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 is certain to receive payment, a SLOC doesn't guarantee the buyer will be happy with the goods. A standby letter of credit can also be abbreviated SBLC.
Key Takeaways
A standby letter of credit (SLOC) reassures another party during a business transaction.
The SLOC guarantees that a bank will financially back the buyer in the event that they can't complete their sales agreement.
A SLOC can offer protection for the selling party in the event of a bankruptcy.
A SLOC 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 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 SLOC 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 SLOC, 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 SLOC 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 SLOC will fulfill its client's obligations. The client pays a fee for each year that the letter is valid. Typically, the fee is 1% to 10% of the total obligation per year.
Advantages of a Stand by Letter of Credit
The SLOC 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 SLOC, 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 SLOC 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 SLOC 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.
How Much Does a Standby Letter of Credit Cost?
Since a bank is taking a risk by offering a SBLC, there are fees to obtain one. Typically, banks will charge between 1% and 10% of the total guaranteed price for each year that the SBLC is active.
Where Can I Apply for a Standby Letter of Credit?
Standby letters of credit are typically offered by commercial banks and lenders. The bank will assess the creditworthiness of the applicant much like a loan application.
When Would You Need an SLBC?
Standby letters of credit are often used in international trade deals where the terms may be different between parties, but that is not the only use. Anytime a buyer needs to guarantee payment for goods or services, a SBLC may be in order.
The Bottom Line
A SBLC is a powerful tool for companies negotiating large deals for goods or services. With the backing of a commercial bank, an SBLC offers reassurance that an agreement will go through, even in a worst-case scenario. But a SBLC is not without cost—there are fees, and your creditworthiness will be assessed.
A standby letter of credit (SLOC) reassures another party during a business transaction. The SLOC guarantees that a bank will financially back the buyer in the event that they can't complete their sales agreement. A SLOC can offer protection for the selling party in the event of a bankruptcy.
It is a payment of the last resort and is used when the seller/exporter feels the buyer/importer may have problems paying for goods received. If a seller feels the buyers credit rating is not good enough, they will ask for a Standby Letter of Credit.
1-6-6- Disadvantages of the standby letter of credit
Low protection in the event of default. Time constraints. Utilized for a shorter duration. Less frequently used as the documentary credit, thus it can be prone to errors.
Without prior written SBA approval, an SBLC must not voluntarily reduce its capital, or repurchase and hold more than 2 percent of any class or combination of classes of its stock.
Some of the risks include bankruptcy and insufficient cash flows on the part of the buyer, which prevents them from making payments to the seller on time. In case of an adverse event, the bank promises to make the required payment to the seller as long as they meet the requirements of the SBLC.
A Standby Letter of Credit (SBLC / SLOC) is a guarantee that is made by a bank on behalf of a client, which ensures payment will be made even if their client cannot fulfill the payment. It is a payment of last resort from the bank, and ideally, is never meant to be used.
An SBLC can act as collateral for a loan when a borrower has limited physical assets to pledge. The SBLC assures lenders of payment from the issuing bank should the borrower default.
Standby letters of credit are often used in international trade deals where the terms may be different between parties, but that is not the only use. Anytime a buyer needs to guarantee payment for goods or services, a SBLC may be in order.
The primary cost associated with an SBLC is the fee charged by the bank for issuing it. This fee typically ranges from 1% to 10% per year of the SBLC's face value, depending on the bank's assessment of risk. The riskier the client's business proposition or the lower their creditworthiness, the higher the fee.
Aside from trade credit insurance, there are other alternatives to a letter of credit. Those include: Purchase order financing: Purchase order financing provides you cash up front to complete a purchase order. Under this agreement, a financing company pays your supplier for goods you need to fulfill a purchase order.
As long as the issuer notifies the beneficiary of their intention to cancel the SBLC within the stated agreed notice period, the SBLC can be cancelled on that expiry without any need to receive consent from the beneficiary.
SBLC Discounting is the process of selling the SBLC to a third party at a discount for immediate cash. The third party becomes the new beneficiary of the SBLC and takes on the risk of the applicant defaulting. The discount is calculated based on the remaining term of the SBLC and the applicant's creditworthiness.
A red clause letter of credit is a form of legal document in payment methods that allows an importer to pay the exporter in advance. Since the importer is confident that the exporter will deliver goods as per schedule, the importer offers to make the payment in advance.
Applicant: The party requesting the SBLC, usually the buyer or importer. Beneficiary: The party receiving payment under the SBLC, usually the seller or exporter. Issuer: The bank that issues the SBLC on behalf of the applicant.
Business Financial Statements: Provide recent financial statements, including balance sheets and income statements, to demonstrate financial health. Trade Contract or Agreement: Submit a copy of the trade agreement or contract necessitating the SBLC, highlighting terms and obligations.
Here's a breakdown of its key components: Applicant: The party requesting the SBLC, usually the buyer or importer. Beneficiary: The party receiving payment under the SBLC, usually the seller or exporter. Issuer: The bank that issues the SBLC on behalf of the applicant.
While the applicant would approach their own bank for the SBLC issuance, the beneficiary needs to ensure they are comfortable with the bank issuing the SBLC in terms of country risk and credit rating. If not, they can either have the SBLC confirmed by an acceptable bank or reissued by a local bank in their own country.
More often than not, the bank will issue the Standby Letter of Credit (SBLC) within 48 hours of release. Once issued, a copy of the SBLC will be emailed to you as it is transmitted by a MT760 SWIFT message to the beneficiary, including the reference number of the SBLC.
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