When businesses extend a line of credit to customers, the money might not be used right away. The amount that isn’t drawn is called the unfunded line of credit. While maintaining an unused reserve of funds that can be accessed if needed may benefit the customer, the decision to leave part of the line untapped also has capital consequences for the bank.
Unfunded Credit Line Benefits
Homeowners or businesses often request lines of credit for a larger amount than they expect to use. A homeowner taking out a home equity line of credit for a renovation may want the peace of mind of knowing funds are available in case of cost overruns, for example, while a business owner might want a ready source of cash in case of unexpected contingencies or opportunities. In each case, the existence of those unfunded credit lines is an obligation for the bank, which must be prepared to provide the extra funds should they be needed.
Unfunded lines of credit affect banks because they still are considered in a bank’s capitalization requirements even though they don’t generate revenue. The unfunded amount must be considered a liability exposure and can represent a liquidity risk. The Federal Deposit Insurance Corporation expects banks to consider unfunded lines of credit as a part of their liquidity risk assessments. In addition, customers also may find themselves considered more of a credit risk if they have unfunded lines of credit, as the mere existence of these accounts offers an easy way they can increase their level of debt quickly.
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