different legally from one with a commercial bank. The corporate bank assumes the gross risk of each unit. Then, on its own books, it can offset one company’s positive exposure with the negative of another. This reduces the amount of net group exposure that has to be hedged and prevents one unit hedging in one direction while another hedges in the opposite, saving from 1/8 percent to 3/16 percent (depending on the currency and the months forward) of the amount of excess hedging that is eliminated.

For years, many multinationals have consolidated subsidiaries’ exposures and hedged only the net amount. While this serves to protect the group’s consolidated accounts, each subsidiary is left with the risk on its own legal and fiscal books. Internal contracts with the bank correct this anomaly, preventing embarrassing local losses, which can lead to serious disputes with minority interests, outside local directors, and the local fiscal authorities.

The bank’s fourth activity is to act as the clearing center for foreign receipts to and foreign payments from the operating companies. The company instructs foreign customers to send checks or remit to the bank’s Euro accounts, and pays foreign suppliers from these accounts. The bank debits and credits receipts and payments to each company in the group. This function can considerably speed up foreign collections (which can take days or weeks clearing some national banking systems) and eliminates each company’s need to buy or sell uneconomical amounts of currency for every small payment and receipt. Savings are approximately 1 percent or more, depending on the number and size of checks and transfers.

I should emphasize that these internal banking functions involve no additional risk to the group. They offer sure savings through the reduction of bank fees, spreads, and charges. The percentages might look small, but when applied to the millions that are often involved, the savings can be substantial.

The only problem some companies have encountered is that local managers perceive some loss of responsibility. It is true that they no longer have the same extensive contacts with the financial community. But they still retain, through the use of arm’s length internal contracts and dealings with the bank, all the authority they ever had to improve their operating performance with good financial management.

External Finance

Internal banking is the administrative function of the corporate bank, a necessary prelude to what follows. The more substantive and difficult managerial functions are: (1) managing the consolidated net liquidity position after pooling and (2) managing the consolidated net currency positions after netting and internal hedging. In performing these, the bank is in a position to make a unique contribution.

The bank enjoys the multinational’s full economies of scale, unavailable to subsidiaries on their own. Size alone is important in obtaining the best rates and services from the financial community. But professional financial talent is the key to exploiting this potential.

During the past decade, there has been a quantum leap in the number of possible financial instruments and techniques to manage a corporation’s financial position. The use of swaps, options, forwards, and futures in endless combinations and permutations can completely change the profile of currency and interest rate risk. At the same time, information systems such as Reuters and Telerate that make subscribers instantaneously aware of all movements in rates and quotes have made markets transparent.

Commercial banks have hired and trained dealers specifically for doing business with corporations. This has resulted in a lessening dependence on established banking relationships for information and transactions and a growing premium on knowing competitive market conditions and being able to seize opportunities as they occur in the financial marketplace. Knowing when and how to use these opportunities effectively requires a professional finance team. The corporate bank is the organizational unit for recruiting, employing, and concentrating this talent.

Liability Management.

A corporate bank also manages market-based corporate liabilities. It runs the Euro-commercial paper program: it coordinates the dealer group, times the issuing amounts, and selects the best maturities and currencies. In the most successful Euro-note programs, the issuer tailors the notes to the investor’s requirements. Notes may be issued in unwanted currencies and then swapped into needed ones. Maturities may be slightly shorter or longer than required, and the interest exposure covered by a future. The corporate bank actively manages the liability side of the corporate balance sheet.

Financial Policy

Companies have adopted new attitudes toward managing financial risk and new approaches to conducting financial transactions. The motivating force is not a desire to speculate for profit, but rather a realization that financial risks, like it or not, are already inherent in the business. The only question is whether these risks are to be managed well, poorly, or not at all.

The corporate bank has become the instrument for implementing the new attitudes and approaches. The intention is not to make the bank into a financial institution, replacing or competing with the commercial banks. The goal is to achieve corporate financial excellence. In the new financial environment, finance has had to shed its traditional staff image and take on a culture more akin to line. Even if most groups reject making the bank into a profit center, the overall mandate is clear: the bank must earn its keep by actively managing the corporation’s financial assets, liabilities, and risks.

Traditional versus Managerial Attitudes toward Risk

The traditional attitude toward currency risk is to cover all risk immediately in the forward market. But experience has shown this to be unnecessarily and prohibitively expensive for many companies, the cost far outweighing any possible risk. For example, the automatic selling forward of marks and yen can result in opportunity costs in excess of 5 percent.

