Two key financial instruments often discussed in the international business arena are the letter of credit and standby letter of credit. Understanding them, how they work, and how to best use them is crucial when navigating business international trade and finance.
What is a Letter of Credit?
A letter of credit (LC) is a payment method used in international trade. With an LC, a bank guarantees payment to the seller on behalf of the buyer. The seller must meet all specified terms and conditions to receive payment. LCs help reduce risks between the buyer and seller.
The LC essentially substitutes the bank’s credit for that of the buyer, ensuring the seller receives payment once they fulfill the terms of the sale.
How a Letter of Credit Works
Understanding how a letter of credit works requires following several steps and involving multiple parties. The process ensures payment to the seller, provided they meet the terms outlined in the LC.
Agreement Between Parties Involved
The buyer and the selling party start the process by agreeing on the terms of the sale, including the use of an LC. The underlying contract outlines the goods or services being traded, the price, delivery terms, and the conditions both parties must meet.
Application to the Buyer’s Bank
Once the agreement is in place, the buyer applies for an LC at their bank. The bank evaluates the buyer’s financial standing.
The buyer may need to provide collateral or make a cash deposit to secure the LC, as the bank guarantees the funds to the seller. This evaluation includes assessing the buyer’s credit rating and financial history to ensure they meet financial obligations.
Issuance and Notification
Upon approval, the issuing bank sends the LC to the seller’s bank and notifies them. This step ensures that all parties understand the terms and conditions, and the seller proceeds confidently, knowing the funds are secured.
The issuing bank ensures that the terms comply with the agreed-upon contract.
Shipping and Document Submission
The seller then ships the goods or provides the services specified in the contract. After shipping, they submit the required documents to their bank, such as the bill of lading, commercial invoice, and packing list. These documents prove that the seller has fulfilled their part of the contract.
The seller’s bank verifies these documents to ensure they meet the conditions outlined.
Verification and Payment
The seller’s bank verifies the documents to ensure they comply with the terms of the LC. Upon verification, the seller’s bank sends the documents to the issuing bank for final approval.
The issuing bank then releases the funds to the seller’s bank, which credits the seller’s account. This process guarantees the seller receives the money promptly, provided all conditions are met.
This procedure protects both the buyer and the seller, ensuring each party meets their contractual obligations.
Benefits of a Letter of Credit
A letter of credit offers several benefits for buyers and sellers involved in international trade. Let’s explore them:
Assured Payment
One of the primary benefits of an LC is that it assures timely payment once the goods are shipped and the required documents are submitted. This reduces the risk of non-payment and provides security for both parties.
This assurance can be crucial when dealing with new or unknown buyers, as it mitigates the risk involved in the transaction.
Negotiation Power for the Buyer
Using an LC can provide significant negotiation power for the buyer. It allows the buyer to negotiate better terms and conserve cash flow until the goods arrive.
This can be particularly beneficial in large or high-value transactions. The buyer can negotiate more favorable terms, knowing that the bank will secure payment.
Enhanced Credibility
The LC enhances the buyer’s credibility by demonstrating their ability to pay. This is crucial in international transactions where the buyer and seller may need an established relationship.
Knowing that the buyer has secured an LC from a reputable bank can be a decisive factor in agreeing to the transaction.
Costs Associated with a Letter of Credit
While a letter of credit provides security and assurance, it commonly has associated costs that businesses must consider.
Issuance Fees
Banks charge a fee to issue a letter of credit, typically ranging from 0.80% to 1.5% of the LC amount. The buyer usually pays this fee, but it can be negotiated between the buyer and seller.
These costs should be considered when deciding whether to use an LC for a business transaction. The fees can vary based on the complexity of the transaction, the amount of the LC, the specific type of letter of credit, and the risk implicated.
Trends in the Use of Letters of Credit
The use of letters of credit has evolved and has been influenced by changes in trade practices and economic conditions globally.
Letters of credit remain a popular payment method in international trade, especially for high-value transactions, new trade relationships, or transactions involving higher-risk countries.
