Centralized Depositories

Every business needs to hold some cash balances for serving accounts that must be paid and for insuring against unanticipated negative variation from its projected cash flows. The critical issue for an international business is whether from its projected cash flows. The critical issue an international business is whether each foreign subsidiary should hold its own cash balances or whether cash balances should be held at a centralized depository. In general, firms prefer to hold cash balances at a centralized depository for three reasons.
First, by pooling cash reserves centrally, the firm can deposit larger amounts. Cash balances are typically deposited in liquid accounts, such as overnight money market accounts. Because interest rates on such deposited normally increase with the size of the deposit, by pooling cash centrally, the firm should be able to earn a higher interest rate than it would if each subsidiary managed its own cash balances.
Second, if the centralized depository is located in a major financial center it should have access to information about good short term investment opportunities that the typical foreign subsidiary would lack. Also the financial experts at a centralized depository should be able to develop investment skills and know how that manager in the typical foreign subsidiary would lack. Thus, the firm should make better investment decisions if it pools its cash reserves at a centralized depository.
Third, by pooling its cash reserves, the firm can reduce the total size if the cash pool it must in highly liquid accounts, which enables the firm to invest a larger amount of cash reserves in longer-term, less liquid financial instruments that earn a higher interest rate. Each subsidiary maintains a cash balance that includes an amount for dealing with its day-to-day needs plus a precautionary amount for dealing with unanticipated cash demands. The firm’s policy is that the total required cash balance is equal to three standard deviations of the expected day-to-day needs amount. The three standard deviation requirement reflects the firm’s estimate that, in practice, there is a 99.87 percent probability that the subsidiary will have sufficient cash to deal with both day-to-day and unanticipated cash demands. Cash needs are assumed to be normally distributed in each country and independent of each other.(e.g. cash needs in Japan do not affect cash needs in china).
However, a firm ability to establish a centralized that can serve short-term cash needs might be limited by government imposed restrictions on capital flows across borders. Also the transaction costs of moving money into and out of different currencies can limit the advantages of such a system. Despite this, many firms hold at least their subsidiaries precautionary cash reserves at a centralized depository, having each subsidiary hold its own day-to-day needs cash balances. The globalization of the world capital market and general removal of barriers to the free flow of cash across borders are two trends likely to increase the use of centralized depositories.