Back-to-Back Loan: a Worked Example

The appeal to the bank is plain. A loan secured by cash it holds needs no valuation, no forecast and little monitoring, and can be priced at a thin margin. The appeal to the group is less obvious, because it pays that margin for the use of its own money. The reasons it gives are usually commercial. A parent may want its cash back on demand when the subsidiary refinances, rather than leave it in the subsidiary as a shareholder loan, exposed to the subsidiary's other creditors and often required to stand behind the bank's lending. A new subsidiary may want a borrowing record of its own. A parent abroad may face rules at home that make lending to a foreign subsidiary harder than placing a deposit with a bank.

Each of those is a reason a credit officer can test. The structure itself proves nothing about the borrower's business: the bank is lending on the deposit, and its reading of the borrower matters only if the deposit fails.

Four documents carry the protection. The depositor grants a charge over the deposit, often with a flawed-asset clause that makes the deposit repayable only once the loan is repaid. A set-off agreement lets the bank apply the deposit against the loan. Because the depositor is not the borrower, it usually also guarantees the loan, which gives the bank a claim the deposit then answers. And the depositor's authority to give security for another company's debt, and the benefit it gets from doing so, are checked as they would be for any third-party security.

The detail matters because general set-off does not reach it. In insolvency, set-off in all three markets generally requires mutual debts between the same parties; a deposit owed by the bank to a parent and a loan owed by a subsidiary to the bank are not mutual. The bank's rights rest on the contract it took, and on the deposit being held by the same legal entity that made the loan.

A distributor of commercial kitchen equipment, constructed for this page like every figure in it, is the new subsidiary of a family-owned manufacturer abroad. It borrows US$4.5m for five years to buy a local competitor. The parent places a US$5.0m deposit with the lending bank on a twelve-month term, renewing, and charges it to the bank. The parent's explanation is that the subsidiary will refinance with an ordinary loan within two years, and the parent wants its cash back then. The rates are the example's.

The 111% looks generous. Now read the terms. The deposit runs twelve months against a five-year loan; unless the documents block it from being withdrawn at each renewal, cover can end in year one. Suppose, too, that the parent had offered the deposit in its own currency rather than in dollars, and that currency then fell 12%:

A loan described as fully cash-secured is then partly unsecured, owed by a subsidiary with one year of trading behind it. What protects the bank is a dollar deposit, blocked for the life of the loan, held by the lending entity itself. The US$48,000 a year is the price the group pays for a structure it says it needs, and the explanation that goes with it belongs in the file.

Lending against a deposit placed somewhere else is a known way to move money. Typology reports describe the pattern: funds are deposited in one place, often offshore, and pledged for a loan of similar size somewhere else, and the borrower can then show the money as a bank loan. So the questions a bank asks of the depositor are the same ones it asks of any customer bringing in a large sum, asked with more care: who owns and controls the depositor, through to its beneficial ownership; where the money came from; whether its size fits what is known of the depositor; and whether the reason given for the structure makes sense.

None of these questions assumes wrongdoing, and most back-to-back loans are ordinary group finance. But the credit quality that makes the loan easy to approve is exactly what removes the usual friction, and a file where the bank lent because the deposit made the loan safe, without asking why the deposit was there, has done half its work.

Cash cover is a deposit behind something that may not become a debt at all: a guarantee or letter of credit the bank has issued, usually funded by the customer itself. A back-to-back loan puts the deposit behind money already lent, often from someone other than the borrower. The documents look alike; the questions they raise do not.

In corporate treasury the name means something else: two parent companies, each based in its own country, lend one another matching amounts in their home currencies. It is a close cousin of the parallel loan, in which each lends to the other's local subsidiary. Both grew up as ways round exchange controls, including in the UK in the 1970s, and cross-currency swaps have largely replaced them.

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