They provide a reliable mechanism to ensure payment and mitigate risk. In situations where trust is not yet established or where significant amounts of money are involved, letters of credit offer a robust solution to ensure both parties meet their obligations.
What is a Standby Letter of Credit?
A standby letter of credit (SBLC) is a legal document in which a bank guarantees payment to a seller on behalf of the buyer if the buyer doesn’t pay or meet contractual obligations.
Unlike a traditional letter of credit, which is used as a primary payment method, a standby letter of credit serves as a secondary payment option, only drawn upon if something goes wrong.
How a Standby Letter of Credit Works
Understanding how a standby letter of credit works can help businesses decide when and how to use this financial tool.
Application and Credit Evaluation
The process begins with the buyer applying for a standby letter of credit at their bank. The bank evaluates the buyer’s creditworthiness.
If the applicant fails to meet the criteria, the bank may require additional collateral, cash deposits, or guarantees. The bank’s evaluation process is thorough, ensuring the buyer has the financial stability to meet their obligations under the standby letter of credit.
Issuance and Notification
If the application is approved, the issuing bank sends the SBLC to the seller’s bank, which informs the seller. This step ensures the seller knows the credit terms’ standby letter and can proceed confidently.
The seller is assured that the bank will cover the payment if the buyer or client fails to meet their payment obligations.
Performance and Non-Payment
The seller ships the goods or provides services as agreed in the underlying contract.
If the buyer fails to pay, the seller can present the unpaid invoice and proof of delivery to the issuing bank and request payment under the standby letter of credit. This acts as a safety net for the seller, ensuring they receive payment even if the buyer defaults.
The seller must provide documentation proving that the buyer did not meet their obligations, which triggers the bank’s guarantee payment under the SBLC.
Payment by the Issuing Bank
Upon receiving the documents, the issuing bank verifies that the standby letter of credit terms have been met. The bank then pays the seller the amount specified in the SBLC, providing a powerful tool for managing payment risks.
This process ensures that the seller is protected against non-payment risk while the buyer is incentivized to fulfill their contractual obligations.
Benefits of a Standby Letter of Credit
A standby letter of credit offers several advantages, making it a valuable tool for businesses.
Assurance of Payment
A standby letter of credit assures the seller of payment if the buyer fails to pay. This reduces the risk involved in international transactions and provides security for both parties.
The seller can be confident that they will receive payment, even if the buyer defaults, which can be critical in maintaining cash flow and financial stability.
Enhanced Contract Security
For the buyer, a standby letter of credit helps secure contracts or better terms by demonstrating the bank’s confidence in their ability to meet financial obligations.
This can be particularly beneficial in competitive bidding situations. By providing an SBLC, the buyer can show that they are a reliable partner, which can help win contracts and secure favorable terms.
Collateral Use and Flexibility
The seller can use the standby letter of credit as collateral to secure financing. Additionally, it allows for flexible terms regarding the amount, duration, and conditions, making it a versatile tool for various business scenarios.
The SBLC can be tailored to fit the specific needs of the transaction, providing flexibility in its use.
Costs Associated with a Standby Letter of Credit
While a standby letter of credit offers significant benefits, it also comes with costs that businesses need to consider.
Banks charge an annual fee to issue a standby letter of credit, typically a percentage of the SBLC amount. The buyer usually pays this fee, which should be considered when evaluating the use of an SBLC.
Trends in the Use of Standby Letters of Credit
The trends in using standby letters of credit reflect their growing importance and evolving applications in trade finance.
Growing Popularity
Standby letters of credit have grown in recent years, mainly to enhance the security of open account transactions. They provide a reliable mechanism to ensure payment if the buyer fails.
This growth is driven by the increasing complexity of international trade and the need for robust financial instruments to manage risks.
Increased Domestic Use
SBLCs are increasingly used in domestic transactions and international trade. This trend reflects their versatility and effectiveness in various business contexts.
In addition to international transactions, SBLCs secure domestic contracts, provide performance guarantees, and support multiple financial arrangements.
