A standby letter of credit (also known as an SLOC or SBLC) is a legal document, typically used in international trade, that acts as a safety net for a deal. It communicates that a bank will guarantee payment if, for example, their customer fails to send funds to a seller for goods or services provided.
Generally, SOLCs are important when the buyer and seller haven’t been acquainted and haven’t yet established a sense of trust. These documents can help a seller secure a contract with a new client. This is especially helpful when they are competing with larger, more established sellers.
What Is a Standby Letter of Credit?
An SLOC (or SBLC; the terms are used interchangeably) is an irrevocable commitment by an issuing bank that it will make payment to a designated beneficiary if the bank’s client defaults on a deal. To phrase it a bit differently, these commitments ensure the payment of a specific amount if one party does not make good on a business agreement. For example, a seller might ship goods to a buyer, but the buyer fails to pay within a specified number of days. In such cases, the bank will intervene and compensate the seller if certain conditions are met.
However, the conditions can be very specific, and failure to meet them can result in the seller not being compensated. For example, issues with shipping or with the product itself could result in denial of payment.
These letters of credit are common in international trade when buyers and sellers aren’t familiar with one another. When entities from two different countries do a deal, the laws and regulations involved may differ. This can add a layer of uncertainty to whether the deal will go through smoothly. An SLOC can help the seller feel more confident they will be paid.
An SBLC acts as a safety net or insurance policy for the seller. If all goes well with the transaction, they won’t have to make use of it. Only if there are issues with the sale will the SBLC be needed, but that bank guarantee adds a level of confidence.
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How a Standby Letter of Credit Works
Now that you know the meaning of SBLC, here’s how it actually functions.
• When a buyer and seller are entering into a large contract, an SLOC might be created, especially if the buyer and seller don’t know one another. The buyer might create one to help secure a contract or the seller might ask the buyer to obtain a letter.
• In either case, the buyer goes to a bank and requests an SLOC.
• The bank will then perform underwriting to verify the buyer’s creditworthiness.
• The bank might also ask the buyer for collateral if they have bad credit (this is an example of why bad credit is a big deal). The amount of collateral will depend on a variety of factors, including the level of risk, the size of the deal, and the strength of the business.
• Once the process is complete, the buyer receives the SLOC.
• The bank will charge a fee, typically between 1% and 10% of value per year while the contract is in effect.
• Once the transaction project is complete, the SBLC is no longer valid, and the bank will no longer charge a fee.
However, if the buyer defaults on the agreement for any reason, the seller must provide all documentation listed in the SBLC to the buyer’s bank, informing them that the buyer has not held up their end of the arrangement. The bank will then reimburse the seller and later collect payment from the buyer, plus interest.
A deal can fail to be completed for many reasons, such as bankruptcy, lack of cash flow, or dishonesty on the part of the buyer. If the bank determines the buyer has violated the terms of the SLOC, it will then make payment to the seller.
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Types of Standby Letters of Credit
There are two types of standby letters of credit: financial SBLCs and performance SBLCs.
Financial SBLC
A financial SBLC guarantees payment for goods or services provided. The SBLC guarantees that the buyer’s bank will pay the seller if the buyer doesn’t pay within the timeframe outlined in the letter. If the bank does need to step in and make payment, it will later collect payment from the buyer, plus interest.
Performance SBLC
A performance SBLC is less common but usually guarantees the completion of a project. In this case, a person or company agrees to complete a project within a specified timeframe. Thus, a performance SBLC would reimburse the party paying for the project if it isn’t completed in time or if the client otherwise feels the project was not completed to satisfaction.
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Standby Letter of Credit Example
The most common use of SBLCs is to guarantee payment when a seller ships goods, typically internationally, to a buyer.
• For instance, a buyer might secure a contract to purchase a large shipment of corn from overseas. The seller, never having done business with the buyer before, might ask the purchaser to obtain an SBLC to ensure they are paid for the shipment. Even if the purchaser has taken steps to build credit, this is a new relationship between the two businesses, and trust hasn’t yet been established.
• The SBLC indicates that the buyer will remit payment within 30 days of receiving the shipment. Thanks to shipment tracking, the seller can see that the buyer has received the shipment of corn. However, 30 days have passed, and the buyer hasn’t paid.
• The seller can then go to the buyer’s bank, which issued to SBLC, and provide the necessary documentation about this deal and lack of payment.
• If the bank agrees that the buyer hasn’t held up their end of the agreement, the bank will then pay the seller for the corn. The bank would then collect payment and additional charges from the buyer.
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Advantages of a Standby Letter of Credit
SLOCs have a few advantages worth noting:
• Guarantee of payment The main benefit of SLOCs is they guarantee payment for the seller. Even if the buyer can’t pay, the seller can ask the buyer’s bank to reimburse them.
• Helps buyers land contracts A seller might hesitate to ship goods to a buyer they don’t know and trust, even if credit monitoring reveals they seem like a good bet. There’s still an element of risk. The SLOC can make a seller more confident about doing a deal since they will be more likely to get paid.
Disadvantages of a Standby Letter of Credit
There are disadvantages to SLOCs, too. These include:
• Increased costs The bank that guarantees the SLOC will charge the buyer a fee for every year the contract is in effect. And if the bank has to pay the seller, they will charge the buyer principal plus interest.
• Not always a guarantee Although SLOCs guarantee sellers will be paid, there can be many hurdles involved before payment is issued. For example, shipping delays or problems with the product itself can lead to denial of reimbursement.
How to Obtain a Standby Letter of Credit
Obtaining a standby letter of credit is generally the responsibility of the buyer. Their bank will reimburse the seller in the event they don’t pay promptly. The bank will also have to determine how creditworthy the client is and decide if collateral is required. (One of the benefits of good credit can be not having to put up collateral in situations like this one.)
To issue the letter, the buyer might work with either a domestic or international trade division of a bank, depending on the deal’s particulars. At this point, it’s also wise for the buyer to have an attorney on site to review the terms of the agreement.
A seller can ask that the buyer obtain an SLOC as part of the contract. All parties should have legal experts involved to ensure the accuracy and conditions of the agreement.
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The Takeaway
Standby letters of credit (SLOCs) are useful legal documents for both buyers and sellers doing business, especially if they are working on an international deal. These letters can act as a safety net, saying that if a buyer doesn’t complete a deal, their bank will step in and make payment. For sellers, these letters can help increase confidence that they will be paid for goods or services. For buyers, they can be helpful in securing new contracts.
Not all banking involves international business deals, however. If you are looking for a reliable bank for your daily personal finance needs, see what SoFi offers.
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FAQ
What does standby mean in letter of credit?
A letter of credit is a legal document that provides a safety net for a financial deal. “Standby” in this context refers to the fact that these letters are only implemented (and funds then issued) by the bank if the buyer fails to pay. If the buyer pays within the expected timeframe, no action is taken. The letter of credit has stayed on standby status.
What is the difference between a letter of credit and a standby letter of credit?
The difference between a letter of credit and a standby letter of credit is what each of them promises. A letter of credit is a guarantee from a bank that the buyer will pay. On the other hand, a standby letter of credit is a guarantee from the bank that they will pay if the buyer fails to do so.
Can SBLC be used as collateral?
The SBLC itself is not usually considered collateral. However, a bank may require the buyer to provide collateral before issuing an SBLC if the bank feels the buyer’s creditworthiness is not up to par.
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