What it means
The everyday commercial meaning is straightforward security. A bank asked to stand behind a $2,000,000 obligation may insist the customer deposits an equivalent or slightly larger sum, so that if the guarantee is called the bank is repaid instantly from money it already holds.
The cost is not the deposit itself but the loss of access to it. Cash sitting in a restricted account cannot pay suppliers, fund inventory or reduce a revolving loan, so the real expense is the difference between what the restricted balance earns and what the money could have done elsewhere.
Collateral is often required at more than 100% of the exposure, a buffer known as a haircut or over-collateralisation. A 105% requirement on a $2,000,000 letter of credit ties up $2,100,000, and the extra 5% protects the bank against fees, interest and timing gaps.
In derivatives and clearing, cash collateral is posted daily as variation margin, moving back and forth as positions gain and lose value. This makes the amount unpredictable, which is why treasurers running hedging programmes hold a liquidity buffer specifically for margin calls.
The insolvency meaning is a different concept sharing the same words. When a business enters a formal restructuring, cash generated from assets a lender has security over is treated as that lender's cash collateral, and the company usually needs a court order and adequate protection terms before it can spend it on wages or suppliers.
In practice
Real-world examples.
Example
A haulage business self-insures its employee injury programme and the insurer requires $3,000,000 of security. It posts cash collateral rather than paying for a surety bond, and the finance director reports the balance as restricted cash so that investors do not count it as available liquidity.
Example
A food producer hedging wheat prices posts variation margin daily with its clearing broker. When prices move sharply against the hedge, $1,200,000 of cash collateral is called in a single week, and the treasury team draws on a standby facility kept specifically for that purpose.
Example
A retailer entering a formal restructuring cannot use the daily takings from its stores because they are the cash collateral of its asset based lender. It negotiates a court approved budget allowing the cash to fund wages and stock in exchange for replacement security and weekly reporting.
Formula
Calculation
Cash collateral required = Exposure x Collateral percentage
Annual carrying cost = (Cash collateral x Opportunity cost rate) + Facility fees
A construction firm needs a $2,000,000 performance letter of credit and the bank requires cash collateral at 105%.
Cash collateral required = $2,000,000 x 105% = $2,100,000.
The restricted account pays 3%, while the same cash used to pay down the company's revolving facility would save 5%. The opportunity cost is therefore 5% - 3% = 2%, or $2,100,000 x 2% = $42,000 a year.
The bank also charges a letter of credit fee of 0.75% on the face amount: $2,000,000 x 0.75% = $15,000.
Total annual cost of the arrangement = $42,000 + $15,000 = $57,000, or 2.85% of the $2,000,000 exposure. That figure is the number to compare against a surety bond or an unsecured guarantee facility, not the letter of credit fee on its own.Case study
Seen in the real world.
The following is an illustrative and entirely fictional example. Silverbrook Logistics, an invented regional freight company, was required by its workers compensation insurer to post $4,000,000 of security. Its bank issued a letter of credit at a 1.25% fee, or $4,000,000 x 1.25% = $50,000 a year, but insisted on cash collateral at 105%, freezing $4,000,000 x 105% = $4,200,000 in a restricted account.
That frozen cash was the real problem. The fictional company was simultaneously borrowing on a revolving facility at 6%, so the trapped balance was effectively costing $4,200,000 x 6% = $252,000 a year on top of the letter of credit fee.
After two clean claims years, Silverbrook's broker placed the obligation with a surety instead, at a premium of 2%, or $4,000,000 x 2% = $80,000, with no cash pledge required. Releasing the collateral and cancelling the letter of credit saved $252,000 + $50,000 = $302,000 of carrying cost against the $80,000 premium, a net annual benefit of $222,000 in this illustrative case.
Watch out
Common mistakes.
- Counting cash collateral as part of available liquidity, when restricted cash cannot be used to pay suppliers or service debt.
- Comparing security options on the headline fee alone, ignoring the far larger opportunity cost of the cash that gets frozen.
- Sizing a treasury buffer without allowing for derivative margin calls, which can demand large amounts of cash collateral at short notice.
Questions
People also ask.
Why do banks ask for cash collateral at more than 100% of the exposure?
The extra margin, or haircut, covers fees, accrued interest and the timing gap between a claim being paid and the account being applied.
Where does cash collateral appear in the accounts?
As restricted cash, usually disclosed separately from cash and cash equivalents, and classified as current or non-current depending on when the restriction lifts.
What does cash collateral mean in a bankruptcy?
It refers to cash and receipts subject to a secured lender's security interest, which the debtor may only use with the lender's consent or a court order providing adequate protection.
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