Cash Cover: a Worked Example

A performance bond, an advance payment guarantee or a standby credit costs the bank nothing until it is called. When it is called, the bank must pay, often on demand and without arguing about the underlying contract, and then recover the money from its customer under the counter-indemnity the customer signed. That recovery is an ordinary unsecured claim unless something stands behind it.

For most customers, the bank's general security and its assessment of the business are enough. Cash cover is for the cases where they are not: a customer whose credit the bank would not take on, a one-off guarantee for a customer with no facilities, a guarantee that will outlast the loans it was issued beside, and, often, a customer moving its borrowing to another bank while guarantees the old bank issued are still live. The old bank can release its security, but it cannot cancel the guarantees before they expire unless their beneficiaries release them.

A deposit is protection only if three things are true, and each is a matter of drafting. The money must be blocked: held in an account the customer cannot withdraw from, often under a flawed-asset clause that makes the deposit repayable only once the exposure has ended. The bank must be able to use it: by a charge over the deposit, a contractual right of set-off, or both. And it must be enough: in the currency of the exposure, or with a margin for the exchange rate, and for as long as the exposure lasts.

How the bank protects its position against other creditors depends on the market. In Australia, a bank that takes security over an account held with itself perfects that security by control under the Personal Property Securities Act, without registering. New Zealand's Act has no control rule: a security interest in the deposit is perfected by registering a financing statement, and a purely contractual right of set-off sits outside the Act. In the UK, a company's charge over a deposit is registrable at Companies House unless it qualifies as a security financial collateral arrangement, which turns on the bank's control of the account. In the Basel capital standards, cash on deposit with the lending bank is eligible collateral that can reduce the capital an exposure needs, only if the documents are legally enforceable, and under the comprehensive approach with an 8% haircut where collateral and exposure are in different currencies. National rules apply it with their own choices.

A lift installation contractor, constructed for this page like every figure in it, refinances its term loan and overdraft to a new bank. Its old bank has three guarantees outstanding for it: a US$1.2m performance bond to a hospital builder that expires in nine months, a US$0.5m retention bond that expires in twenty months, and an advance payment guarantee to an overseas buyer, denominated in euro and worth US$800,000 at today's rate. The old bank agrees to release its general security if the guarantees are cash-covered, at 100% for the dollar bonds and 110% for the euro guarantee. The ratios are the example's, not a market norm.

Nine months later the performance bond expires with no demand made, and the old bank releases US$1.2m back to the contractor. Then the contractor delivers late, and the overseas buyer calls the advance payment guarantee in full. The euro has risen 7% against the dollar since the cover was set.

The margin did its job. Without it the old bank would hold an unsecured claim of US$56,000 against a customer that banks elsewhere. The contractor, for its part, took US$2.58m out of its working capital at the start, a gap the new bank's facilities carried, in this example, before they funded any growth. Had the contractor held euro, cover in that currency would have matched the guarantee without a margin.

Both rest on a deposit held by the bank, so they are often confused. Cash cover sits behind an exposure that may not become a debt at all: a guarantee, a credit, a card limit. A back-to-back loan puts a deposit behind money already lent, and the deposit is often placed by someone other than the borrower, a parent or an owner, which is why it draws questions from financial crime teams that ordinary cash cover does not.

It also differs from margin under a derivatives credit support annex, which moves, often daily, with the value of the trades. Cash cover is usually sized when it is given and follows the exchange rate only if the documents include a top-up clause, which is why it often carries its own allowance for the currency. And it differs from general security, which covers the customer's bank accounts too but leaves the customer free to spend them.

DEFINED IN ONE PARAGRAPH → · PRODUCT FILE: BANK GUARANTEE → · COUNTER-GUARANTEE →

In a refinance, cash cover is one of three common ways to deal with the old bank's guarantees. The new bank can issue replacements and the beneficiaries return the originals, which needs each beneficiary's cooperation. The new bank can give the old one a counter-guarantee, which needs the old bank to accept the new bank's risk. Or the customer can cash-cover them, which needs the cash. The credit officer at the new bank reads the third option as a working capital cost, and tests liquidity headroom with the deposit taken out.

Where a bank cash-covers a guarantee for a weak customer, the credit decision is small and the operational one is large: the deposit must be in the right account, under the right document, in the right currency, before the guarantee is issued. A file where the guarantee went out a week before the deposit was blocked has, for that week, no cover at all.

REFINANCING A BUSINESS LOAN → · WHAT YOUR BANK HOLDS AS SECURITY →