Multinational Cash Management in Europe Towards Centralisation and Disintermediation: The Philips Case
Wim Westerman and Henk von Eije, University of Groningen[1]
Correspondence: Wim Westerman, WSN 720, P.O. Box 800, 9700 AV Groningen,
The Netherlands, (+31) 50 363-7088,
Key words:liberalisation, deregulation, euro, European Union, multinationals, cash management, centralisation, disintermediation, conglomerate discounts
Abstract
Liberalisation and deregulation of financial markets, lower currency volatility and the introduction of the euro have reduced transaction and bankruptcy costs for multinationals in Europe. Internal European transfers of cash became easier and cheaper. This enabled the centralisation of cash management activities. The centralisation at headquarters of multinational enterprises also opened the road to financial disintermediation. These trends may have helped to create conglomerate benefits in Europe. The case of the cash management at the Netherlands-based Royal Philips Electronics is used to illustrate these tendencies.
Multinational Cash Management in Europe Towards Centralisation and Disintermediation: The Philips Case
Key words:liberalisation, deregulation, euro, European Union, multinationals, cash management, centralisation, disintermediation, conglomerate discounts
Abstract
Liberalisation and deregulation of financial markets, lower currency volatility and the introduction of the euro have reduced transaction and bankruptcy costs for multinationals in Europe. Internal European transfers of cash became easier and cheaper. This enabled the centralisation of cash management activities. The centralisation at headquarters of multinational enterprises also opened the road to financial disintermediation. These trends may have helped to create conglomerate benefits in Europe. The case of the cash management at the Netherlands-based Royal Philips Electronics is used to illustrate these tendencies.
1. Introduction
As many financial markets were freed about a decade ago, globalisation of cash management became feasible [Sandford, 1994; Holland et. al., 1994; Valenzuela and Eveges, 1995], although many corporate treasuries in Europe still opted for different approaches per country. Recent European legislation, however, increased the efficiency of cross-border financial markets. These developments affected cash management of multinational firms in Europe. Especially in the euro zone[2] centralisation of cash management is feasible nowadays. In-house banks at European corporate headquarters that handle financial transactions become more common, while the resulting disintermediation of cash management reduces the level of cash held within multinationals as well as the costs of cash management.
In this article we discuss the consequences of the changing short-term financial market circumstances for non-financial multinationals. In particular we will concentrate on the consequences for cash management with European multinationals, though also non-European multinationals may benefit, depending on their global cash management system design. We illustrate the trends with the case of Royal Philips Electronics (Philips). Having been founded in The Netherlands in 1891, the high-volume electronics firm has vast European operations, meanwhile being active on all continents. Philips consists of five product divisions that employ about 160.000 people. The corporate turnover in 2002 was €32,305 million, while assets at the end of 2002 amounted to €32.289 million.
We chose Philips as an example of a firm with a progressive global cash management system. In-depth access to the firm’s European cash management system was enabled by studies in co-operation with Philips officers over the years. Articles in newspapers an the like, external publications of the firm, internal documents of various kinds and professional articles on Philips’ cash management system helped to get a grasp of the object of study. In an explorative research such as this one, unstructured contacts help to require insights. Especially on-site visits in April 2002 and October 2003, both followed by regular direct and indirect contacts with various corporate treasury officers, provided much information for this study. However, a checklist was used to assemble missing data via the phone and the e-mail.
In section 2 we describe the background of liberalisation and deregulation of financial markets, the introduction of the euro and the cash management system with Philips. In section 3 we deal with European cash management centralisation. Its consequences are lower levels of cash, lower costs and more central control. Moreover, multinationals like Philips may handle a larger part of corporate financing, resulting into disintermediation. In section 4 we discuss additional advantages for conglomerates such as Philips. Finally, section 5 provides our conclusions and recommendations to this article.
2. Backgrounds
The European Union[3] (EU) has issued many directives on short-term financial markets. In particular the “Europe 1992” program expressed a sense of urgency for Europe to cope with the move in the United States towards free financial markets. Since then, intra-company dividend transfers and royalty payments are tax-free in the EU and bilateral tax treaties have lowered withholding taxes on intra-company interest payments. Banks now also get a “Single Banking License” throughout the EU and financial products authorised in one EU-member state may also be sold in other states. Moreover, the EU has issued legislation to urge cross-border cash transfer tariffs to fall. We can thus conclude that EU liberalisation and deregulation processes make progress [Templeton and Clark, 2001; ECB, 2002; Hartmann, Maddaloni and Manganelli, 2003].