The managerial attitude toward currency risk is to hedge it selectively — accept an open position from time to time, leave it temporarily uncovered (i.e., unhedged), and actively manage it. For some, active management means trading a position by constantly monitoring the markets, covering the position in the event of adverse change, and then uncovering (i.e., reestablishing) the position should conditions again become acceptable. Other companies adopt percentage coverage techniques depending on their assessment of the risk. Some effect coverage by weighted average techniques. Some gear their coverage to their product-profit margins. Many use derivatives such as options to limit the downside risk.

Of course, all of this runs counter to a theory of market efficiency that suggests the long-term results cannot be improved by market timing. It is certainly true that selective hedging will not be successful all the time. But the fact that bank dealing rooms are returning consistent and sometimes record profits should make one pause. Dealers seem to be thriving despite theory. Not surprisingly, theoretical support for selective hedging is now beginning to emerge. There are imperfections, and these can provide opportunities to profit from timing.

The corporate bank can play a vital role in the selective-hedging, decision-making process. Economic and technical market forecasts need to be tempered by what market makers are thinking and doing. Market sentiment is at times the strongest force and the primary explanation of market behavior, and those who do not take this into account are sure to be left out. The corporate bank is the group’s in-house source of independent, responsible, and unbiased market advice.

Once a decision is made, the fact that the bank is there to manage the position can make all the difference. Those who have embarked on a program of selective hedging without providing the means to manage it have learned to their regret that it is not a job for the inexperienced or part-time staff. A bad experience has led some to conclude that no risk is worth taking. What they have lost through this inflexible policy could have paid for a corporate bank.

Benefits and Risks

The potential benefits and risks of a selective hedging program depend on the currency profile of each multinational and its tolerance for risk. It is possible to get an idea of this — the potential extremes of currency gains and losses — by looking at past years’ exposures and then calculating what would have been the result of hedging at the best and worst moments. This can then be refined by eliminating the exposures that would have exceeded tolerance levels and be immediately hedged. The results then have to be compared with the group’s alternative policy, either total hedging or no hedging, to get the maximum marginal gain or loss from selective hedging.

What would actually have been achievable within these extremes depends on the team’s professionalism and can be judged only over time from experience. Inexperienced and part-time staff would almost certainly lose money. A full-time team of two with a minimum of five years corporate treasury experience might achieve 2 percent to 3 percent of the maximum. A team of three or more professional dealers might achieve from 5 percent to 10 percent.

Traditional versus Transactional Approach

Many corporate banks have hired professional dealers and adopted a dealing mentality toward financial transactions. Dealing transforms the traditional, relationship-oriented approach of doing business to a financial market-driven approach. The bank does not ignore the group’s relationship banks. On the contrary, most corporate banks have direct telephone links and extensive contacts with most of the commercial banks’ dealing rooms. But business will be driven by the rates and advice the dealing rooms provide rather than any other criteria.

For example, consider money market operations. The traditional approach is to preselect the currency and duration before asking for quotes. The transactional approach is to place or take funds from the most attractive, approved source, using swaps and adjusting duration if this gives a better rate under prevailing market conditions. This should improve average rates by 1/16 percent to 1/4 percent.

In foreign exchange, the traditional approach is to call a preselected list of banks in rotation, two or three at a time, taking the most competitive bid. The transactional approach is to continually monitor the market and to deal at the correct time with whatever approved bank is offering the best rate. This can improve average results by 1/32 percent to 1/8 percent, depending on the skill of the dealers, for reasons I shall explain more fully later on.

The Case of Peugeot S.A.

Peugeot is the largest publicly held company in France, with annual sales, mostly in the automotive sector, in excess of $25 billion. Its French plants account for about 80 percent of production. Approximately half of this is shipped to other Common Market countries, giving rise to more than $1 billion in currency transactions per month, mostly selling other European currencies to buy the French franc. The size of this steady commercial (as opposed to volatile interbank) activity makes Peugeot an important factor in the European market.

Peugeot had traditionally left currency management to its various operating divisions, where accounting staff would call local banks, as required, for spot purchases of francs. There was no systematic attempt to anticipate needs or try to manage the risk. Since the staff almost always bought francs, the banks were left in little doubt as to which side of the market they should quote. Sometimes, due to other staff demands, there was no time to ask for competitive quotes.

