Thursday, December 8, 2022

The Debt Service Reserve Account: An Overview of What It Does and Why You Need One

What is a Debt Service Reserve Account?

This is a reserve account which, as defined by the IMF and the FOMC, includes:

The balance of proceeds from net debt issuance, mainly interest-bearing, plus proceeds from the sale of short-term US government securities and repurchase agreements with dealers, minus amounts due to the Federal Reserve System in exchange for collateral.

It can be thought of as a reserve account which can be drawn upon to temporarily replace short-term financing in a scenario of liquidity shortage. The proceeds from net debt issuance can be drawn from, for example, the GSEs.

The amount of proceeds that are available to be tapped into the reserve account is determined by the Internal Capital Market System (ICMS).

Why do you need one?

The Reserve Account is a part of a bank’s (government-controlled) accounts that is designed to back up a customer’s (that is, someone who borrows money from you) debt obligations. These are usually government bonds or other types of bonds. Typically, the bank will make you a loan based on collateral, which is usually the bonds or other bonds you own, or on assets that are of high-quality. But what the bank isn’t allowed to do is promise to repay the loan to the lender. The bank’s responsibility is to support the debt, to prevent the borrowers from defaulting on the loan, or to be liquidated (disbursed to other borrowers) in the event of default.

The debt service reserve account is a supplementary account that the bank keeps on behalf of you.

What are the different account types?

There are three different types of account to keep in your portfolio.

Emergency Reserve: This account is typically set up to pay bills in the case of an emergency. When the money in the account is needed to pay your monthly bills, you will need to withdraw it from your normal account and transfer it to the Emergency Reserve account.

This account is typically set up to pay bills in the case of an emergency. When the money in the account is needed to pay your monthly bills, you will need to withdraw it from your normal account and transfer it to the Emergency Reserve account. Efficient Debt Management Account: This account is set up to keep you on track with paying off your debt and keeping your interest costs low.

How do I set up a Debt Service Reserve Account?

Starting a Debt Service Reserve Account (DSRA) for your business is relatively easy and there are several options available for you to choose from.

In the following sections, we will outline some of the options and provide details of their benefits, drawbacks, and limitations.

First of all, what is a DSRA?

A DSRA is a tax-free account that is reserved for debt service payments in the event you cannot service your existing debt or for other essential business purposes.

Since you set up a DSRA, you can draw funds out for these purposes tax-free and do not have to worry about the associated paperwork involved. This allows you to apply your available cash to meeting your immediate debt payments instead of the paperwork.

What are the Pros and Cons of using a DSR Account?

Proponents of using a DSR account offer three main advantages over the traditional cash reserve account, and the two main cons.

Pros of Using a DSR Account

One advantage is that there’s a reserve account already on the books. The other is the annual minimum payment doesn’t really matter. It’s a non-issue.

Using a DSR account instead of a cash reserve can result in smaller-than-normal minimum payments because of the regular and predictable flow of revenue. However, there will still be adjustments needed for the actual minimum payments needed to ensure the overall cash position stays close to the required amount.

A DSR account allows for greater predictability of the payment due dates and can reduce the requirement for cash on hand, the liquidity cost.

Conclusion

The onus of the debt portfolio, including associated liabilities, in most jurisdictions is largely carried by one party (the Department of Finance in Ireland). For the financial sector, this means two things: that a de-risking exercise has to be undertaken, and that contingency plans have to be made in case of a political crisis. With the many risks that these books carry, this strategy is not only prudent, but also necessary, both from an accounting and political point of view. With this in mind, it is worthwhile to consider the structure of the debt portfolio in Ireland and the two reserve accounts (DSRA and NSRA) it consists of.

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