Revolving Letter of Credit

A letter of credit (LC) covers the default risk for the exporter. The issuer of LC acts as an intermediary and guarantees the payment in case its customer defaults. Under normal circumstances, the letter of credit facility is issued once and with specified terms.

The bank verifies the creditworthiness of the applicant and issues a letter of credit. The process is an iterative one each time the applicant approaches the bank. In some cases, the applicant may obtain a certain limit of credit facility from the bank and use the facility on revolving terms. Although the practical uses of such revolving letters of credit are limited, it still is in use.

What is a Revolving Letter of Credit?

It acts as a credit facility issued by the bank on a revolving credit basis. The applicant can utilize the approved limit of credit to issue letters of credit up to an approved limit of time or value. The applicant can make multiple transactions without the amendments or negotiations with the bank on LC each time.

Much like a revolving financing facility, the advantage for the applicant is the one-time approval of credit from the bank. However, the bank can impose credit covenants and limit the number of LC issuance or by maturity period of the facility.

How a Revolving Letter of Credit Facility Works?

The foremost step involved in the revolving LC is the assessment of the creditworthiness of the applicant. Any letter of credit or other forms of bank guarantee would require a significant credit profile with the issuing bank. As the terms do not change and the banks do not require approving the limits each time, credit assessment may be stricter with revolving LCs.

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A usual workflow with a revolving facility would involve the following steps:

  • The applicant approaches the bank with an application for the issuance of a revolving credit facility.
  • The bank performs the assessment of the creditworthiness of the applicant.
  • The bank approves the limit and issues the revolving letter of credit facility with certain terms.
  • Both parties can agree on the terms as setting the limit and clause on cumulative basis use of the facility.

Once approved the applicant can use the revolving LC facility until maturity.

Types of Revolving Letter of Credit

By authorization type, a revolving letter of credit can take two forms. A revolving facility can be cumulative or non-cumulative. With the basic working mechanism, the revolving facility can roll over on an automatic or manual basis.

Automatic Rolling Facility

As with any bank revolving credit facility, the applicant can use the revolving credit facility automatically rolled over until the maturity date. This type of contract does not require any amendments to each transaction.

Manual Rolling Facility

The bank may attach certain conditions or require some amendments over time. This arrangement reduces bank risk of the customer default.

Time-Based Revolving Letter of Credit

The applicant can utilize the approved revolving letter of credit facility until a specified time. The contract comes with a maturity date and the bank may restrict transactions on a specified period such as on a monthly or quarterly basis. The applicant may not fully utilize the approved limit. Hence the functionality can further be divided into two sub-categories as below.

Cumulative Revolving Letter of Credit

Once a credit facility is issued, the applicant can utilize the full limit within the time specified. Any remaining balance can be carried forward to the next period. The facility works on a cumulative balance basis.

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For example, if the applicant has the approval of a total limit of $500,000 as a revolving credit facility for five months. Suppose the bank allows $100,000 per month and the applicant utilizes only $ 300,000 in the first four months. The remaining balance can be carried forward to the next month and so on.

However, the bank can only allow the revolving credit facility up to the contract maturity.

Non-Cumulative Revolving Letter of Credit

As the name suggests, the remaining balance of the revolving credit facility cannot be carried forward. If the applicant utilizes a portion of the revolving letter of credit facility, it may only be used the next month’s approved amount only.

Value-Based Revolving Letter of Credit

The value basis condition more often comes from the applicant rather than the bank. With an ongoing trade contract and a series of goods supplies, the importer may ask the exporter to send shipments in standard quantity and value. The exporter can receive payments through the release of revolving LC once the importer receives a certain value of shipped goods.

A revolving letter of credit can also combine other features of the LCs such as irrevocability or red/green clause. It can also combine other features such as confirmed, transferable, back-to-back or standby letters of credit.

Advantages of Using a Revolving Letter Of Credit

All three parties can benefit from the revolving letter of credit facility. With bank being the most vulnerable at risk of bearing the default risk of the applicant. For the beneficiary of the revolving LC, it can save time and quickly proceed with the payments.

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Some common advantages for all three parties involved in a letter of credit:

  • It saves time and costs for the applicant with a one-time limit approval.
  • It increases the creditworthiness of the applicant and increases its negotiating power with the seller.
  • The bank may charge higher fees as it is a form of an unsecured loan and rolling facility.
  • It works well for the trade parties on an ongoing basis as it saves time and builds trust.

Disadvantages of Using a Revolving Letter Of Credit

As we mentioned, the most vulnerable party in a revolving letter of credit facility is the issuing bank. With the riskiest nature of the contract, the use of a revolving LC facility is limited in modern international trade.

  • The credit profile of the applicant may change quickly which may put the bank at risk.
  • The beneficiary of the LC may not like the arrangement such as value-based or a series of small payments over time.
  • The associated costs of a revolving facility may be higher for the applicant.

Conclusion

Theoretically, the revolving letter of credit provides significant benefits to all parties. However, as the working mechanism of LCs is complex, it takes a toll on the financial institutes and banks. Practically, the revolving LC facility presents limited functionality.

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