‘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.
SBLCs, unlike other types of LCs, are a type of contingency plan. In the case of other LCs, the bank makes the payment first, and then the applicant pays to the bank at a later date. However, when a bank issues an SBLC, they are only required to make the payment if the buyer or the applicant defaults.
Any bank or NBFC can issue an SBLC once they are confident about the creditworthiness of the applicant . This is because the banks or the issuing institutions are exposed to the highest risk in the process.
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.
A financial SBLC guarantees payment to the seller or the service provider for the goods or the services rendered as per the agreement within the stipulated time frame.
Example: If an edible dye manufacturer sends a shipment to a soft drink company against a financial SBLC, and the company is unable to pay for it, the issuing bank will step in and pay the manufacturer for the dye. Later on, the soft drink company would have to pay the full amount and interest to the issuing bank.
A performance SBLC is less commonly used compared to a financial SBLC. Performance SBLCs provide a guarantee of completion of a project as per the agreement or the contract. If the service provider fails to complete the project within a stipulated time frame, the bank steps in and reimburses the client.
Example: An IT company hires a contractor to construct a new office. The contractor agrees to complete the construction within a specific time frame but fails to deliver. However, if this deal is protected by a performance SBLC, the issuing bank will pay entire project fees to the IT company and will charge penalties to the contractor. This acts as a safety check to ensure that heavy budget projects are completed in a timely fashion.
Advance Payment Standby LC provides security against one party’s failure to pay the other party’s advance payment.
Bid bond/Tender Standby LCs act as a security against failure to complete the project once the applicant has been awarded the bid or the tender for it.
Also known as a backstop or a protective standby, Counter SBLC is a type of LC issued by a bank in one country to a bank in another country, asking them to issue a new standby LC to their local beneficiary.
Direct Pay SBLCs act as a security in the instance of financial instability of the applicant. A direct pay standby is irrevocable.
Insurance SBLC provides support to the beneficiary in case the applicant has committed for insurance or reinsurance but fails to do so.
A lease support SBLC is issued by the bank representing the tenant to the landlord. The bank generally takes a deposit as collateral for the SBLC. It pledges to pay the rent to the landlord in case the tenant is not able to do so.
Here’s a step by step process of how an SBLC works:
1) The process of obtaining an SBLC is fairly simple and similar to that of obtaining any other type of LC or a loan from a bank. A buyer simply walks into a bank or a financial institution and applies for an SBLC.
2) The bank then starts looking into the creditworthiness of the applicant and decides whether or not the person should be credited with the SBLC. The bank looks into the financial history of the applicant as well as their credit reports and ratings.
3) If the bank suspects that the buyer will not be able to honor the LC, they may ask for additional collateral to be provided. The size of the collateral depends on the risks as well as the nature of the business.
4) Once the buyer establishes sufficient creditworthiness, the bank asks for the details of the agreement between the buyer and the seller. Information such as the seller’s name and address, company details, the time period for which SBLC is to be taken as well as shipping documents, etc., are submitted to the bank.
5) Once the bank is satisfied with all the information at their disposal and their background checks have yielded satisfactory results, it provides an SBLC to the buyer. The bank charges 1% to 10% of the amount of SBLC as a yearly fee, and it’s applicable until the SBLC is valid.
6) If the buyer meets its obligations in the contract before the due date, the bank will terminate the SBLC without a further charge to the buyer. Once the buyer pays the seller for the goods or the services, the bank terminates the SBLC and doesn’t charge him beyond that point.
7) As discussed above, SBLC is not actually meant to be used and only acts as a security against default. It comes into action if the buyer is not able to honor the agreement with the seller, the seller goes to the bank and submits the proofs as mentioned in the SBLC. Once the bank verifies the proofs, they release the payment to the seller. The buyer then makes the payment to the bank at a later date along with interest.
Of the total SBLC amount, banks charge about 1% to 10% as annual fees -- depending on the risks and the amount. The charges are applicable as long as the SBLC is valid.
Lack of trust and fear of payment default is one of the key reasons why some international trade deals don't take off. An SBLC is the best way to bridge the gap and ensure that all the worst-case scenarios are dealt with.
Once a reputed financial institution lends someone a standby letter of credit, they’re practically making a statement about their and their company’s financial situation. This goes a long way in establishing creditworthiness.
Businesses that are just starting might fail to land big projects because they have no legacy to back them. Companies often get cold feet about working with such individuals or businesses. However, with an SBLC, they have a solid backing of a reputed financial institution and hence can successfully compete for prestigious contracts and big-ticket projects.
The fundamental difference between a Letter of Credit and a standby letter of credit is that the former can be encashed or discounted during a trade transaction. While an SBLC is just a safety measure and is only encashed if any of the parties fail to honor the agreement, one cannot get an SBLC discounted if there is no default. Most trades are honored by all the parties without any irregularities and hence the SBLC is discontinued once the trade takes place.
On the other hand, while a bank guarantee only protects the buyer against a non-performing seller, SBLCs protect both the buyer and the seller -- depending on the type of SBLC issued.
Standby Letters of Credit are highly secure documents that guarantee the payment for the goods in case the buyer defaults or is unable to pay as per the agreement.
An SBLC is used as a safety mechanism in a trade to ensure that the agreement is honored by both parties.
Yes, an SBLC can be confirmed just like a normal letter of credit.
The SBLC is an irrevocable document and hence it cannot be canceled without the consent of all the parties involved.
Yes, SBLC can be monetized.
An SBLC is transferable in that the beneficiary can sell or assign the rights to the proceeds from the SBLC, but the beneficiary remains the only party who can demand payment of the SBLC.
Many companies and service providers claim that they do provide SBLC without upfront payment. However, experts call it a myth and say that there can be no SBLC without any upfront payment since the risk is too high.
Yes, SBLC is legal and fully operational in India when issued by banks certified by the Reserve Bank of India.
Yes, an SBLC can be discounted and is often considered a great investment instrument.