Part 2: Understanding and Utilizing Letters of Credit (LC) and Standby Letters of Credit (SBLC)

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Access to reliable and secure payment methods is crucial for the growth and sustainability of small and medium-sized enterprises (SMEs) in Africa. Letters of Credit (LC) and Standby Letters of Credit (SBLC) are two financial instruments that can significantly enhance the credibility and operational efficiency of SMEs, particularly in international trade.

This article explores how SMEs can leverage LCs and SBLCs to facilitate transactions, mitigate risks, and expand their business horizons.

A Brief History of Letters of Credit

Letters of Credit have a rich history dating back to ancient times. The concept emerged during the era of medieval trade in Europe, particularly in Italy during the 12th and 13th centuries. Italian merchants and bankers, operating in a fragmented political landscape with varying currencies and trade laws, developed LCs to facilitate international trade. These early LCs were essentially promises of payment, providing a reliable means for merchants to trade across borders without the need to carry large sums of cash.

The use of LCs spread throughout Europe and later to the rest of the world as international trade expanded. By the 19th century, with the rise of global banking institutions, LCs had become a standardized and widely accepted method of ensuring secure transactions. Today, they remain a cornerstone of international trade finance, providing security and trust in global commerce.

What is a Letter of Credit (LC)?

A Letter of Credit (LC) is a financial instrument issued by a bank on behalf of a buyer, guaranteeing payment to the seller, provided the terms and conditions specified in the LC are met. LCs are commonly used in international trade to ensure that transactions are completed smoothly and securely.

Types of Letters of Credit

1. Commercial Letter of Credit: This is the most common type of LC used in trade transactions. It guarantees payment to the seller upon the presentation of specified documents, such as a bill of lading, invoice, and packing list.
2. Revocable and Irrevocable Letters of Credit: A revocable LC can be amended or canceled by the issuing bank at any time without prior notice to the beneficiary. In contrast, an irrevocable LC cannot be altered or canceled without the consent of all parties involved.
3. Confirmed Letter of Credit: This type of LC includes an additional guarantee from a second bank, usually in the seller's country. It offers extra security to the seller, ensuring payment even if the issuing bank defaults.
4. Sight and Deferred Payment Letters of Credit: A sight LC requires payment to be made immediately upon the presentation of compliant documents, while a deferred payment LC allows payment at a later date, as specified in the LC terms.

How LCs Work

1. Agreement: The buyer and seller agree on the terms of the transaction and specify the documents required for payment.
2. Issuance: The buyer applies for an LC from their bank (issuing bank), which then issues the LC in favor of the seller (beneficiary).
3. Advising: The LC is sent to the seller's bank (advising bank), which notifies the seller of the LC's issuance.
4. Shipment: The seller ships the goods and presents the required documents to their bank.
5. Document Examination: The advising bank examines the documents and forwards them to the issuing bank.
6. Payment: If the documents comply with the LC terms, the issuing bank makes payment to the seller's bank, which then credits the seller's account.

Benefits of Using LCs for SMEs

1. Risk Mitigation: LCs provide a secure payment mechanism, reducing the risk of non-payment for the seller and assuring the buyer that payment will only be made if the terms are met.
2. Enhanced Credibility: Using LCs can enhance the credibility of SMEs in the eyes of international partners, facilitating smoother and more reliable trade relationships.
3. Access to Finance: Banks are more willing to finance transactions backed by LCs, providing SMEs with access to necessary working capital.

Costs Associated with Letters of Credit (LCs)

1. Issuance Fee: Charged by the issuing bank for creating the LC. This fee is typically a percentage of the LC amount.
2. Advising Fee: Charged by the advising bank (the seller's bank) for notifying the seller that the LC has been issued.
3. Confirmation Fee: If the LC is confirmed by a second bank (usually in the seller's country), this bank charges a fee for providing an additional guarantee.
4. Amendment Fee: Charged for any changes or amendments made to the LC terms after it has been issued.
5. Document Handling Fee: Charged for the processing and examination of documents submitted under the LC.
6. Discrepancy Fee: Charged if the documents presented do not comply with the terms and conditions of the LC.
7. Payment/Negotiation Fee: Charged by the negotiating bank for processing the payment once the documents are found to be in order.

What is a Standby Letter of Credit (SBLC)?

A Standby Letter of Credit (SBLC) is a financial guarantee issued by a bank on behalf of a client, ensuring that the beneficiary will receive payment if the client fails to fulfill contractual obligations. Unlike a commercial LC, an SBLC acts as a safety net rather than a primary payment method.

