What is a Parallel Loan
A parallel loan is a four-party agreement where two parent companies in different countries borrow money in their local currencies and then lend that money to the other's local subsidiary. Currency swaps mostly replaced this strategy.
Similar to a back-to-back loan.
BREAKING DOWN Parallel Loan
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 to secure their funds in the proper currency but they would face exchange risk.
For example, 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 their operations and investments. Rather than each parent company borrowing in their home currency and converting into the other currency, they enter into a parallel loan agreement.
The Indian company borrows the equivalent of $10 million pounds in Indian rupees from its 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 for a defined period of time and interest rate. 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 there was no currency 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.
Benefits and Risks
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 over 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.
The biggest risk 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 their fees add to the cost of the funding.
Default risk is also a problem as 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.