Stricter Issuance Policies
Since the 2008 financial crisis, banks have become more stringent in issuing standby letters of credit (SBLCs). This increased scrutiny ensures that the financial risks associated with SBLCs are carefully managed.
Banks now require more comprehensive documentation and higher levels of collateral to issue SBLCs, which helps mitigate the risks involved.
When an LC or SBLC May Not Be the Best Option
While letters of credit and standby letters of credit are valuable tools for facilitating trade finance and reducing risk, there are better options for some business transactions.
Small Transactions
For small transactions, the costs associated with issuing an LC or SBLC may outweigh the benefits. In such a case, other payment methods may be more cost-effective and efficient.
The fees and administrative requirements of an LC or SBLC can be burdensome for small deals, making more straightforward payment methods more attractive. Also, the costs involved, including those charged by the buyers and commercial banks, can be significant, making these financial instruments less suitable for low-value transactions.
Established Relationships
If the buyer and seller have a long-standing, trusted relationship, an LC or SBLC may not be necessary. Established relationships often rely on open account terms or other straightforward payment methods.
Trust and a history of reliable transactions can reduce the need for formal guarantees provided by LCs and SBLCs. In such scenarios, the need for a financial institution to intervene with trade finance mechanisms like performance bonds or financial SBLCs is minimized.
Additionally, this scenario can be a good opportunity to use guaranteed invoices.
Unstable Environments
Banks may be reluctant to issue an LC or SBLC in countries with unstable economic or political environments.
The risk involved in such environments can make it challenging to secure bank guarantees. The buyer’s creditworthiness might also be questioned, complicating the issuance process.
In these situations, alternative methods of securing payment, such as early payments or escrow accounts, may be more appropriate. These alternatives can act as a safeguard where the usual financial instruments might fail.
Urgent Shipments
If a fast shipment is required, the time needed to issue an LC or SBLC may be an obstacle. The due date for shipping and the need for immediate processing can make the lengthy bank procedures impractical.
In these situations, alternative payment methods that do not involve lengthy bank processes may be more suitable. The time required for the application, approval, and issuance of an LC or SBLC can delay the shipment and complicate the transaction.
Businesses must weigh the need for a quick turnaround against the security provided by these instruments.
How to Obtain an LC or SBLC
Obtaining a letter of credit or standby letter of credit is a process that requires careful planning and documentation.
Approach Your Bank
Start by contacting your bank and explaining your requirement for a letter of credit or standby letter of credit.
The bank will provide guidance on the application process and the necessary documentation. It is essential to clearly outline the transaction details and the reasons for needing the LC or SBLC.
Complete the Application
Fill out the application form and provide supporting documents about the underlying transaction. This may include the sales contract, purchase order, and details of the goods or services being traded.
Ensure all the required information is accurate and complete to ensure a timely approval process.
Bancoli customers with verified accounts can request LC and similar documentation by contacting the support team from their dashboard.
Undergo Credit Evaluation
The bank will conduct a credit evaluation based on your financials, credit history, and collateral. This step is crucial to determine your creditworthiness and the terms of the LC or SBLC.
The bank will assess the risk and may require additional guarantees or collateral to secure the financial instrument.
Approval and Issuance
If the bank approves your application, you must pay the issuance fee and provide the necessary details to prepare the letter of credit or standby letter of credit.
The bank issues the LC or SBLC according to the agreed terms and sends it to the seller’s bank. The issuance process requires careful coordination between the buyer, seller, and their respective banks to meet all terms.
In Conclusion
A letter of credit is a primary payment method in which the bank substitutes its creditworthiness for the buyer and guarantees payment to the seller upon presentation of compliant documents.
A standby letter of credit is a secondary payment method in which the bank pays only if the buyer fails to do so directly.
Both instruments are important tools for facilitating trade and reducing risk, but they carry costs and may not always be the optimal solution. By understanding their workings, benefits, costs, and trends, business owners can make informed decisions for their international operations.
