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WHAT IS A STANDBY LETTER OF CREDIT (SLOC)?
A standby letter of credit (SLOC) is a legal document that guarantees a bank's commitment of payment to a seller in the event that the buyer–or the bank's client–defaults on the agreement.
A standby letter of credit helps facilitate international trade between companies that don't know each other and have different laws and regulations. Although the buyer is certain to receive the goods and the seller certain to receive payment, a SBLC doesn't guarantee the buyer will be happy with the goods. A standby letter of credit can also be abbreviated SBLC.
HOW A STANDBY LETTER OF CREDIT WORKS
A SBLC is most often sought by a business to help it obtain a contract. The contract is a "standby" agreement because the bank will have to pay only in a worst-case scenario.
Although an SBLC guarantees payment to a seller, the agreement must be followed exactly. For example, a delay in shipping or a misspelling a company's name can lead to the bank refusing to make the payment.
There are two main types of standby letters of credit:
• A financial SBLC guarantees payment for goods or services as specified by an agreement. An oil refining company, for example, might arrange for such a letter to reassure a seller of crude oil that it can pay for a huge delivery of crude oil.
• The performance SBLC, which is less common, guarantees that the client will complete the project outlined in a contract. The bank agrees to reimburse the third party in the event that its client fails to complete the project.
The recipient of a standby letter of credit is assured that it is doing business with an individual or company that is capable of paying the bill or finishing the project.
The procedure for obtaining a SBLC is similar to an application for a loan.
The bank issues it only after appraising the creditworthiness of the applicant.
In the worst-case scenario, if a company goes into bankruptcy or ceases operations, the bank issuing the SBLC will fulfill its client's obligations.
ADVANTAGES OF A STANDBY LETTER OF CREDIT
The SBLC is often seen in contracts involving international trade, which tend to involve a large commitment of money and have added risks.
For the business that is presented with a SBLC, the greatest advantage is the potential ease of getting out of that worst-case scenario.
If an agreement calls for payment within 30 days of delivery and the payment is not made, the seller can present the SBLC to the buyer's bank for payment.
Thus, the seller is guaranteed to be paid.
Another advantage for the seller is that the SBLC reduces the risk of the production order being changed or canceled by the buyer.
An SBLC helps ensure that the buyer will receive the goods or service that's outlined in the document. For example, if a contract calls for the construction of a building and the builder fails to deliver, the client presents the SBLC to the bank to be made whole.
Another advantage when involved in global trade, a buyer has an increased certainty that the goods will be delivered from the seller.
Also, small businesses can have difficulty competing against bigger and better-known rivals. An SBLC can add credibility to its bid for a project and can often times help avoid an upfront payment to the seller.
WHAT IS THE DIFFERENCE BETWEEN SBLCS AND LCS?
A Standby Letter of Credit is different from a Letter of Credit.
An SBLC is paid when called on after conditions have not been fulfilled. However, a Letter of Credit is the guarantee of payment when certain specifications are met, and documents received from the selling party.
Letters of credit promote trust in a transaction, due to the nature of international dealings, distance, knowledge of another party and legal differences.
SWIFT FOR ELECTRONIC FUNDS TRANSFERS
Behind most international money and security transfers is the Society for Worldwide Interbank Financial Telecommunications (SWIFT) system.
SWIFT is a vast messaging network used by banks and other financial institutions to send and receive information, such as money transfer instructions quickly, accurately, and securely.
Every day, nearly 10,000 SWIFT member institutions send approximately 24 million messages on the network.
WHAT IS A LETTER OF CREDIT?
A letter of credit, or "credit letter," is a letter from a bank guaranteeing that a buyer's payment to a seller will be received on time and for the correct amount.
In the event that the buyer is unable to make a payment on the purchase, the bank will be required to cover the full or remaining amount of the purchase.
It may be offered as a facility.
Due to the nature of international dealings, including factors such as distance, differing laws in each country, and difficulty in knowing each party personally, the use of letters of credit has become a very important aspect of international trade.
KEY TAKEAWAYS
• A letter of credit is a document sent from a bank or financial institute that guarantees that a seller will receive a buyer's payment on time and for the full amount.
• Letters of credit are often used within the international trade industry.
• There are many different letters of credit including one called a revolving letter of credit.
• Banks collect a fee for issuing a letter of credit.
HOW A LETTER OF CREDIT WORKS
Because a letter of credit is typically a negotiable instrument, the issuing bank pays the beneficiary, or any bank nominated by the beneficiary. If a letter of credit is transferable, the beneficiary may assign another entity, such as a corporate parent or a third party, the right to draw.