Types of SBLCs

1. Performance SBLC: Guarantees the fulfillment of contractual obligations, such as completing a project on time.
2. Financial SBLC: Ensures payment if the client defaults on a financial obligation, such as a loan repayment.

How SBLCs Work

1. Issuance: The client applies for an SBLC from their bank, which issues the SBLC in favor of the beneficiary.
2. Demand for Payment: If the client fails to fulfill their obligations, the beneficiary can demand payment under the SBLC by presenting specified documents.
3. Payment: Upon verifying the documents, the issuing bank makes payment to the beneficiary.

Benefits of Using SBLCs for SMEs

1. Credit Enhancement: SBLCs enhance the creditworthiness of SMEs, making it easier to secure contracts and financing.
2. Risk Management: SBLCs provide a safety net, protecting SMEs from potential losses due to non-performance by counterparties.
3. Facilitating Trade: SBLCs facilitate international trade by providing a reliable payment guarantee, fostering trust between trading partners.

Costs Associated with Standby Letters of Credit (SBLCs)

1. Issuance Fee: Charged by the issuing bank for creating the SBLC. Similar to LCs, this fee is typically a percentage of the SBLC amount.
2. Advising Fee: Charged by the advising bank for notifying the beneficiary that the SBLC has been issued.
3. Confirmation Fee: If the SBLC is confirmed by another bank, there is a fee for this additional guarantee.
4. Renewal Fee: Charged if the SBLC needs to be renewed after its initial expiry date.
5. Drawing Fee: Charged when the beneficiary makes a draw under the SBLC.
6. Amendment Fee: Charged for any changes or amendments made to the SBLC terms after issuance.

Examples of Costs

• Issuance Fees: Can range from 0.1% to 1.5% of the LC/SBLC amount, depending on the risk and duration.
• Confirmation Fees: Typically between 0.5% and 2% of the LC/SBLC amount.
• Amendment Fees: Generally fixed amounts, e.g., $100 to $300 per amendment.

Factors Affecting Fees

1. Transaction Size: Larger transactions may incur higher fees, although sometimes banks offer tiered pricing with lower percentages for higher amounts.
2. Risk Assessment: The perceived risk associated with the transaction or the parties involved can affect fees.
3. Complexity: More complex terms and conditions can lead to higher fees due to the additional work involved.
4. Bank Policies: Fees can vary widely between different banks and financial institutions.

Case Study: Utilizing LCs and SBLCs

Example 1: Bismark Textiles Ltd (Imaginary Company)

Bismark Textiles, a Ghanaian SME specializing in fabric manufacturing, sought to expand its market to Europe. To secure a large order from a German retailer, Bismark Textiles used an irrevocable LC. This ensured that they would receive payment upon fulfilling the order requirements. The LC provided the retailer with confidence in the transaction, and Bismark Textiles successfully completed the shipment, receiving timely payment and establishing a foothold in the European market.

Example 2: Nile Agri Ltd Imaginary Company)

Nile Agri, a Kenyan agricultural exporter, entered into a contract with a major international buyer. To mitigate the risk of non-payment, Nile Agri obtained a financial SBLC from their bank. When the buyer faced liquidity issues and could not make the payment on time, Nile Agri invoked the SBLC and received the payment from the bank, ensuring their cash flow remained unaffected.

Factors to Consider When Using LCs and SBLCs

1. Cost: Both LCs and SBLCs involve fees, which can vary depending on the issuing bank, the transaction amount, and the complexity of the terms. SMEs should carefully assess these costs relative to the benefits.
2. Bank Relationships: Establishing strong relationships with banks can facilitate smoother issuance and negotiation of LCs and SBLCs.
3. Regulatory Compliance: SMEs must ensure compliance with local and international trade regulations when using these instruments.
4. Documentation: Accurate and timely documentation is crucial for the successful utilization of LCs and SBLCs. SMEs should invest in training and resources to manage documentation effectively.

Letters of Credit (LC) and Standby Letters of Credit (SBLC) are powerful tools that can help SMEs in Africa overcome the challenges of international trade and finance. They provide secure payment mechanisms and enhance creditworthiness. These financial instruments also enable SMEs to expand their markets, mitigate risks, and access necessary capital.

Call to Action!!!!!!: Go to your bank or banker and ask them more about their product offerings for LCs and SBLCs and how you can leverage them in your next transaction.