In 1980, Peugeot decided to change all this by establishing a corporate bank in Geneva. It chose Switzerland because, at the time, France was still operating tight exchange controls. Under Swiss law, Peugeot’s operation was granted the status of a near bank.

The first thing Peugeot did was hire a professional dealing staff from some of the major French banks. It then set up a full-scale dealing room. It made the Geneva bank responsible for all of Peugeot’s foreign exchange activity. The foreign currency receipts from the sales branches outside France were remitted to the bank, which bought francs for the accounts of the French operating divisions and then remitted them to France.

The bank’s dealers had modest dealing positions, which served to keep them in the market every day. Continual dealing was essential so they would be accepted by commercial bank dealers as more than just another corporate client. It allowed them to keep constantly abreast of market conditions, and it meant they would be on both sides of the market, not buying only francs. The banks were kept guessing; they had to sharpen their quotes because they could never be sure if the Peugeot bank was dealing on its own account or for the account of one of the operating companies.

In one stroke, Peugeot was actively managing its risk, obtaining the best rates with no cost to the group. It now had a professional dealing organization to manage its risk on a full-time basis. Moreover, the dealing team turned a profit on its activity, paying for itself and its overhead.

The Corporate Bank and Accountability

The corporate bank is, as a matter of policy for many multinationals, the bank of first, last, and only resort for all the operating companies. The companies are allowed to have working cash balances and working overdrafts with local banks and to borrow local funds if capital controls prevent the bank from doing so. But apart from these exceptions, they deposit all their excess cash with and borrow all their short-term funds from the corporate bank.

To assure this does not diminish the operating company’s incentive to manage its own operating cash flow, depositing with and borrowing from the bank are done at arm’s length rates. An objective, easily verifiable rate is chosen, such as the bid or asked rate for the agreed term shown on the Reuters screen at noon on the day of the deal. For borrowing, a standard bank margin of, say, 1/2 percent is added. Operating companies are thus no worse off in interest income from using the bank. In fact, they may be better off in interest expense since the corporate bank, unlike a commercial bank, generally ignores their individual credit standing. They are fully accountable as they get the full benefit in interest income or pay the full penalty in interest expense on the cash flow consequences of their operating decisions.

The bank, on the other hand, is fully accountable for how well it manages the net corporate cash or debt in the financial markets. It has to pay an arm’s length rate for its deposits and it receives an arm’s length rate on its loans. Through the standard banking margin, it enjoys some of the benefits of internal banking while the rest is passed on to the borrowing companies. How well it can manage its net liquidity book, place its net surplus funds, and source its net requirements in the market determines its marginal contribution to the multinational.

Spot or forward currency transactions, options, and futures hedging are handled in the same way. The operating companies first enter into arm’s length internal contracts with the bank at objective, verifiable rates. The bank then takes these into its position, manages them, eventually hedging them in the external market. The difference between the rates it offers the companies and rates it achieves in the market determines its marginal contribution.

The use of arm’s length rates for internal dealing and contracts clearly sorts out the issue of accountability. Operating companies receive equal, if not better, treatment than they would from their commercial banks. Their results are not influenced by the decisions of the bank. And the bank is solely and fully accountable for how it manages its risks in the financial markets.

Responsibilities for Risk Management

Most companies have adopted a formal, structured approach to risk management that starts with a corporate risk committee, charged with overall responsibility within the board’s mandate. Members of the committee are generally senior finance and operating managers.

The committee’s first task is to adopt a clear definition of the exposure base. This can range from current risks on booked receivables, payables, and so on, to future risks from planned sales, purchases, and so on. It can include long-term balance sheet items like financial assets and debt and budgeted profit. The horizon can be anywhere from only a few months to the end of the budget year or longer.

No matter how broad or refined the definition, there are bound to be arbitrary cutoffs or exclusions that will have to be reviewed and changed from time to time. But once defined, and until changed, it is important that this base constitute the total risk that the risk committee controls, the operating units consider, and the bank manages. Exposures outside the agreed base should be ignored, since hedging nonexistent or unrecognized exposure is a form of speculation that will eventually lead to an unanticipated loss.

The committee must then decide what level of risk it is prepared to accept for selective hedging. At first, the committee will probably adopt a very risk-averse attitude because financial risk taking is not the group’s main business. Over time, as the bank improves its ability to manage risk, the committee may feel comfortable in raising its tolerance levels.

Ultimately, the committee should base the approved limits on a judgment of what is prudent for the group and how much confidence it has in the bank. Exposure beyond this level will be subject to mandatory hedging, with the operating companies entering into internal contracts with the bank and with the bank immediately hedging them in the external market.

