Table of Contents
Definition of Standby Letter of Credit
A Standby Letter of Credit is a document that provides a guarantee to the beneficiary that if due to any circumstances, the importer is unable to pay; the bank will make the payment to the beneficiary i.e. the exporter.
Let us understand the concept of Standby Letter of Credit with the help of an example.
Example of Standby Letter of Credit
Niya Ltd., an exporter from India received an order to supply goods to John Ltd., an American company. Niya Ltd. wants an assurance from John Ltd. that it would make a timely payment for the goods. Obliging to the request of Niya Ltd., John Ltd. issued a Standby Letter of Credit in favour of Niya Ltd. In this case, if due to any circumstances John Ltd. fails to make the payment to Niya Ltd., the Indian company can claim the credit on the Standby Letter of Credit. Thus, the Standby Letter of Credit acts as an assurance to the exporter that he would be paid for the export of goods.
The concept of Standby Letter of Credit is often confused with the Letter of Credit. However, there is some difference between the two:
Standby Letter of Credit vs. Letter of Credit
Letter of Credit is a credit document that is used to make payment to the beneficiary on the fulfillment of contractual obligations. However, Standby Letter of Credit is a standby payment mode that can be used by the beneficiary only when the purchaser fails to make him the payment due to any reason.
Types of Standby Letter of Credit
Standby Letter of Credit is of two types:
- Financial Standby Letter of Credit
- Performance Standby Letter of Credit
Let us understand the meaning of each type of Standby Letter of Credit.
Financial Standby Letter Of Credit
Financial Standby Letter of Credit is an irrevocable undertaking by the bank to make payment to the beneficiary if the purchaser fails to meet the obligation. The bank pays the guarantee amount in full as all the financial standby letters of credit have 100% conversion factor.
Performance Standby Letter of Credit
Performance Standby Letter of Credit is an irrevocable obligation by the bank to pay the beneficiary on the failure of the purchaser to fulfill any contractual obligations. Performance Standby Letter of Credit is based on the fulfillment of performance and the bank makes 50% payment to the beneficiary if the purchaser fails to make the payment.
Revolving Letter of Credit
Revolving Letter of Credit is a special type of Letter of Credit that facilitates long-term business contracts between the exporters and importers. The Revolving Letter of Credit involves contracts covering multiple shipments or purchases over a long duration of time.
Standby Letter of Credit is the growing need for international transactions. The exporter of goods always wants to be assured that his payment would be timely made. If for any reason his payment is not made, he must have an alternative source from where he can recover his money. Standby Letter of Credit acts as that alternative source. It gives confidence to both the parties in International trade. In the coming years, the businesses are expected to utilize Standby Letter of Credit at a higher rate.