Banks also collect a fee for service, typically a percentage of the size of the letter of credit. The International Chamber of Commerce Uniform Customs and Practice for Documentary Credits oversees letters of credit used in international transactions.1 There are several types of letters of credit available.
MOST COMMONLY TYPES OF LETTERS OF CREDIT
*COMMERCIAL LETTER OF CREDIT - This is a direct payment method in which the issuing bank makes the payments to the beneficiary. In contrast, a standby letter of credit is a secondary payment method in which the bank pays the beneficiary only when the holder cannot.
*REVOLVING LETTER OF CREDIT - This kind of letter allows a customer to make any number of draws within a certain limit during a specific time period.
*TRAVELER'S LETTER OF CREDIT - For those going abroad, this letter will guarantee that issuing banks will honor drafts made at certain foreign banks.
*CONFIRMED LETTER OF CREDIT - A confirmed letter of credit involves a bank other than the issuing bank guaranteeing the letter of credit. The second bank is the confirming bank, typically the seller’s bank. The confirming bank ensures payment under the letter of credit if the holder and the issuing bank default. The issuing bank in international transactions typically requests this arrangement.
WHAT IS THE DIFFERENCE BETWEEN A COMMERCIAL LETTER OF CREDIT AND A REVOLVING LETTER OF CREDIT?
As one of the most common forms of letters of credit, commercial letters of credit are when the bank makes payment directly to the beneficiary or seller. Revolving letters of credit, by contrast, can be used for multiple payments within a specific time frame. Typically, these are used for businesses that have an ongoing relationship, with the time limit of the arrangement usually spanning one year.
LETTER OF CREDIT VS. BANK GUARANTEE
A Bank guarantee is a commercial instrument. It is an assurance given by the bank for a non-performing activity. If any activity fails, the bank guarantees to pay the dues. There are 3 parties involved in the bank guarantee process i.e the applicant, the beneficiary and the banker.
Whereas a Letter of Credit is a commitment document. It is an assurance given by the bank or any other financial institution for a performing activity. It guarantees that the payment will be made by the importer subjected to conditions mentioned in the LC. There are 4 parties involved in the letter of credit i.e the exporter, the importer, issuing bank and the advising bank (confirming bank).
BANK GUARANTEE - BG
A bank guarantee is a type of financial backstop offered by a lending institution.
The bank guarantee means that the lender will ensure that the liabilities of a debtor will be met. In other words, if the debtor fails to settle a debt, the bank will cover it. A bank guarantee enables the customer, or debtor, to acquire goods, buy equipment or draw down a loan.
• A bank guarantee is when a lending institution promises to cover a loss if a borrower defaults on a loan.
• Parties to a loan choose direct guarantees for international and cross-border transactions.
• The guarantee provides additional risk to the lender, so loans with such a guarantee will come with greater costs or interest rates.
UNDERSTANDING BANK GUARANTEES
A bank guarantee is when a lending institution promises to cover a loss if a borrower defaults on a loan. The guarantee lets a company buy what it otherwise could not, helping business growth and promoting entrepreneurial activity.
There are different kinds of bank guarantees, including direct and indirect guarantees. Banks typically use direct guarantees in foreign or domestic business, issued directly to the beneficiary. Direct guarantees apply when the bank’s security does not rely on the existence, validity, and enforceability of the main obligation.
Individuals often choose direct guarantees for international and cross-border transactions, which can be more easily adapted to foreign legal systems and practices since they don't have form requirements.
Indirect guarantees occur most often in the export business, especially when government agencies or public entities are the beneficiaries of the guarantee. Many countries do not accept foreign banks and guarantors because of legal issues or other form requirements. With an indirect guarantee, one uses a second bank, typically a foreign bank with a head office in the beneficiary’s country of domicile.
BANK GUARANTEE TYPES
• Performance guarantee: The issuing of this type of guarantee is to ensure that a party entrusted with a given project completes the task as per the contracts specification.
• Financial guarantee: This type of guarantee ensures that the applicant will meet its financial obligation. Where the borrower defaults on its repayment obligation, the guarantor will step in to pay.
• Advance payment guarantee: It gives assurance that the amount a party gives as advance will be returned should there be a failure in honoring the contract.
• Loan Guarantee: This type of guarantee assures loan repayment even if the borrower fails to do so. It means that the guarantor has to pay the loan on behalf of the borrower.
• Bid Bond Guarantee: It gives assurance that the bidding process will honor the contract he or she has bid for as per the terms specified in the contract.