Groups differ in assigning responsibility for selective hedging. Some require the operating companies to automatically hedge all their exposures and play no further role, giving the bank full responsibility. Others give each operating company discretion over its own risk management. The discretionary approach is consistent with decentralized operating authority. Since financial risk is an inherent aspect of their business, it can be argued that operating managers should take an active role in managing it. They are then more likely to make operating decisions (such as pricing and sourcing) that lessen the effects of risk on their results. Moreover, since the cost of hedging will be accounted for in their results, they may well feel they should have the authority over how it is conducted.

In practice, operating managers are almost always biased toward hedging any risk that may unpredictably affect the achievement of their budgets. Just occasionally, however, some managers may want to leave a position unhedged, hoping that favorable currency movements will make up for a shortfall in operating results. This gamble could affect not only their results, but also the group’s consolidated accounts.

To preclude this, the multinational can give the bank the authority to hedge independently of what the operating managers do. The bank takes into account all un-hedged net risks, whether these risks are on its own books or those of the operating companies. Should the bank decide, because of market conditions, that the operating managers are mistaken in their decision not to hedge internally, the bank can hedge on its own books.

The Case of RJR Nabisco

RJR first established its corporate bank in the early 1980s. It was formally incorporated in Geneva as an ordinary société anonyme, but its dealing operations were located in London. This meant it received the best fiscal treatment, while, at the same time, it was able to recruit its dealing staff from the much broader London market.

It performed all the internal banking functions with the exception of intercompany netting, there being no significant cross-border intercompany flows. It had a four-person dealing team that dealt actively in volumes of about $1 billion per month. The team was permitted overnight limits of $20 million per currency and daily limits triple that amount. At the end of each day, the positions were evaluated at closing market prices to determine the unrealized profit and loss on each overnight position. Dealing profits and internal banking activities paid for the staff and overhead and provided an adequate return on the capital employed.

At the time the bank was organized, RJR measured the performance of the operating units before financial costs. It took all interest income and expense and foreign exchange gains and losses and consolidated them centrally. In this way, it was felt the bank could make decisions strictly on financial grounds, independent of any influence from the operating divisions.

But there was a major problem. The potential impact of currency movements on future, not yet recorded, sales and purchases would show up in future operating margins rather than in accounting gains and losses. These would hit division performance, and, as a result, divisions were vitally interested in whether their future sales and purchases were being hedged. They normally wanted to protect their budgeted margins by hedging. The bank, on the other hand, refused to oblige when, in its view, there was no real financial risk. The result was a great deal of acrimony between the bank and the operating staff.

Only by introducing internal contracts and giving the operating divisions discretionary authority over the selective hedging decision, was this conflict finally resolved. What happened next was not anticipated. The divisions came to see the bank not as an adversary, but as their closest and most important adviser on foreign exchange management. Conflict turned into partnership, as both were now fully responsible and accountable for their respective spheres of authority.

Measuring and Assessing Performance

Measuring the performance of the bank is straightforward financial accounting. There is no need for supplemental management accounts. Internal arm’s length transactions and contracts with subsidiaries give the bank financial assets, liabilities, and positions. How well it then manages these in the external financial markets determines its gross margin. This, after its expenses, determines its accounting profit or loss and its return on capital.

If the bank were totally independent, like a commercial bank, its income statement would be sufficient to assess its performance. But corporate banks are rarely set up to make a profit per se. Rather, they exist to implement corporate policy. The bias is toward risk minimization, and the level of permitted risks and the range of permitted activities are likely to be more constrained than at a commercial bank. For instance, the bank will probably not be allowed to speculate purely in currencies. At times, the corporate risk committee will dictate action for strictly corporate purposes. Internal contracts cannot be refused even when offered in a bad market. Thus the bank is not in a position to control and shape its activities to best suit its financial results.

Management has to account for this when assessing the bank’s performance. It is no different from other parts of the business. Performance evaluation is always more complex than simply going straight to the bottom line. In any event, management should avoid setting performance objectives too high or giving uncapped bonuses pegged directly to bank profits. Bank staff would then have a powerful incentive to encourage or recommend the assumption of imprudent risks that would undermine the group’s basic risk policies.

