Credit sweep

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Credit sweep refers to a contract between the bank and the customer (usually a corporation) which says that all free funds and surpluses on deposit accounts will be used to repay short-term loans under the credit line. The target balance is usually set by the client, it determines how much of his funds will be used[1].

Use of credit sweep

Credit sweep is used to minimize costs of having line of credit. Customer of a bank that has line of credit can define that all idle funds in a deposit account will be used to pay down short-term borrowings. Usually customer defines also the lowest state of the account that enables such payment[2].

Characteristics

If necessary, the bank may withdraw its support or change the terms of the contract to suit the new situation. As the borrower's situation is changing in a dynamic competitive market, the availability of a bank loan must be continually reassessed. Sweeps, carried out annually so that they coincide with the financial statements, are also an important tool for credit supervision. They are particularly recommended for working capital loans, as the borrower's working capital is constantly changing[3].

The sweeps also formalize the right to repay on demand a loan that has not passed the exam. In addition, sweeps are applied to term loans (even if it is not possible to make changes to the credit without violating the terms of the contract), not only to check whether there has been a breach of contract, but also to know in advance about a decrease in the borrower's creditworthiness or to prevent such a decrease. This task can be entrusted to persons acting as a sponsor (which contributes to increasing their responsibility) or an independent unit at the bank (which is a form of additional internal control)[4].

Credit Sweeps in Banks

Characteristics of Credit Sweeps in Banks [5]:

  • Banks use sweep accounts as a legal workaround to the prohibition to pay interest on business checking. By "sweeping" funds overnight to an investment vehicle of some sort, otherwise idle cash (credit) can be more effective in generating marginally more return
  • There are many forms of sweep arrangements. Commercial banks can afford different solutions, which is why they enjoy aggressive strategies (they offer a much higher rate of return), while smaller entities use the sweep account for their own convenience. Very different service levels are common when establishing a credit sweep agreement.

Examples of Credit sweep

  • A corporate customer has a credit line of $2 million and a working capital account with a current balance of $500,000. The customer sets the target balance to $400,000 and implements a credit sweep. Under the terms of the agreement, the bank will use any free funds in the customer’s working capital account to pay down the credit line up to the target balance.
  • A customer has a $1 million line of credit and a cash balance of $200,000. The customer sets the target balance to $100,000 and implements a credit sweep. The bank will then use the free funds in the customer’s cash balance to reduce the amount outstanding on the line of credit until it reaches the target balance.
  • A customer has a $500,000 line of credit and a checking account balance of $50,000. The customer sets the target balance to $25,000 and implements a credit sweep. The bank will then use the free funds in the customer’s checking account to reduce the amount outstanding on the line of credit until it reaches the target balance.

Advantages of Credit sweep

Credit sweeps offer numerous advantages for businesses. * They provide a simple and efficient way for businesses to manage their cash flow by automatically transferring excess cash from deposit accounts to pay off short-term debt. * This can help businesses avoid extra costs associated with short-term borrowing, such as interest payments and late fees. * It can also help businesses maintain a higher liquidity ratio, allowing them to quickly access funds when needed. * Credit sweeps also serve to reduce the administrative burden of manually transferring funds, freeing up time and resources for other business operations.

Limitations of Credit sweep

A credit sweep has some limitations that should be taken into consideration:

  • The funds are not accessible to the customer until the loan is repaid, which can limit the customer’s ability to use the funds for other purposes.
  • The customer may be liable for additional fees and charges if the loan is not repaid in time.
  • The customer may have less control over their cash flow, as the sweep is only initiated when the balance of their deposit accounts reaches a set target.
  • The customer may be exposed to additional risk due to the fact that the loan is repaid with their own funds, as opposed to funds from other sources.
  • The customer may be unable to access their funds for a period of time if the loan is not repaid in time.

Other approaches related to Credit sweep

In addition to Credit Sweep, there are several other approaches which companies can take to manage their corporate cash more efficiently. These include:

  • Zero Balance Accounts (ZBA): a cash management system which allows companies to maintain multiple bank accounts and automatically transfer funds between them to ensure that each account maintains a zero balance.
  • Lockbox: a service provided by banks to companies which helps speed up the collection of payments from customers. The company provides a post office box address to its customers, and the bank collects any payments that are sent there.
  • Cash Concentration: when a company uses a single account to consolidate all of its cash flows and manage its liquidity on a daily basis.
  • Liquidity Management Software: a software solution which provides companies with a comprehensive view of their cash position and helps them to more efficiently manage liquidity.

In summary, Credit Sweep is just one of several strategies available to companies for managing their cash more efficiently. Other approaches include Zero Balance Accounts, Lockbox, Cash Concentration, and Liquidity Management Software.

Footnotes

  1. ↑ Richards I. E., (2014),p. 12
  2. ↑ Wrbka S., (2014), p. 67
  3. ↑ Barone M., (2016), p. 217
  4. ↑ Rodgers D., (2013), p. 6
  5. ↑ Scott-Quinn B., (2012), p. 25

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Credit sweep — recommended articles
Bridge Bank — Advance funding — Capital Base — Non current liability — Borrowing capacity — Borrowing Base — Creation of money — Revenue reserve — Customer deposits

References

Author: Monika Sojka

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