• Foreign Bank Guarantee: It gives assurance to those parties taking part in foreign transactions that each party will fulfill part of their deal in the contract.
• Shipping Guarantee: This type of guarantee gives protection to the shipping company from financial risks in case a customer fails to pay for the goods. In such a situation, the document allows it to repossess the goods.
EXAMPLE OF HOW A BANK GUARANTEE WORKS
Below are Tree examples of how a bank of guarantee works:
Example One
For instance, let’s assume that a construction company and a cement supplier enter a new contract to build a mall.
In this case, both parties may be required to obtain a bank guarantee from their banks as a way of proving their financial capability.
If a supplier is late in delivering cement in time as specified in the contract, the construction company can let the bank know.
The bank will then come in to cover for the default as per the bank guarantee specification.
Example Two
Let’s assume that there a new gym that wants to purchase gym equipment worth $2 million.
The vendor then demands that the gym owner should first obtain a bank guarantee that will assure payment before effecting the shipment.
The gym owner will request a bank guarantee from us.
The bank will assess and make a judgment whether its customer deserves the bank guarantee and his capacity to repay. The bank will use information from the assessment to gauge the appropriate amount for the bank guarantee.
If the deal involves too much risk, then the bank will ensure that it sets a bank guarantee with a higher fee.
Example Tree
Company A is a new restaurant that wants to buy $3 million in kitchen equipment.
The equipment vendor requires Company A to provide a bank guarantee to cover payments before they ship the equipment to Company A.
Company A requests a guarantee from the lending institution keeping its cash accounts.
The bank essentially cosigns the purchase contract with the vendor.
DOES A BANK GUARANTEE HAVE ANY LIMITS?
Banks have limits when it comes to issuing bank guarantees. The limit for each business entity depends is based on factors such as:
• The financial position of the business
• Their business track record
• Business security in place
BANK GUARANTEE VS. LETTER OF CREDIT
It is worth noting that a bank guarantee differs from a letter of credit.
However, the common thing with the two documents is that the issuing bank accepts liability should its customer defaults in honoring part of their contract deal.
When it comes to a bank guarantee, the claim of the seller will be on the buyer.
If the buyer fails to honor his part of the deal as per the contract, then the claim is passed on to the buyer’s bank.
With a letter of credit, the claim of the seller is first passed on to the bank and not the purchaser.
There is assurance in both cases that the seller will receive payment.
However, a letter of credit gives more assurance to the seller than a bank guarantee.
WHAT'S THE DIFFERENCE?
A bank guarantee and a letter of credit are both promises from a financial institution that a borrower will be able to repay a debt to another party, no matter what the debtor's financial circumstances. While different, both bank guarantees and letters of credit assure the third party that if the borrowing party can't repay what it owes, the financial institution will step in on behalf of the borrower.
By providing financial backing for the borrowing party (often at the request of the other one), these promises serve to reduce risk factors, encouraging the transaction to proceed. But they work in slightly different ways and in different situations.
Letters of credit are especially important in international trade due to the distance involved, the potentially differing laws in the countries of the businesses involved, and the difficulty of the parties meeting in person. While letters of credit are primarily used in global transactions, bank guarantees are often used in real estate contracts and infrastructure projects.
KEY TAKEAWAYS
• A bank guarantee is a promise from a lending institution that ensures the bank will step up if a debtor can't cover a debt.
• Letters of credit are also financial promises on behalf of one party in a transaction and are especially significant in international trade.
• Bank guarantees are often used in real estate contracts and infrastructure projects, while letters of credit are primarily used in global transactions.
BANK GUARANTEE
Bank guarantees represent a more significant contractual obligation for banks than letters of credit do. A bank guarantee, like a letter of credit, guarantees a sum of money to a beneficiary. The bank only pays that amount if the opposing party does not fulfill the obligations outlined by the contract. The guarantee can be used to essentially insure a buyer or seller from loss or damage due to nonperformance by the other party in a contract.
Bank guarantees protect both parties in a contractual agreement from credit risk. For instance, a construction company and its cement supplier may enter into a contract to build a mall. Both parties may have to issue bank guarantees to prove their financial bona fides and capability. In a case where the supplier fails to deliver cement within a specified time, the construction company would notify the bank, which then pays the company the amount specified in the bank guarantee.
TYPES OF BANK GUARANTEES
Bank guarantees are just like any other kind of financial instrument—they can take on a variety of different forms. For instance, direct guarantees are issued by banks in both domestic and foreign business. Indirect guarantees are commonly issued when the subject of the guarantee is a government agency or another public entity.
