Pooling, Netting, Credit substitution

& Delegation

FI-III
 Financial system’s basic
technology

Financial system’s basic technology includes

• Delegation
• Credit Substitution
• Pooling
• Netting
 Delegation
• Rather than doing the things oneself, one can
assign some one else to the work on his behalf
• This is being done mostly to reduce costs and
make the operations more efficient.
• Examples: indirect lending
* Consumer lending through dealers / suppliers
* Lenders delegating to underwriter task of
setting up a loan & documentation
* In forward trx, traders delegate to Futures EX.
 Delegation- Reducing costs
• Many costs of a trx. are indivisible eg.
Syndication of loans.
• Delegation allows specialization. The
delegate representing many lenders and
lending more often acquires expertise.
• The delegate can negotiate better terms.
• Revealing information to one delegate
would be more acceptable to the borrower.
Delegation- Fundamental issue

• How the delegate to be trusted?

• Two possible solutions to this are:
1.Bonding: putting up of assets to guarantee
performance
2.Reputation:General estimation in which
someone is held by the public
 Credit Substitution
• Replacement of credit of one party to a transaction with the
(superior) credit of a financial institution.
• In many cases delegation combined with credit substitution.
eg. A bank substitutes its own credit for the credit of the
borrower: depositors lend to the bank rather than to the
ultimate borrower.
• Credit substitution works because the promise of bank,
insurance company or future exchange is more acceptable
than the promise of the ultimate trading partner. This is due
to following two reasons:
* Reputation of FI
* FI’s resources and capabilities in fulfilling the promise.
Delegation & Credit substitution
• Delegation & credit substitution may not
always go together.
• Underwriters don't guarantee the issues
they float : there is a delegation but not
credit substitution.
• When bank money is used in payment, the
bank substitutes its own credit for the
credit of the buyer: there is credit
substitution but no delegation.
 POOLING
• Pooling is combination of assets & liabilities
in ways that reduce risk or improve liquidity.
• Pooling makes the liabilities of an FI (the
promises it makes) safer and more liquid
than its assets (the promises to it). Eg.
pooling makes bank depositors safer and
more liquid than assets.
• One reason pooling works is diversification,
other is netting.
 NETTING
• Netting is offset of one trx. against another, to
reduce the number of trx.s that actually need to
be executed.
• Executing a trx. is costly. Netting lowers costs by
offsetting one trx. against another.
• Example: clearing of checks, by netting bank’s
obligations to one another reduces the need for
physical transfer and thereby reduces costs.
 Netting
• Netting also creates liquidity eg. Bank can
hold relatively illiquid assets because it
can meet withdrawals out of new deposits,
without having to liquidate the underlying
assets. By netting new deposits and
withdrawals, it reduces the need to buy
and sell the underlying assets.
• Secondary markets work in much the
same way.
 Technology of financial systems in
Cash Management
• The role of finance and treasury in sustaining and creating
value is changing substantially.
• The traditional guardianship and risk management roles of
finance and treasury are being continually revised.
• Finance is being asked to become more effective and
efficient in supporting core needs across the enterprise.
• In terms of cash management, this means enabling a
continuous and accurate reporting of the cash position,
providing responsive forecasting data and handling payment
transactions more efficiently, as well as managing and
evaluating financial risks with greater precision.
 Current trends in Cash Management
• Efficient cash management is expected to significantly improve both
the profitability and growth of a company.
• There is an increased convergence of cash, liquidity, risk and trade
management. Cash management is not only related to ensuring
solvency and handling of payment transactions, but also involves
risk management and working capital management alongside the
entire financial supply chain (purchase-to-pay, order-to-cash, etc).
• As a result of globalization and the competitive environment,
companies are seeking more sophisticated cash management
solutions and focusing on standardized processes and
strengthening internal controls, which will lead to a higher degree of
centralization of cash management activities. The ongoing
centralization of corporate cash management activities is no longer
restricted to larger corporate but is also on the agenda of small and
mid-sized companies.
 Trends in Cash Management-
Centralization
• Trend of transition from decentralized to
centralized cash management on a global - or at
least regional – level.
• Enterprise-wide common data definition, a
standard chart of accounts, standard common
processes and globally mandated standards.  
• Integrated finance organization will also have an
impact on organizational cash management
structures (shared service centres, payment
factories, in-house banks, etc), as well as on IT
developments.