Parallel Loan: Definition & Overview

KEY TAKEAWAYS

• A parallel loan is a four-party loan that allows parent companies to borrow multiple currencies.
• Making use of a parallel loan allows businesses to avoid cross-country borrowing and avoid any potential restrictions or fees.
• Parallel loans were first introduced in the United Kingdom in the 1970s as a way to bypass certain taxes.
• This method allows parent companies to protect themselves and their subsidiaries from capital risk.

What Is a Parallel Loan?

A parallel loan is a type of loan that is a four-party agreement. It involves a process where two parent companies that work out of different countries borrow money in their local currencies. They then lend that money to the local subsidiary of the other company. It is otherwise known as a back-to-back loan. 

How Does a Parallel Loan Work?

The main aim of a parallel loan is to avoid borrowing money across international borders. This is with the hope of avoiding possible fees and restrictions. Each separate company could alternatively go to the foreign exchange market (forex trading). This would be in order to secure their funds in the desired currency. But in this case, they would face currency risk. Currency risk, or foreign exchange risk, is the losses that may occur during a financial transaction across international currency markets. This is mostly due to currency fluctuations. 

A Short History of Parallel Loans

Parallel loans were first introduced in the United Kingdom in the 1970s. They were created to bypass taxes that were put in place to make foreign investments a more costly venture for a British company. In the modern business world, currency swaps are the more popular way of doing things. 

An Example of a Parallel Loan

Let’s say that a company based in the United States has a subsidiary in Japan. And a Japanese company has a subsidiary in the United States. Each of the subsidiaries needs the equivalent of $15 million USD. This is to finance their investments and general business operations. 

Each company could borrow the money and then convert it into the other currency. But instead, the two parent companies will enter into a parallel loan agreement. 

The Japanese company would borrow the equivalent of $15 million USD from a local bank. While the American company would borrow $15 million USD from its local bank. They would each then loan the money that they have taken out to the subsidiary of the other company. They would first agree on a certain period of time as well as an interest rate. At the end of the term, the money is repaid with interest and each company repays the respective banks. 

In this case, there was no need for exchange from one currency to the other. And neither the subsidiaries or the parent companies were open to any exchange risk due to fluctuating exchange rates. 

Alternatively, a company may want to make out loans directly to each other. This would be without the use of a bank. So when the loan term comes to an end, each company simply repays the loan at the agreed-upon fixed rate. 

Advantages and Disadvantages of a Parallel Loan

Parallel loans eliminate the potential legal restrictions of cross-border lending as well as currency risk. They also permit cheaper interest rates since local businesses may find it advantageous to borrow on their own soil. This is rather than as the local subsidiary of a multinational corporation. Because it is a foreign corporation, the subsidiary’s credit rating could not be as strong and it might be thought of as a riskier venture.

Finding counterparties with comparable finance requirements is the primary challenge businesses encounter when seeking parallel loans. Even if they do discover a compatible business, the terms and conditions that each party wants might not match up. Some parties will use a broker, but then the cost of the financing must be increased to account for the brokerage fees.

Default risk is another issue. This is because if one party does not repay the loan in a timely manner, the other party is still liable for the debt. This risk is typically mitigated by a different financial arrangement or a contingency provision included in the original loan agreement.

Parallel Loan – Special Considerations

A similar hedging method could be used by businesses through trading in the foreign exchange markets, whether for futures or cash. Parallel loans have actually grown less typical as forex trading has developed over the past 20 years. The rise of digital platforms has enabled almost 24/7 trading. Nevertheless, they can still be more practical, particularly if the two parties want to lend directly to one another.

Summary

Parallel loans are a smart way for companies to get capital to companies without currency risk. They are protecting both themselves, their subsidiaries, as well as the company that they’re dealing with. This is from risks such as exchange rate risk and possible legal limitations that come with cross-border lending. As well as minimize borrowing costs.