What Is a Parallel Loan?
A parallel loan is a four-party agreement in which two parent companies in different countries borrow money in their local currencies, then lend that money to the other's local subsidiary.
The purpose of a parallel loan is to avoid borrowing money across country lines with possible restrictions and fees. Each company can certainly go directly to the foreign exchange market (forex) to secure their funds in the proper currency, but they then would face exchange risk.
The first parallel loans were implemented in the 1970s in the United Kingdom in order 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 United Kingdom and a U.K. firm has a subsidiary in India. Each firm's subsidiary needs the equivalent of 10 million British pounds to finance its operations and investments. Rather than each company borrowing in its home currency and then converting the funds into the other currency, the two parent firms enter into a parallel loan agreement.
The Indian company borrows 909,758,269 rupees (the equivalent of 10 million pounds) from a local bank. At the same time, the British company borrows 10 million pounds from its local bank. They each then loan the money to the other's subsidiaries, agreeing on a defined period of time and interest rate (most loans of this type come due within 10 years). At the end of the term of the loans, the money is repaid with interest, and the parent companies repay that money to their home banks. No exchange from one currency to the other was needed and, therefore, neither the two subsidiaries nor their parent firms were exposed to currency risk due to fluctuations in the rupee/pound exchange rate.
Companies might also directly make loans to each other, skipping the use of banks altogether. When the loan term ends, the company repays the loan at the fixed rate agreed upon at the beginning of the loan term, thereby ensuring against currency risk 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.]
Pros and Cons of a Parallel Loan
As mentioned, parallel loans avoid currency risk and possibly legal limitations of cross-border lending. They also allow for lower interest rates as each local company might have an advantage in borrowing on its home turf, as opposed to borrowing as the local subsidiary of a foreign company. The credit rating of the subsidiary may not be as high and as a foreign company, it may be considered as riskier.
In pursuing parallel loans, the biggest problem companies face is finding counterparties with similar funding needs. And even if they do find appropriate partners, the terms and conditions desired by both may not match. Some parties will enlist the services of a broker, but then brokerage fees have to be added to the cost of the financing.
Default risk is also a problem, as a failure by one party to pay back the loan in a timely manner does not release the obligations of the other party. Typically, this risk is offset by another financial agreement, or by a contingency clause covered in the original loan agreement.
Special Considerations for a Parallel Loan
Companies could accomplish the same hedging strategy by trading in the currency markets, either cash or futures. And indeed, as the forex trading has expanded in the last two decades, with digital platforms allowing for trading virtually around the clock, parallel loans have become less common. Still, they can be more convenient, especially if the two parties plan to lend directly to each other.