Fronting, Collateral, and Lender Risk: A Look into Letters of Credit

In international trade, letters of credit are one of the most reliable tools for getting deals done. Where buyers and sellers are often strangers separated by borders, laws, and time zones, trust is not assumed; it must be built. And sometimes, it is borrowed. That’s where a letter of credit steps in. It allows the buyer to demonstrate creditworthiness by asking their bank (the Issuing Bank) to issue a letter in favour of the seller. In simple terms, the buyer is saying: “You may not know me, but you know my bank. They will pay you, and I will pay them.” That quiet shift, from trusting the buyer to trusting their bank, eases global trade. The Loan Market Association has published template loan agreements with specific terms for letter of credit facilities. These templates reflect standard market practice, clarify how these instruments are used, and outline obligations related to payment, indemnity, and how the letter of credit interacts with the entire loan structure.

So, how does a letter of credit work?

At its core, it’s a binding commitment from the Issuing Bank to pay the seller (Exporter) once the goods are shipped and the required documents are presented. From the seller’s perspective, this shifts the risk of non-payment away from the buyer and onto the Issuing Bank. When a buyer requests the Issuing Bank to issue a letter of credit, they are granting the bank full authority to honour any claims made under that instrument without hesitation, and without needing to check in with the buyer or anyone else first.  This way, the seller feels secure about receiving payment, and the buyer is reassured that payment will only be made once the goods are shipped, as he immediately reimburses the Issuing Bank. There is no room for second-guessing; the obligation is straightforward. The diagram below shows clearly a typical structure of how letters of credit work:

Where does this fit within a syndicated loan?

As previously mentioned, letters of credit are often issued in support of real trade activity. Think of scenarios like pre-export financing, where a borrower needs to purchase and ship goods. In such cases, rather than seeking support outside the financing structure, the borrower simply leans on the existing syndicate. One of the lenders, usually the one best positioned to do so, steps in as the issuing bank to issue the letter of credit on behalf of the entire syndicate. This means the letter of credit sits comfortably within the framework of the facility agreement. So, to ensure clarity and coordination, the facility agreement will typically include detailed provisions on how this instrument is issued, renewed, reduced or cancelled and how reimbursements and indemnities will be handled if drawn. The goal is to support the borrower's trade-related obligations without stepping outside the credit structure already in place. Here's a simplified structure of how it works:

• Step 1 - The issuing bank makes payment to the seller (the beneficiary) once the correct documents are presented.
• Step 2 - The borrower reimburses the issuing bank for any amount that has been paid. This obligation is irrevocable and unconditional. The borrower must pay the full amount claimed.

Step 3 - Can the Issuing Bank seek reimbursement from the Syndicate Lenders?

Yes, it can. In many syndicated loan transactions, the issuing bank is part of the syndicate and typically issues the letter of credit on a “fronted” basis. This means that while the issuing bank makes the payment to the beneficiary, it does so on behalf of the syndicate. If the borrower fails to reimburse the issuing bank as required, the bank may rely on indemnities provided by the other lenders (each contributing in proportion to their share in the facility) to recover the outstanding amount. In such cases, the lenders step in and cover the shortfall. Once this occurs, the borrower becomes responsible for reimbursing the lenders directly. These amounts are often regarded as part of the loan and repaid by the borrower in instalments over time. To reflect this arrangement, the borrower would typically enter into separate reimbursement and indemnity agreements with the lenders, especially when it has failed to meet its obligations to the issuing bank.

What happens if a syndicate lender defaults or faces financial difficulties?

Of course, things can get complicated if one of the lenders in the syndicate begins experiencing financial issues. Under the LMA template facility agreement, these lenders are referred to as Non-Acceptable L/C Lenders. But let’s call them what they often turn out to be: Problematic Lenders. Who qualifies as a Problematic Lender? Usually, it is a lender whose credit rating has fallen below the agreed minimum (i.e., Moody's or Fitch ratings), or one that fails to fund its share of a loan on the agreed utilisation date. It could also be a lender that refuses to issue a letter of credit when required, fails to pay a claim under a letter of credit, or fails to make its outstanding payments under a finance document. Now, when a lender in a revolving facility is identified as a Problematic Lender, the Issuing Bank has several options to protect itself:

• Cash Collateral - The Issuing Bank can request that the Problematic Lender deposit the relevant amount into an interest-bearing account as cash collateral before the payments are due. This account is then ring-fenced - withdrawals can only be made to reimburse the Issuing Bank for amounts due under the letter of credit. If that collateral is not needed, or if the lender resolves its position (for example, by settling its obligations or being replaced in the syndicate), it can request a refund of the unused portion of the cash collateral.
• Reduction of Participation - If the letter of credit has not yet been issued, the Issuing Bank can simply reduce the size of the proposed letter of credit by removing the Problematic Lender’s share from the calculation. This way, the Issuing Bank limits its exposure from the outset.

What if the Problematic Lender refuses to provide cash collateral?

That situation worsens matters. If the Problematic Lender either refuses or fails to post the cash collateral owed, the issuing bank does not just wait. It notifies the borrower and places the responsibility squarely on them. In this case, the borrower must provide a cash cover equivalent to the Problematic Lender’s share of the letter of credit. Of course, if the borrower has already provided a standing cash cover that remains valid, no additional cover is necessary. Importantly, the timelines built into the facility agreement are favourable to both the Issuing Bank and the borrower. The Problematic Lender is typically required to provide the collateral before the letter of credit is due to be issued. If they fail to do so, the borrower still has some time to step in and provide the cover themselves, thereby avoiding delays in issuing the LC.

Will the issuing bank issue more letters of credit?

Probably not; at least, not immediately. If a syndicate member already shows signs of instability, it’s natural for the issuing bank to hesitate. Why would it increase exposure when there is trouble within the group? In practice, most Issuing Banks would be reluctant to approve new letters of credit until the Problematic Lender is either replaced or its processes are regularised.

A few other points to consider:

• Letters of credit are treated similarly to loans regarding collateral and guarantees. They benefit from the same security arrangements that support the rest of the credit facility. This means any guarantee or charge backing the loans also covers the borrower’s obligations under the letters of credit. For lenders, this ensures consistent protection across all exposures, whether it is a drawn loan or a contingent letter of credit obligation.
• Even undrawn letters of credit influence the borrower’s access under a revolving facility. Once an LC is issued, even if it has not been drawn by the seller, it is counted as a potential use of the facility. This is because the lender has already committed to fund that amount if needed. Consequently, the undrawn letter of credit reduces the borrower’s available headroom under the facility.
• There are fees associated with these arrangements, and they go to the parties bearing the risk. Lenders receive a letter of credit fee for their proportion of the contingent exposure, while the issuing bank earns a fronting fee for actually issuing the letter of credit. These fees are typically outlined in the facility agreement.
• Since the global financial crisis in 2008, fewer banks are willing to act as Issuing Banks on a syndicated basis. That reluctance often relates to risk. Being the fronting bank means the issuing bank assumes the initial exposure, and not all banks are comfortable taking that role, especially where coordination within a syndicate is uncertain.

In a world where trade spans continents and counterparties rarely meet, letters of credit remain a discreet but vital enabler; one that ensures trust, secures payment, and keeps global commerce moving. If nothing else, I hope this article breaks down the process sufficiently to make letters of credit feel a little less technical and a bit more familiar.