Introduction
A revocable letter of credit (RLC) is a financial instrument issued by a bank that provides conditional payment assurance to a beneficiary. Unlike an irrevocable letter of credit, an RLC can be modified or canceled by the issuing bank without prior consent from the beneficiary. While rarely used in international trade due to its inherent risk to sellers, understanding its mechanics, applications, and implications is critical for financial professionals and businesses engaging in trade transactions.
Table of Contents
Definition of a Revocable Letter of Credit
A revocable letter of credit is a type of credit issued by a bank that may be altered or revoked by the issuing bank at any time without prior notification to the beneficiary. It serves as a short-term financial guarantee between a buyer and a seller but lacks the stability and security offered by irrevocable letters of credit.
Mathematically, a revocable letter of credit’s payment obligation can be expressed as:
P = \begin{cases} \text{Amount due}, & \text{if issuing bank does not revoke LC} \ 0, & \text{if issuing bank revokes LC before payment} \end{cases}where P represents the payment received by the beneficiary.
Characteristics of a Revocable Letter of Credit
- Modifiable or Revocable: The issuing bank can change or cancel the LC at its discretion.
- Limited Security: The seller lacks a guarantee of payment as the LC can be withdrawn before funds are transferred.
- Not Widely Used: Due to its high risk for exporters, this type of LC is uncommon in global trade.
- Used for Domestic Transactions: In some cases, businesses within the same country use RLCs where trust between parties exists.
- Lower Costs: Due to its lack of security for the seller, issuing banks may charge lower fees than irrevocable LCs.
Comparison Between Revocable and Irrevocable Letters of Credit
| Feature | Revocable Letter of Credit | Irrevocable Letter of Credit |
|---|---|---|
| Can Be Revoked or Modified Without Consent | Yes | No |
| Security for the Seller | Low | High |
| Commonly Used in International Trade | No | Yes |
| Requires Buyer and Seller Agreement for Changes | No | Yes |
| Risk to Seller | High | Low |
| Cost | Lower | Higher |
Practical Applications of Revocable Letters of Credit
Despite their risks, RLCs can be useful in specific scenarios:
- Intra-company Transactions: Large corporations with subsidiaries may use RLCs for internal trade where payment certainty is less critical.
- Trust-Based Business Relationships: Firms with long-standing relationships might use RLCs to reduce banking fees while maintaining a degree of formality.
- Short-Term or Sample Shipments: In cases where a seller sends a sample shipment, an RLC may provide a temporary payment agreement.
Example of a Revocable Letter of Credit Transaction
Assume a U.S. company, ABC Corp., agrees to purchase office supplies from XYZ Ltd. in Canada. ABC Corp. arranges an RLC with its bank for $50,000, payable upon shipment verification. However, before XYZ Ltd. ships the goods, ABC Corp.’s bank revokes the RLC due to a sudden financial downturn. As a result, XYZ Ltd. does not receive payment and must find alternative buyers.
The financial risk to XYZ Ltd. is apparent. If the bank had issued an irrevocable LC, XYZ Ltd. would have received payment regardless of ABC Corp.’s financial situation.
Risks and Limitations
- Risk to the Seller: A revocable LC offers no guarantee of payment.
- Not Suitable for International Trade: Due to regulatory frameworks and business risk, irrevocable LCs dominate global trade finance.
- Dependence on Buyer’s Financial Health: If a buyer’s financial situation deteriorates, the bank may revoke the LC before fulfillment.
- Minimal Legal Recourse: Since revocation is permitted, beneficiaries have limited legal standing if the LC is withdrawn.
Case Study: A Revocable LC in Action
Scenario:
A U.S.-based manufacturer sources raw materials from a domestic supplier using an RLC for $100,000. The agreement stipulates payment upon delivery verification. However, due to unexpected financial constraints, the buyer’s bank cancels the LC before disbursing funds.
Impact on Stakeholders:
- Buyer: Avoids payment obligations due to financial troubles.
- Seller: Incurs a financial loss due to non-payment.
- Bank: Exercises discretion in revoking the LC, mitigating its exposure.
Alternative Approach:
Had an irrevocable LC been used, the supplier would have been guaranteed payment, securing business continuity.
Conclusion
Revocable letters of credit play a limited role in modern trade finance. While they provide flexibility to buyers and issuing banks, they expose sellers to significant financial risks. Businesses engaging in transactions requiring payment security should prefer irrevocable LCs. Understanding the nuances of revocable LCs enables businesses to make informed decisions, balancing cost savings against payment risks.