The most common kinds of guarantees include:
• SHIPPING GUARANTEES: This kind of guarantee is given to the carrier for a shipment that arrives before any documents are received.
• LOAN GUARANTEES: An institution that issues a loan guarantee pledges to take on the financial obligation if the borrower defaults.
• ADVANCED PAYMENT GUARANTEES: This guarantee acts to back up a contract's performance. Basically, this guarantee is a form of collateral to reimburse advance payment should the seller not supply the goods specified in the contract.
• CONFIRMED PAYMENT GUARANTEES: With this irrevocable obligation, a specific amount is paid by the bank to a beneficiary on behalf of the client by a certain date.
Bank guarantees are commonly used by contractors while letters of credit are issued for importing and exporting companies.
LETTER OF CREDIT
Sometimes referred to as a documentary credit, a letter of credit acts as a promissory note from a financial institution—usually a bank or credit union. It guarantees a buyer's payment to a seller or a borrower's payment to a lender will be received on time and for the full amount. It also states that if the buyer can't make a payment on the purchase, the bank will cover the full or remaining amount owed.
A letter of credit represents an obligation taken on by a bank to make a payment once certain criteria are met. After these terms are completed and confirmed, the bank will transfer the funds. The letter of credit ensures the payment will be made as long as the services are performed. The letter of credit basically substitutes the bank's credit for that of its client, ensuring correct and timely payment.
For example, say a U.S. wholesaler receives an order from a new client, a Canadian company. Because the wholesaler has no way of knowing whether this new client can fulfill its payment obligations, it requests a letter of credit is provided in the purchasing contract.
The purchasing company applies for a letter of credit at a bank where it already has funds or a line of credit (LOC). The bank issuing the letter of credit holds payment on behalf of the buyer until it receives confirmation that the goods in the transaction have been shipped. After the goods have been shipped, the bank would pay the wholesaler its due as long as the terms of the sales contract are met, such as delivery before a certain time or confirmation from the buyer that the goods were received undamaged.
TYPES OF LETTERS OF CREDIT
Just like bank guarantees, letters of credit also vary based on the need for them. The following are some of the most commonly used letters of credit:
• An irrevocable letter of credit ensures the buyer is obligated to the seller.
• A confirmed letter of credit comes from a second bank, which guarantees the letter when the first one has questionable credit. The confirming bank ensures payment in the event the company or issuing bank default on their obligations.
• An import letter of credit allows importers to make payments immediately by providing them with a short-term cash advance.
• An export letter of credit lets the buyer's bank know it must pay the seller, provided all the conditions of the contract are met.
• A revolving letter of credit lets customers make draws—within limits—during a certain time period.
SPECIAL CONSIDERATIONS
Both bank guarantees and letters of credit work to reduce the risk in a business agreement or deal. Parties are more likely to agree to the transaction because they have less liability when a letter of credit or bank guarantee is active. These agreements are particularly important and useful in what would otherwise be risky transactions such as certain real estate and international trade contracts.
Banks thoroughly screen clients interested in one of these documents. After the bank determines that the applicant is creditworthy and has a reasonable risk, a monetary limit is placed on the agreement. The bank agrees to be obligated up to, but not exceeding, the limit. This protects the bank by providing a specific threshold of risk.
Another key difference between bank guarantees and letters of credit lies in the parties that use them. Bank guarantees are normally used by contractors who bid on large projects. By providing a bank guarantee, the contractor provides proof of its financial credibility. In essence, the guarantee assures the entity behind the project it is financially stable enough to take it on from beginning to end. Letters of credit, on the other hand, are commonly used by companies that regularly import and export goods.
RELATIONSHIP MANAGEMENT APPLICATION (RMA)
Via Relationship Management Application (RMA) keys, banks can connect with each other.
The RMA is a SWIFT-mandated filter that enables financial institutions to define which counterparties can send them FIN messages.
RMA is a system, where a sender bank and receiver bank have to authorize each other to send swift messages and also what type of swift message they can send each other.
Thus, making the communication system more secure.
So, in cases where banks do not have an RMA with another bank, LOU issuing bank either must set up an RMA with Buyers Credit Bank or has to route the swift message through a bank / branch with whom both banks have an RMA.
Also note, there is an additional cost which correspondent bank will charges for Relaying or Forwarding the swift message.