Another major development in Europe was the introduction of the euro. This single currency had its roots in the European Monetary System (EMS) under which foreign exchange controls were gradually lifted. Later developments culminated in the European Monetary Union (EMU) that knitted monetary policies together and resulted in the euro as a single inter-bank and securities currency in 1999 (except for Denmark, Great Britain, and Sweden). In January 2002 all countries involved finally also adopted the euro also as their currency. As a result the foreign exchange (FX) risks on short-term financial markets were reduced, while they completely disappeared in the euro zone [Satillán, Bayle and Thygesen, 2000; Templeton and Clark, 2001; Hartmann, Maddaloni and Manganelli, 2003].
The developments had their impact on Philips. Nowadays, Philips’ Corporate Treasury has six focal areas: corporate finance, financial risk services, the operational hub, cash management, insurance and treasury control. Corporate Finance is mainly involved in financial structuring. Financial Risk Services identifies and measures financial risk exposures. The Operational Hub is the processing centre for treasury transactions. Cash Management focuses on day-to-day management of cash flows. Its aims are to save costs of cash, to lower financial risks and to shorten the balance sheet by focussing on financial logistics and information control [Biekart and Swagerman, 1999]. Insurance is also a part of corporate treasury. Treasury Control handles internal control of financial cash flows. In the remainder of this article, we will mainly deal with the largely interrelated operational hub and cash management activities. The operational hub, a fairly new and still expanding services centre, consists of a “payment factory” for outgoing cash, a narrowly defined in-house bank, a middle office for payments and receipts, as well as a corresponding back office.
As a consequence of the liberalisation and deregulation tendencies, Philips’ transaction costs fell while European intra-firm cash flow transfers gradually became less taxed[4]. Formerly local, small, illiquid and disintegrated money markets have become very large, very liquid and highly integrated, especially in the euro zone. Costs of precautionary cash balances could thus also be brought down considerably. Liberalisation and deregulation, however, did not yet make the use of the banking system cheap. Inefficient payables and collections products such as cheques are still in use, and only a few banks can offer the complete range of short-term financial market products. Moreover, deposits and loans channelled via banks, even in the euro zone, are still small, quite illiquid and locally different. That is why Philips has come up with other solutions to deal with liquidity issues. These solutions will be discussed later.
Philips’ financial hedging instruments costs (in fact corporate financial distress avoidance costs) were brought down too because of the diminishing European currency risks, especially in the euro zone. Though short-term securities euro instruments became available, short-term markets in the euro zone are lagging behind the dollar markets and Philips therefore only maintains commercial paper programs in risky US dollars. Local loans (and local deposits) became very limited with Philips in Europe, as mainly structures offered by a few large banks are in use. Of main importance to Philips are the overnight euro deposits and loans at these banks that bear no FX risks. Nevertheless, a good many cash flows are in British pounds, because the pound is an important international currency. Philips therefore also uses FX hedging instruments, such as forwards, futures, options and swaps, for the British pound as the corporate hedging strategy prevails here. This also counts for quite a number of non-euro (pegged) currencies, as Philips’ activities outside the euro zone expanded over the years.
3. Centralisation and disintermediation
Liberalisation and deregulation as well as declining currency volatility and the introduction of the euro have made centralisation of cash management and disintermediation more feasible.
Centralisation and disintermediation in Europe
A trend towards centralised cash management centres, netting cash flows and pooling cash balances, gets more apparent in Europe [Peters, 1999; Veuger and De Busscher, 2002]. These centres may perform many functions related to working capital too: speeding up collections, prudently managing payments, as well as cautious order of and holding stock. Moreover, the centre can reduce bank charges of debit balances, bank transactions, FX-spreads and other indirect banking costs. Also, current accounts and deposits may be managed with less lending and borrowing requirements, while liquidity shortages and surpluses may be limited by controlling cash levels. Furthermore, bank relations may be managed to facilitate the functions just mentioned. Finally, all corporate finance functions may be located at the centre.
Cash management systems also involve external relationships, in particular with banks, which may become more structured over time [Hagemann, 1991]. However, relationships with major (“house”) banks are loosened as the central cash management function accrues knowledge. The "shopping" from one bank to another grows and only banks with international networks, know-how and information systems skills may be able to provide the products and services needed. A financial centre that finally acts as an in-house bank provides financial products and services by itself, to the detriment of the intermediary function of the banks. Nevertheless, a large bank that can provide the multinational and its subsidiaries with additional services may still have competitive advantages[5] [ECB, 2000; Aliana, 2002].
Centralisation and disintermediation of in particular European cash management functions may offer various advantages[6] [Kenyon et. al., 1992; Brown, 1997; Miles, 1997; Jacqmotte, 2003]. Firstly, cash balances, cash flows and risk exposures may decline and thereby reduce financing costs. Secondly, concentrating financing may give rise to successful interest rate reduction endeavours. Thirdly, the services of banks in transferring cash will be reduced and concomitant costs can drop once more. Fourthly, administration may become easier and less costly. Fifthly, treasury personnel at various levels may be reduced overall. Sixthly, leading and lagging of intra-company cash flows can be traced and controlled more easily. Seventhly, it becomes possible to monitor and reconcile accounts for a large region. Eighthly, higher level of security of cash flows may be attainable. Ninthly, advanced information systems connectivity is enabled. Tenthly, one point of liaison eases internal and external contacts[7].
