Standby Letter of Credit (SBLC)
A document created by a bank on behalf of its customer that
guarantees the bank's promise to compensate the seller in the event that the
client (the buyer) violates the terms of the contract
A Standby Letter of Credit (SBLC) is what?
In a standby letter of credit, also known as an SBLC, a bank
guarantees the payment of a certain sum of money to a seller in the event that
the buyer breaches the contract.
In the event that anything unforeseeable prevents the buyer from
paying the agreed-upon payments to the seller, an SBLC serves as a safety net
for the payment of a shipment of tangible products or a completed service to
the seller. In such a situation, the SBLC makes sure the necessary payments are
provided to the seller following the completion of the necessary requirements.
In local or international transactions when the seller and the
buyer do not know one another, a standby letter of credit is utilized to try to
mitigate the risks involved. Some of the risks include bankruptcy and the
buyer's inability to make payments to the seller on schedule due to inadequate
cash flows.
As
long as the seller complies with the SBLC's standards, the bank guarantees that
it will pay the seller what is necessary in the event of an unfavorable
occurrence. The bank's payment to the seller is a sort of credit, and as per
the bank's agreement, the buyer is obligated to pay back the principle plus
interest.
Summary
• A standby letter of credit (SBLC) is a document that a
bank issues on behalf of a customer that guarantees the payment of the seller
in the event that the client (the buyer) fails on the contract.
• International and local transactions when the parties to a
contract do not know one another typically employ an SBLC.
• A standby letter of credit acts as a safety net by
guaranteeing the seller that, in the event that the buyer is unable to pay on
time, the bank will pay for the products or services supplied.
Standby Letter of Credit Explained
In international trade, a standby letter of credit is frequently
needed to support a company's bid for a contract. The letter increases the
seller's trust in the transaction because the parties to the contract do not
know one another. Since it demonstrates the buyer's creditworthiness and
capacity to make payments for products and services even in the event of an
unanticipated incident, it is regarded as a sign of good faith.
The buyer's bank does an underwriting task to confirm the
buyer's credit quality while setting up an SBLC. The seller's bank receives
notice from the buyer's bank assuring it of its commitment to compensate the
seller if the buyer defaults on the agreement after the buyer's bank is
satisfied that the buyer is in good credit standing. It offers evidence of the
buyer's capability to pay the seller.
How an SBLC Works
An SBLC application procedure is comparable to a loan
application process. The procedure begins when the buyer submits an SBLC
application to a commercial bank. Based on prior credit history and the most
recent credit report, the bank will do its due diligence on the buyer to
determine the buyer's creditworthiness. The bank may want collateral up front,
such as an asset or the money deposited, if the buyer's creditworthiness is
questioned.
The amount of collateral required will vary depending on the
level of risk, the viability of the company, and the value of the SBLC.
Additional information about the seller, shipping papers needed for payment,
the beneficiary's bank, and the duration of the SBLC's validity must be
provided by the buyer to the bank.
The commercial bank will provide the buyer an SBLC after
reviewing the paperwork. For each year that the financial instrument is still
in effect, the bank will impose a service fee ranging from 1% to 10%. The bank
will end the SBLC without further charging the buyer if the buyer fulfills its
contractual obligations before the due date.
The seller is required to deliver all required documentation
listed in the SBLC to the buyer's bank within a certain time period, and the
bank will make the payment due to the seller's bank in the event that the buyer
fails to comply with the terms of the contract due to various reasons, such as
bankruptcy, cash flow issues, dishonesty, etc.
Types of Standby Letter of Credit
The two main types of SBLC are:
1.
Financial SBLC
The financial-based
SBLC guarantees payment for goods or services, as stipulated in the agreement. For example,
if a crude oil company ships oil to a foreign buyer with an expectation that
the buyer will pay within 30 days from the date of shipment, and the payment is
not made by the required date, the crude oil seller can collect the payment for goods
delivered from the buyer’s bank. Since it is a credit, the bank will collect
the principal plus interest from the buyer.
2.
Performance SBLC
A performance-based SBLC guarantees the completion of a project
within the scheduled timelines. If the bank’s client is unable to complete the
project outlined in the contract, then the bank promises to reimburse the third
party to the contract a specific sum of money.
Performance SBLCs are used in projects that are scheduled for
completion within a specific timeline, such as construction projects. The
payment serves as a penalty for delays in the project’s completion, and it is
used to compensate the customer for the inconvenience caused or to pay another
contractor to take over the project.
Related
Readings
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Credit. In order to help you become a world-class financial analyst and
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