A line of credit and a revolving credit agreement are similar and related finance terms. They are at times used interchangeably since only a slight difference exists between them. The lack of a clear distinction between these two terms has led to their abuse by many people. This paper elaborates the difference between these two terms, gives instances of abuse of these two terms and then suggests possible ways of avoiding abuse of these two terms.
A revolving credit agreement is a more flexible form of a line of credit. This flexibility is brought about by the fact that with a revolving credit agreement the credit balance can be replenished after it is exhausted. In a normal non revolving line of credit it is not possible to replenish or top up the credit once the maximum set balance is exhausted. This forms the major difference between a normal line of credit and a revolving credit agreement (McNett,2005).
In terms of functionality a revolving credit agreement functions just like a normal credit account. With these credit accounts credit limits can be adjusted at the discretion of the user. These accounts also do not have set monthly payments and there are no set monthly payments just like in the case of ordinary non revolving credit cards. The credit can be used for a variety of purposes. After payments are made on a revolving credit account these funds are available again for borrowing provided that the maximum credit limit is not exceeded.
A line of credit functions in a similar way since a credit limit is set just like a revolving credit agreement account. The credit can be used for any purposes and the credit can be used to for a variety of purposes. However when the credit amount is exhausted the account is closed unlike in a revolving credit account in which case the amount is replenished.
There have been many reported cases of revolving credit agreement accounts and line of payment accounts. One of the most common violations occurs when there is an attempt by users of both accounts to exceed the maximum set limit. It may take some time for the bank to realize that a credit limit has been exceeded and respond appropriately. The other instance in which an ordinary line of credit is misused is when by mistake a bank replenishes the credit in the account just like in the case of a revolving credit account. This means that a line of credit account acts like a revolving credit agreement account.
Low profitability firms and customers who are at risk of bankruptcy may also abuse lines of credit and to their advantage. In this case they tend to make huge withdrawals to without the knowledge of the banks. This puts banks at risk of losing a lot of money. A good example of such as scenario is the case of Enron Corporation. In the year 2001, Enron Corporation drew $ 3 billion from JP Morgan bank. After two weeks the bank realized that the corporation was under investigation by the SEC and it was destined for closure. As the time the corporation closed down JP Morgan chase bank had a lot of money in unsecured exposure to the corporation (Amir, 2005).
There are also instances in which customers that have pending loans in banks draw from lines of credits so as to offset these loans. This is a misuse of lines of credit because it is like borrowing money to pay off a loan that is due. According to Balten(2011), since very few limitations exist as to how money from lines of credit maybe used it is difficult for the banks to do anything about such as scenario. In case the customers are unable to pay these loans the banks stand to lose a lot of money.
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To avoid these major forms abuse to lines of credit and revolving credit agreements adequate investigation documentation of customers should be done before being granted. This will enable the banks to detect malicious customers and avoid the occurrence of scenarios similar to the one involving JP Morgan Chase Bank and Enron Corporation. This strategy should be adopted specifically for lines of credit since according to Amir (2005) they are most prone to abuse of all types of credit systems.
Another solution to this type of abuse would be limiting the flexibility and unconditionality of both lines of credit and revolving credit agreements. Both these two arrangements are characterized by speed of withdrawals and flexibility.
In conclusion, lines of credit and revolving credit agreements are very efficient credit mechanisms for the customer. However this flexibility renders them very vulnerable to abuse by customers at risk of bankruptcy and unprofitable corporations. To try and avert this risk banks should always try not to give credit to such firms. The close similarity between the line of credit and the revolving credit agreement also provides another channel for the abuse of these channels.
References
- AMIR.S.(2005). Bank Lines of Credit in Corporate Finance: An Empirical Analysis. University of Chicago Graduate School of Business. Retrieved 27 May, 2015 from.
- https://www.fdic.gov/bank/analytical/cfr/2005/sept/workshop_Asufi.pdf
- Balten. J. (2011).Ga/e encyclopedia of Americacn Law(3rd edition).Detroit, Michigan. Gale Publishers.
- Mcnett, J.(2005).The Blackwell encyclopedia of management .Madden, Mass.: Blackwell
Publishers.
