The Standby Letter of Credit (SBLC) is classified as a “letter of credit” (LC), also called “documentary letter of credit” (DLC). It is a term widely used to secure payments in national and international trade. The document is issued by a financial institution, at the request of the buyer. The buyer also provides instructions for preparing the document.
A standard commercial LC is used principally in international trade finance dealings of substantial value, for trades between a provider in one area and a client in another; which usually provides an irrevocable payment bank undertaking. However, there are other purposes and uses of a DLC.
The letter of credit format under a Standby Letter can also be used for payment on a transaction. When redeemed, the Letter compensates an exporter. Additionally, an SBLC can be used in a land development effort to ensure that approved public installations (streets, sidewalks, storm water system ponds, etc.) will be built. The companies to a LC are usually a beneficiary who is to obtain the money, the issuing bank of whom the applier is a client, and the advising bank of whom the beneficiary is a client.
The International Chamber of Commerce (ICC) in the Uniform Custom and Practice for Documentary Credit (UCPDC) defines an LC as follows:
An arrangement, however named or described, whereby a bank (the Issuing bank) acting at the request and on the instructions of a customer (the Applicant) or on its own behalf:
Is to make a payment to or to the order third party (the beneficiary) or is to accept bills of exchange (drafts) drawn by the beneficiary.
Authorized another bank to effect such payments or to accept and pay such bills of exchange (draft).
Authorized another bank to negotiate against stipulated documents provided that the terms are complied with.
A key principle to remember with the Standby Letter of Credit is banks deal only in documents or goods and do not involve themselves in the commitments and contracts between the two parties directly. The concern of the issuing bank is the terms and conditions of the letter of credit itself. The decision to pay by an SBLC is based entirely on whether the documents submitted to the bank appear on their face to comply with the terms of the LC.
Unlike a traditional LC where the beneficiary obtains payment against papers demonstrating delivery, the SBLC may allow a beneficiary to obtain payment from a financial institution even when the applier for the credit has neglected to perform as per bond.
Initially used by the depository financial institutions in the United States, the standby letter of credit is very much alike in nature to a bank guarantee. Under this context, the main object of writing out such a credit is to secure bank loans. The SBLC instruments are usually cut by the appliers bank in the applicant’s country and apprised to the beneficiary by a bank in the beneficiary’s country.
How Is A Standby Letter of Credit Used In Project Financing?
Although some restrictions and conditions apply from one instrument to the next, all letters of credit are negotiable bank instruments. This allows the instrument to be rated and valued and exchanged for consideration. In other words, being a bank instrument not unlike a bank guarantee, the standby letter can then be monetized.
The use of this type of LC is almost altogether separate in purpose and issuance than a traditional import LC. Asset holders can leverage their financial holdings by issuing bank instruments for the purpose of making loans and issuing lines of credit for project financing.
The text or legal verbiage used on the SBLC will likely differ in substance from its use in payments for international trade, but will still keep intact its identity and core functionality as a DLC. Once an applier’s issuing bank agrees upon the language of the bank instrument with the lender’s beneficiary bank, the instrument would be issued usually through the SWIFT interbank communication protocols to make the necessary bank guarantees in the delivery process.
The most commonly used SWIFT communication for documentary letters of credit is the SWIFT MT760. This format of the SWIFT code is used when orders are made for a bank to aval (make commitment) with full banking responsibility on a promissory note. With the successful execution of the SWIFT MT760 the instrument is also considered to have been “fully delivered” from the issuing bank ledger to the beneficiary bank ledger.
By doing this an asset holder can leverage and monetize the financial assets on account with a bank and thus promote project financing through credit enhancement; a process of providing cash collateral security through bank instruments making loans and lines of credit.
Banks can then allow the financing against bank instruments issued from an asset holder on behalf of a beneficiary, which beneficiary constitutes a lender looking to make loans for an applicant seeking project financing.
The applicant approaches both the asset holder and its issuing bank concurrently with the lender beneficiary and its bank. Through a fee-based contract with a service provider the applicant can utilize the asset holder’s banking capability and credit worthiness to fulfill the lender’s security requirements for making a line of credit towards project funding. The bank instrument may be the primary security or secondary collateral used to make the loan.
The rating of the issuing bank as well as that of the letter of credit itself make up some of the constituents the lending ratios are based on. Other parameters may also include the viability of the project itself, the assets of the project, the assets of the company applicant, and the credit worthiness and financial soundness of the applicants involved.
One of the key components to the transaction for the asset holder, or original owner of the cash assets backing the standby letter, is ensuring the applicant is successful in getting a banking undertaking from a top rated and financially sound bank. The bank undertaking makes promises to guarantee the safe return of the instrument upon its contracted term expiry unencumbered and free of any liens.
This may sound easy enough, but most underestimate the willingness of a beneficiary bank to guarantee such a promise on behalf of its borrower unless they feel a) the project is sound, b) there is a sound repayment plan with exit strategies in place for fail safes against potential default, and c) the client has the wherewithal to make extensions on the loan should they be required, and they often are.
The beneficiary bank cannot return an instrument before the loan is repaid and lien removed. Like it would be expected of a lender they will go through often exhaustive measures to ensure their risks are minimal, otherwise there will be an unwillingness to stand behind the loan undertaking in the first place.