Standby Letter of Credit in detail

A Standby letter of credit (SLOC) is a financial instrument used primarily in international trade and domestic construction projects. It 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.

SLOC are created as a sign of good faith in business transactions and are proof of a buyer’s credit quality and repayment abilities.

TYPES OF STANDBY LETTER OF CREDIT

There are two main types of SLOC which are discussed below :

  1. FINANCIAL SBLC – A financial SLOC guarantees payment for goods or services as specified by an agreement. For example, an exporter sells goods to an overseas buyer who guarantees payment in 30 days. When the payment does not appear by the deadline, the exporter presents the SBLC to the importer’s bank and receives the payment.
  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.

PROCESS OF GETTING SLOC

In order to obtain a standby letter of credit, a buyer has to contact a bank and establish their creditworthiness. The bank may ask for additional collateral if the risk or the amount is too high. Once the buyer fulfills all the conditions and the bank deems them fit for receiving the credit, the bank issues them an SBLC and charges 1% to 10% of the total amount as an annual fee for as long as the standby letter of credit is valid.

ADVANTAGES OF STANDBY LETTER OF CREDIT

The following points highlight the advantages of SLOC –

  • SBLC reduces the risk of the production order being changed or canceled by the buyer.
  • When a financial institution gives a SLOC it serves as a proof of its creditworthiness as it shows that the company has a stable financial condition.
  • The SLOC ensures that the payment will be made to the seller as per the agreement in case of default made by the buyer in making the payment to seller on time. This also helps in promoting international trade deals.
  • Setting up new business connections is not easy. It is very difficult to find a new buyer who will be ready to make an advance payment to an inexpert professional. Issuing a letter of credit helps the service provider to secure the order.

 

Thus, in simple words a Standby Letter of Credit (SBLC) is a type of letter of credit (LC) where the issuing bank commits to pay to the beneficiary if the applicant fails to make the payment.

 

Accounting & Finance for Banking

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