Controlling a Corporate Bank

Clear and simple controls are the prerequisite for a proactive approach to finance. Board-approved management controls set out objectives, operating policies, authorized activities, and permitted limits. These must provide for regular measurement and reporting. Next, organizational controls establish procedures for conducting, confirming, and reconciling transactions and provide for the separation of duties within the bank and protection for its systems. These must be subject to periodic internal and external audits.

Control starts with a list of approved currencies, financial instruments, institutions, and exchanges. Its purpose is to preclude speculating in currencies with no commercial justification, doing business with unfamiliar or inappropriate financial institutions and exchanges, or dealing in financial instruments that have not been fully studied and assessed.

The approved list should include daily and overnight limits for each approved currency and instrument and maximum limits for each institution and exchange. The daily limits must be high enough to permit the orderly hedging of internal contracts during the day. Overnight limits must be consistent with the selective hedging program. Institutional limits require a balanced judgment of the risk, as reflected in credit ratings, and the bank’s operational requirements. Specific approvals are required for credit risks associated with swaps.

Board approval notwithstanding, the bank’s management should not be complacent just because it is within its limits. A bank that consistently offers a better rate is often a tip-off to trouble ahead. Bankers will sometimes stop dealing with an institution before the agencies put it on a credit watch. The bank is responsible for being alert to such changes and not dealing with these institutions even though they may be on the approved list.

Operational controls that assure early and certain detection stop unauthorized risks. The first line of defense is the bank’s management and its respect and support for established policies and limits. The second is restrictive banking mandates that limit what can and should be done and by whom. The third is dealing only with known, reputable institutions whose staffs will report questionable activity. The fourth is a clear separation of duties between the dealing room and the back office.

There has to be an inviolate rule that the dealer record all transactions immediately and report to the back office. Fortunately, there are now networked PC or minicomputer systems so the dealer can enter deals directly. These deals are then processed to update positions and flag over-limit situations. Using external digital feeds, the profit or loss on positions can be immediately evaluated. The information is fed into the bank’s automated accounting and control system.

To catch deals that are either not recorded or improperly recorded, counterparty banks are instructed to confirm all deals directly to the bank’s back office where they are then reconciled against what is already in the system. The bank can make settlement payments only after this has taken place. Dealers should be permitted to deal only while at the bank. Most banks now tape dealers’ phone conversations so they have a record in case there are any misunderstandings about verbal deals. And most modern telephone exchanges record the number to which calls have been made. Both can be used in extreme cases to help monitor dealing activity.

It is imperative that managers who are not involved in the decision making and do not report to those who are have the ultimate responsibility for controlling the dealing activity. They must have the authority and will to eliminate positions and cut losses regardless of the consequences to those who have made the decisions. Managers have to report and remove immediately anyone who transgresses from established controls.

The major auditing firms know how to establish and maintain safe controls. So long as these are clearly set and adhered to, unauthorized activity can be prevented. The fact that the vast majority of corporate banks and commercial bank dealing rooms continue to function well is evidence that proper controls can be made to work.

Corporate Dealing

As the cost of even minimum dealing capability will more than double the cost of operating a bank, how and why dealing works need to be more fully explained. Those unfamiliar with corporate dealing may regard it as the prerogative of the banks, or worse, something akin to gambling. However, there is a distinction between corporate dealing and bank dealing. The purpose of corporate dealing is not to speculate or take dealing positions. Corporate dealers do not make two-way markets, as bank dealers do.

So why have corporate dealers? Wouldn’t it be cheaper and just as effective to pick up the telephone, call two or more banks, and take the most competitive quote? Cheaper, yes. But just as effective, no — unless you know exactly when to call and exactly whom to call. That requires a continual market presence, knowing what is happening in the market, and who is the most active. When an opportunity arises, the deal has to be made immediately. This is precisely the expertise the corporate dealer offers and the capability a dealing room with direct lines provides.

There is no hidden mystique to dealing. It is like any other skill learned by practice and experience. Dealers develop a feel for and knowledge of the market, so they are better able to detect changes in market mood and direction. They are more likely to be aware when central banks or unusually large orders are temporarily influencing quotes. They can better time when a deal should be done and better execute when the timing is right. Not everything is shown on the Reuters or Telerate screens. Those who want to either increase or decrease a position do not advertise their intentions. By being in continual contact with bank dealers, corporate dealers unearth this information. It sometimes allows them to get in the middle between the buy and sell or deal on the other side.

