What is a parallel loan?
A side loan is a four-party arrangement in which two parent companies from different countries borrow money in their local currency and then lend that money to the other’s local branch.
The purpose of a parallel loan is to avoid borrowing money from one country to another with possible restrictions and fees. Every business can certainly go directly to the Change market (forex) to secure their funds in the appropriate currency, but then they would face risk of change.
The first parallel loans were implemented in the 1970s in the UK to bypass taxes that were imposed to make foreign investments more expensive. Nowadays, currency swaps have mostly replaced this strategy, which is similar to a back-to-back loan.
How a parallel loan works
For example, say an Indian company has a subsidiary in the UK and a UK company has a subsidiary in India. Each company’s subsidiary needs the equivalent of £ 10million to finance its operations and investments. Instead of each company borrowing in its original currency and then converting the funds into the other currency, the two parent companies enter into a parallel loan agreement.
The Indian company borrows 909,758,269 rupees (the equivalent of £ 10 million) from a local bank. At the same time, the British company is borrowing £ 10million from its local bank. They then each lend the money to each other’s affiliates, agreeing to a set term and interest rate (most loans of this type mature within 10 years). At the end of the loan term, the money is repaid with interest and the parent companies repay this money to their home bank. No exchange from one currency to another was necessary and therefore neither the two subsidiaries nor their parent companies were exposed to currency risk due to fluctuations in the rupee / pound exchange rate.
Companies can also lend to each other directly, completely avoiding the use of banks. At the end of the loan term, the company repays the loan at the fixed rate agreed upon at the start of the loan term, thereby ensuring risk of change during the term of the loan.
[Important: By having each party borrow funds in its home currency, a parallel loan seeks to avoid exchange risk—an adverse change in exchange rates between two currencies.]
Advantages and disadvantages of a parallel loan
As mentioned, parallel lending avoids the currency risk and possibly the legal limitations of cross-border lending. They also allow for lower interest rates, as each local business might have an advantage in borrowing in its own territory, as opposed to borrowing as a local affiliate of a foreign business. The credit rating of the branch may not be as high and as a foreign company it may be considered more risky.
When looking for parallel loans, the biggest problem companies face is finding counterparties with similar financing needs. And even if they find suitable partners, the terms and conditions desired by the two may not match. Some parties use the services of a broker, but brokerage fees must then be added to the cost of financing.
The risk of default is also an issue, as failure by one party to repay the loan on a timely basis does not release the obligations of the other party. Usually, this risk is offset by another financial agreement or by a conditional clause covered in the original loan agreement.
Special considerations for a parallel loan
Companies could implement the same hedging strategy by trading in currency, cash or future. And indeed, as forex trading has grown over the past two decades, with digital platforms allowing trading virtually around the clock, side lending has become less common. Still, they can be more convenient, especially if both parties plan to lend to each other directly.