Fronting Loans
A fronting loan is a loan between a parent and its subsidiary channeled through a financial intermediary, usually a large international bank. In a direct intrafirm loan, the parent company lends cash directly to the foreign subsidiary, and the subsidiary repays it later. In a fronting loan, the parent company deposits funds in an international bank, and the bank then lends the same amount to the foreign subsidiary. Thus, a US firm might deposit $100,000 in a London bank. The London bank might then lend that $100,000 to an Indian subsidiary of the firm. From the bank's point of view, the loan is risk free because it has 100 percent collateral in the form of the parent's deposit. The bank "fronts" for the parent, hence the name. The bank makes a profit by paying the parent company a slightly lower interest rate on its deposit than it charges the foreign subsidiary on the borrowed funds.
Firms use fronting loans for two reasons. First, fronting loans can circumvent host-country restrictions on the remittance of funds from a foreign subsidiary to the parent company. A host government might restrict a foreign subsidiary from repaying a loan to its parent in order to preserve the country's foreign exchange reserves, but it is less
Figure 20.1
An Example of the Tax Aspects of a Fronting Loan
likely to restrict a subsidiary's ability to repay a loan to a large international bank. To stop payment to an international bank would hurt the country's credit image, whereas halting payment to the parent company would probably have a minimal impact in its image. Consequently, international businesses sometimes use fronting loans when they want to lend funds to a subsidiary based in a country with a fairly high probability of political turmoil that might lead to restrictions on capital flows (i.e., where the level of political risk is high).
A fronting loan can also provide tax advantages. For example, a tax haven (Bermuda) subsidiary that is 100 percent owned by the parent company deposits $1 million in a London-based international bank at 8 percent interest. The bank lends the $1 million to a foreign operating subsidiary at 9 percent interest. The country where the foreign operating subsidiary is based taxes corporate income at 50 percent (see Figure 20.1).
Under this arrangement, interest payments net of income tax will be as follows:
The foreign operating subsidiary pays $90,000 interest to the London bank. Deducting these interest payments from its taxable income results in a net after-tax cost of $45,000 to the foreign operating subsidiary.
The London bank receives the $90,000. It retains $10,000 for its services and pays $80,000 interest on the deposit to the Bermuda subsidiary.
The Bermuda subsidiary receives $80,000 interest on its deposit tax free.
The net result is that $80,000 in cash has been moved from the foreign operating subsidiary to the tax haven subsidiary. Because the foreign operating subsidiary's after-tax cost of borrowing is only $45,000, the parent company has moved an additional $35,000 out of the country by using this arrangement. If the tax haven subsidiary had made a direct loan to the foreign operating subsidiary, the host government may have disallowed the interest charge as a tax-deductible expense by ruling that it was a dividend to the parent disguised as an interest payment.
Techniques For Global Money Management
We now look at two money management techniques firms use in attempting to manage their global cash resources in the most efficient manner: centralized depositories and multilateral netting.
Centralized Depositories
Every business needs to hold some cash balances for servicing accounts that must be paid and for insuring against unanticipated negative variation from its projected cash flows. The critical issue for an international business is whether each foreign subsidiary should hold its own cash balances or whether cash balances should be held at a centralized depository. In general, firms prefer to hold cash balances at a centralized depository for three reasons.
First, by pooling cash reserves centrally, the firm can deposit larger amounts. Cash balances are typically deposited in liquid accounts, such as overnight money market accounts. Because interest rates on such deposits normally increase with the size of the deposit, by pooling cash centrally, the firm should be able to earn a higher interest rate than it would if each subsidiary managed its own cash balances.
Second, if the centralized depository is located in a major financial center (e.g., London, New York, or Tokyo), it should have access to information about good short-term investment opportunities that the typical foreign subsidiary would lack. Also, the financial experts at a centralized depository should be able to develop investment skills and know - how that managers in the typical foreign subsidiary would lack. Thus, the firm should make better investment decisions if it pools its cash reserves at a centralized depository.
Third, by pooling its cash reserves, the firm can reduce the total size of the cash pool it must hold in highly liquid accounts, which enables the firm to invest a larger amount of cash reserves in longer-term, less liquid financial instruments that earn a higher interest rate. For example, a US firm has three foreign subsidiaries--one in Spain, one in Italy, and one in Germany. Each subsidiary maintains a cash balance that includes an amount for dealing with its day-to-day needs plus a precautionary amount for dealing with unanticipated cash demands. The firm's policy is that the total required cash balance is equal to three standard deviations of the expected day-to-day-needs amount. The three-standard-deviation requirement reflects the firm's estimate that, in practice, there is a 99.87 percent probability that the subsidiary will have sufficient cash to deal with both day-to-day and unanticipated cash demands. Cash needs are assumed to be normally distributed in each country and independent of each other (e.g., cash needs in Germany do not affect cash needs in Italy).
The individual subsidiaries' day-to-day cash needs and the precautionary cash balances they should hold are as follows (in millions of dollars):
|
Day-to-Day Cash |
One Standard |
Required Cash |
|
Needs (A) |
Deviation (B) |
Balance (A + 3 * B) |
Spain |
$10 |
$1 |
$13 |
Italy |
$ 6 |
$2 |
$12 |
Germany |
$12 |
$3 |
$21 |
Total |
$28 |
$6 |
$46 |
Thus, the Spanish subsidiary estimates that it must hold $10 million to serve its day-to-day needs. The standard deviation of this is $1 million, so it is to hold an additional $3 million as a precautionary amount. This gives a total required cash balance of $13 million. The total of the required cash balances for all three subsidiaries is $46 million.
Now consider what might occur if the firm decided to maintain all three cash balances at a centralized depository in London. Because variances are additive when probability distributions are independent of each other, the standard deviation of the combined precautionary account would be:
Therefore, if the firm used a centralized depository, it would need to hold $28 million for day-to-day needs plus (3 x $3,741,657) as a precautionary amount, or a total cash balance of $39,224,972. In other words, the firm's total required cash balance would be reduced from $46 million to $39,224,972, a saving of $6,775,028. This is cash that could be invested in less liquid, higher-interest accounts or in tangible assets. The saving arises simply due to the statistical effects of summing the three independent, normal probability distributions.
However, a firm's ability to establish a centralized depository that can serve short-term cash needs might be limited by government-imposed restrictions on capital flows across borders (e.g., controls put in place to protect a country's foreign exchange reserves). Also, the transaction costs of moving money into and out of different currencies can limit the advantages of such a system. Despite this, many firms hold at least their subsidiaries' precautionary cash reserves at a centralized depository, having each subsidiary hold its own day-to-day-needs cash balance. The globalization of the world capital market and the general removal of barriers to the free flow of cash across borders (particularly among advanced industrialized countries) are two trends likely to increase the use of centralized depositories.