The benefits of execution and timing from corporate dealing are particularly important in the forward markets where spreads are wider and the markets thinner and in nervous markets when spreads can widen by a factor of two or three. At such times, it may be difficult to find a quote. This is just when the expertise of a corporate dealer is required to hedge at a reasonable rate.

When to Develop a Corporate Bank

The decision to set up a corporate bank depends on the nature and size of the multinational’s activities and whether these offer sufficient potential benefits to justify the cost of a bank over other possible alternatives. Commercial banks are now able to pool the corporation’s cash across borders daily. A multinational can set up an account at a commercial bank so subsidiaries can lend to or borrow from each other automatically at arm’s length rates. The commercial banks also offer money market funds for investing net surplus cash and multicurrency overdraft facilities for borrowing net requirements. The company can establish procedures in advance so there is little need to be involved on the spot. The big disadvantage is being tied to one particular bank, which may negatively affect relationships with the other banks that will miss out on fee-generating business. But this approach can prove quite cost-effective for multinationals with gross liquidity positions of less than $50 million.

The issue of currency and risk management is more complex. Some banks and financial boutiques will manage the group’s risks for a fee based on a percentage of any net gains they can achieve over an agreed benchmark, although they will not contribute toward net losses. Their major drawback is that their profit orientation is seldom in accord with a multinational’s approach to risk. Moreover, using an outside service to manage risk could prove difficult to explain if something goes wrong.

When the risks are small — for instance, from transactions of $25 million or less a month — it is best to avoid the issue altogether and adopt a policy of covering all exposures in the forward market. There is no need to be involved daily as this can be done well in advance on forecasted flows. There will certainly be opportunity costs, as well as real costs, when actuals differ from forecasts, but they are unlikely to be large enough to justify developing a bank.

Only when the multinational’s currency activity reaches $50 million a month is there likely to be sufficient volume and opportunity to support a small-scale in-house bank. It could start with a team of two treasury professionals with support staff and systems, costing $400,000 a year. This team could further justify its cost by bringing in house all the internal banking functions and the management of net liquidity. The group would now be large enough to benefit from doing business directly with its major relationship banks, particularly if these are providing credit facilities.

For European groups, location is rarely a major issue. Their banks have simply evolved from their headquarters finance staff. They usually operate from the holding company, although a few have set up specific legal entities for control or in other countries for fiscal reasons. North American groups, however, face the question of whether to establish a bank in Europe. The advantages of being in one time zone are very compelling, whether for efficiency in the internal banking functions or for external finance. London is the biggest currency market in the world, and not being there makes it harder to evaluate European markets and know what European institutions are doing. But that does not preclude the bank locating in North America and doing business with London throughout the day, assuming the staff comes in early enough. Of course, the farther west the bank is, the more difficult this becomes.

When currency activity reaches $200 million a month, it is time to consider hiring professional dealers and setting up a dealing room to give the bank full transactional capability. A dealing room can be as simple as a few tables with a number of telephones and an information service. Or it can be so complex that it requires architects and engineers to design the raised flooring for cables, acoustical ceiling, standby power, protection and security systems, specially designed dealer desks, leased direct lines to bank dealing rooms, multiple interactive information services, and voice-recording systems. While dealers can function in a simple room, most banks are able to justify the cost of adding more sophisticated capabilities for greater efficiency, security, and control.

When the group’s activity starts to approach $500 million a month and is global in scope, it is time to open up a branch of the bank in another time zone, such as the Far East. Some multinationals can justify having a presence in all the major centers, London, New York, and Tokyo. Positions are traded in each and then passed from one member to another for truly global, round-the-clock capability, akin to the major international banks.

Conclusion

The corporate bank has become a permanent feature of corporate finance. With the fall of internal trade barriers, cross-border shipments will increase, placing greater emphasis on the management of cross-border cash flows and foreign exchange. As the last of the controls are dismantled, all national financial markets will open to capital transfers, borrowing, and investment. The corp bank is ideally suited for this new environment.

The much discussed European Monetary Union will naturally simplify cash and currency management when (and if) a single currency is adopted for the twelve core countries of Europe. But this is now unlikely to happen before the end of the decade, at the earliest. By the time it does, trade with Central and Eastern Europe and the former Soviet Union will have increased, not to mention with the rest of the world.

The number of sophisticated techniques for managing assets, liabilities, and risk will also expand. So, while the bank’s exact duties and emphasis may change somewhat over time, the basic need is sure to continue. Its mission is timeless — employing active financial management to contribute to the multinational’s overall performance. The opportunities are there for those who choose to pursue them.