There are, however, also disadvantages of centralisation and disintermediation of European cash management functions. Foremost, a centralised cash management system goes along with rising regulative, administrative and information costs. It requires a highly formalised and upgraded cash balance control system that may be contrary to the corporate decentralisation philosophy. Local managers may then be less motivated to control cash flows adequately. Moreover, central cash management disciplines may lose sight of local operational needs. In addition, the corporate staff at headquarters may lack capacity to perform cash management functions satisfactorily. Finally, internalising and reorganising cash balances and flows may disturb relationships of subsidiaries with local banks. Observers claim that advantages of centralised European cash management systems have risen, while the disadvantages have fallen over the years [Van Alphen, 1998].
Centralisation and disintermediation tendencies at Philips
Philips central treasury is involved in all of the cash management functions distinguished above: working capital management, bank account management, funds management and bank relations management. This also holds for the cash management function located in Amsterdam (the Netherlands) and Hamburg (Germany). “Hamburg” is a cash management cluster (operational) centre. The corporate focus is currently on working capital management [Wood, 2002]. Philips aims to streamline operations, to free up capital and to cut costs. Inventory management improvements led to annual cost savings of over €600 million in the five years before 2002 and another €2½ billion was planned for the next five years. Philips has become especially keen on tightening its cash conversion cycle that should become zero or even negative in the end. Cash management is mostly concerned with accounts payable management and accounts receivable management as parts of working capital management.
Philips set up an operational hub and a “centre of expertise” in The Netherlands that could handle almost each of its payments. The so-called “payment factory” (PF) acts as an agent on behalf of the entities. It processes the third party payments so that cross-border payments are converted into domestic payments, using both resident and non-resident accounts to enable payments to suppliers in the currencies agreed upon. In the latter case a domestic fee structure applies. Starting in Europe in 1999, about 1,100 entities were connected to the PF in two years. This was done in close co-operation with the Canadian software supplier Alterna Technologies and the US-based Citibank and Bank of America as the two disbursement banks[8]. The next step is to centralise the management of receivables too. The bank account structure created at Citibank may be used as a starting vehicle here. Customers should pay in current functional currencies of Philips in such a way that for example euros are transferred to an account in London. Customers may need to open a euro account in London then.
Philips had about 600 banking relationships in 1997 and an even larger number of bank accounts. After a restructuring process, the firm kept one cash management bank per country, thereby creating overlay structures per currency. The number of active bank accounts was reduced dramatically this way. Philips established a “zero balance” facility with Citibank as the euro was introduced in 1999. The bulk of the European balances are pooled at the bank daily now. The euro cash pool, replacing the eleven[9] distinct currency cash pools in the euro zone countries, is located in London (together with the pound cash pool). Almost all of the external European bank accounts of the entities have been replaced by “paper” bank accounts at the in-house bank (IHB). Intercompany payments are notionally (without actual payments) processed via the PF and settled at the IHB. “In fact, we internalised the old netting service of the banks this way”, Senior Consultant Global Treasury Management Simon Braaksma notes.
Philips uses an account structure consisting of header accounts per currency, an operational account for treasury transactions and national organisation accounts. As a result of a global overlay structure created per currency at Citibank this way, Philips does in principle not even need cash locally for external payments anymore. Moreover, costly international transfers can now be treated as if they are domestic. The IHB and Citibank manage excesses and shortages of funds sophisticatedly in each of the 60 currencies in close cooperation. Idle cash balances denominated in euros do not involve FX risks. However, FX risks on idle non-euro (pound, frank, dollar, etceteras) balances subsist, as notional pooling of the residual currency balances is not cost efficient for Philips. Idle cash balances still bear interest costs. Cash positions stem for example from mismatches between local cash forecasts and actual cash transfers.
Philips is keen to establish a high quality/low cost central (global) cash management function at headquarters. In doing so, the company distracted business from many small banks, both in Europe and elsewhere. Apart from the many activities that have been internalised, the overlay bank has largely taken over the business from the small banks. The financial know-how, the software/EDI services and the international networks of a house bank are still indispensable for Philips. Philips, nevertheless, remains in contact with other banks, in order not to lose sight of market developments and because she is keen on keeping bank costs under control. Philips central cash management function, although having added a true corporate finance orientation next to an in-depth operational focus, is explicitly not run as a real bank. Internal cash management products mirror the external products. The firm does not aim to issue short-term securities by herself, or to become on equal footing with a fully licensed bank.