Standby letter of credit
A standby letter of credit (SLC) is a written form of guarantee by a bank to provide payment for goods and services, in the event that the customer fails to meet its obligations. Unlike traditional letters of credit, in which payment is made to a beneficiary upon presentation of documents stipulated in the letter of credit, standby letters of credit are typically not used as a primary payment mechanism, but as a form of payment “back-up” in the event that a business defaults in its obligations.
A standby letter of credit is an irrevocable undertaking only payable upon successful provision of a claim. Banks are required to show that the claim or demand for payment is in compliance with the original credit document. If successful the banks are required to pay the supplier and to then recover their losses from the customer through legal procedures. The issuing bank accepts to pay their customers committed sum of money on demand with due presentation of certain documents. In other words, the principal debtor is usually liable to the beneficiary up to a certain limit, should the principal debtor fail to honor its obligation. This instrument is binding as soon as it is issued or confirmed and does not depend on any future event.
The standby letter of credit is most commonly used in international transactions for:
• Regulating advance payments.
• Ensuring performance of the signed contract.
• Providing a sure of payment in the event that the buyer fails to pay.
Risk mitigation against commercial fraud is an important factor in standby letters of credit. Since banks can not adequately mitigate against the irrational behaviour of a defaulting customer, standby letters of credit provide an effective risk management instrument. Banks will only issue letters of credit to clients who are believed to have the financial ability to honor their obligations.
The primary benefit of standby letters of credit is that they provide a secure method of payment for a customer. When a letter of credit is accepted by all parties, it creates a reliable and traceable record of payment that increases the customer’s confidence in the transaction. Furthermore, standby letters of credit are typically less expensive than other methods of payment, such as bank transfers or cheques, and the fees for issuing a standby letter of credit are generally much lower than those for an irrevocable letter of credit.
Due to their advantages, standby letters of credit have become a popular tool for businesses to manage their risk and grow their business. The benefits are also compounded when businesses use these letters of credit to finance large international transactions, as they provide a reliable and secure form of payment and reduce the risk of non-payment.
In conclusion, a standby letter of credit is an important risk mitigation tool for businesses, providing security, reliability and a traceable payment method. Standby letters of credit are particularly useful for businesses who are looking to grow their international transactions, as they provide an effective method of payment and can help to protect a business against non-payment.