SWIFT’s RMA plays an important part in supporting communication between different financial institutions. The RMA is a SWIFT-mandated filter that enables financial institutions to define which counterparties can send them FIN messages. Any unwanted traffic is blocked at the sender level, reducing the operational risks associated with handling unwanted messages and providing a first line of defence against fraud.
WHAT IS A FULLY FUNDED DOCUMENTARY LETTER OF CREDIT (FFDLC)?
A fully funded documentary letter of credit (FFDLC) is a documented letter of credit that serves as a written promise of payment provided by a buyer to a seller.
With a fully funded letter of credit, the buyer’s funds for the required payment are held in a separate account for use when needed, similar to the process for escrow.
The seller receives payment when all the terms of the agreement are fulfilled.
UNDERSTANDING FFDLC's
Letters of credit are commonly used in commercial, international transactions.
They allow a buyer to manage risks of international business dealings while also obtaining support through the promise of borrowed funds. A letter of credit is documented by a bank who serves as a third party in the transaction.
A seller may have certain requirements for the financial institutions from which it will accept letters of credit. A letter of credit serves as a binding and legal document that the seller can accept and legally contest if payment is not made according to the detailed terms.
LETTERS OF CREDIT CAN BE FUNDED OR UNFUNDED
A fully funded documentary letter of credit is a letter of credit in which the funds necessary are held in a separate account which serves as a type of escrow account. Buyers using an FFDLC may deposit some of their own funds and require funding from a financial institution for the remainder of the funds.
Typically, in an FFDLC, the buyer will need to begin paying interest on the borrowed funds as soon as they are placed in the separate account.
Buyers and sellers will usually work with third parties to fully complete transactions involving all types of letters of credit and specifically FFDLC. The seller may hold documentary letters of credit with their own bank who then acts as their agent. The seller’s agent bank can manage the documentary collection process when appropriate and can help the seller to more easily receive payment into its account.
Other operational procedures may also be included in the documentary collection. Some documentary letters of credit may include an at sight provision, which requires that the buyer initiate the transaction as soon as they receive the specified goods and accompanying paperwork.
Overall, an FFDLC provides assurance to the seller that the buyer has the necessary funds for the transaction, as it proves the buyer has transferred cash to a separate account. With an FFDLC the buyer does not have to risk sending payment to the seller without knowing whether or not the goods have actually been shipped.
Fully funded documentary letters of credit include comprehensive provisions detailing all of the necessary business and operational provisions. Such terms may include clauses for proof of shipment, such as a bill of lading stamped by customs. The conditions under which funds may revert to the buyer, such as the seller's failure to provide a bill of lading within a set time, are also outlined in the FFDLC.
FUNDED VS. UNFUNDED
Letters of credit can be funded or unfunded.
A fully funded documentary letter of credit will provide assurance that cash for the value necessary in payment has been moved to a separate account for payment when required. Unfunded letters of credit do not set aside funds specifically through a separate, escrow type of account.
In an unfunded letter of credit, the bank backing the letter of credit promises to pay if the buyer is unable to at the time payment is required. In an unfunded letter of credit, the bank may pay the full amount or a partial amount depending on the funds the buyer has available. If a bank must issue funds for an unfunded letter of credit, then interest on the funds being borrowed from the bank would usually not begin until transferred.
KEY TAKEAWAYS
• An FFDLC is a letter of credit backed by funds in escrow.
• Businesses can use an FFDLC to obtain some or all of the funds moved to an escrow account for final payment.
• Letters of credit can come in many different variations and may be either funded or unfunded.
TYPES OF LETTERS OF CREDIT
There can be numerous types of letters of credit. Each may or may not be funded. Some of the most common types of letters of credit include the following:
• Commercial/documentary letter of credit
• Standby letter of credit
• Secured letter of credit
• Revocable letter of credit
• Irrevocable letter of credit
• Revolving letter of credit
• Red clause letter of credit
• Green clause letter of credit
FINANCIAL ACCOUNTING FOR LETTERS OF CREDIT
Companies may need to make special considerations for accounting for letters of credit. These considerations can depend on whether the letter of credit is funded or unfunded. Letters of credit serve as access to borrowed funds. Funded letters of credit may involve some fees or accumulating interest, depending on the agreement.
In general, a funded letter of credit may need to be reported on the balance sheet as a liability if funds are transferred to a separate account and begin accumulating interest. An unfunded letter of credit would not necessarily need to be reported as a liability on the balance sheet until the letter of credit has been utilized in exchange for borrowed funds.
Typically, funded and unfunded letters of credit are associated with a credit line. Large institutions using funded letters of credit will usually have a designated line of credit account tied to their letter of credit needs.