What is a Standby Letter of Credit (SBLC)?

The term “standby letter of credit,” also known as “SBLC,” refers to a legal document in which a bank guarantees the payment of a certain amount of money to a seller in the event that the buyer fails to fulfill the terms of the contract.

In the event that something unexpected prevents the buyer from paying the agreed-upon payments to the seller, an SBLC serves as a safety net for the payment of a shipment of tangible products or a fulfilled contract to the seller. In such a situation, the SBLC makes sure the necessary payments are made to the seller following the completion of the necessary requirements.

A standby letter of credit is provided in local or international transactions where the seller and the buyer are strangers in an effort to lessen the risks involved. Some of the risks include bankruptcy and the buyer’s failure to make payments to the seller on schedule due to insufficient cash flows.

As long as the seller complies with the SBLC’s standards, the bank guarantees that it will pay the seller what is necessary for the event of an unfavorable event. The bank’s payment to the seller is a sort of credit, and as per the bank’s agreement, the buyer is obligated to pay back the principal plus interest.

In international trade, a standby letter of credit is frequently needed to support a company’s bid for a contract. The letter increases the seller’s trust in the transaction because the parties to the contract do not know one another. Since it indicates the buyer’s creditworthiness and ability to make payments for products and services even in the event of an unforeseen incident, it is regarded as a sign of good faith.

The buyer’s bank does an underwriting task to confirm the buyer’s credit quality while setting up an SBLC. The seller’s bank receives notice from the buyer’s bank assuring it of its commitment to compensate the seller if the buyer defaults on the agreement once the buyer’s bank is satisfied that the buyer is in good credit standing. It offers evidence of the buyer’s capability to pay the seller.

An SBLC application process is similar to a loan application process. The procedure begins when the buyer submits an SBLC application to a commercial bank. Based on past credit history and the most recent credit report, the bank will conduct its due diligence on the buyer to determine the buyer’s creditworthiness. The bank may want collateral up front, such as an asset or the money deposited, if the buyer’s creditworthiness is questioned.

The amount of collateral required will vary depending on the level of risk, the position of the business, and the value of the SBLC. Additional information about the seller, shipping documents needed for payment, the beneficiary’s bank, and the duration of the SBLC’s validity must be provided by the buyer to the bank.

The commercial bank will give the buyer an SBLC after reviewing the paperwork. The bank will impose a service fee varying from 1% to 10% for each year that the financial instrument is still in effect. The bank will end the SBLC without further charging the buyer if the buyer fulfills its contractual obligations before the due date.

The seller is required to deliver all required documentation listed in the SBLC to the buyer’s bank within a certain time period, and the bank will make the payment due to the seller’s bank in the event that the buyer fails to comply with the terms of the contract for various reasons, such as bankruptcy, cash flow issues, dishonesty, etc.

Different kinds of standby letters of credit

There are two primary forms of SBLC:

Financial SBLC

The financial-based SBLC ensures that goods or services will be paid for in accordance with the contract’s terms. For instance, if a crude oil company delivers oil to a foreign customer with the expectation that the customer will pay within 30 days of the date of delivery and the payment is not made by the due date, the crude oil seller may be able to claim payment from the customer’s bank for the goods delivered. Since it is a credit, the buyer will be required to pay the bank both the principal and interest.

Performance SBLC

A measure of performance The project will be finished by SBLC according to the planned timeline. The bank guarantees to pay the third party to the contract a particular amount of money in the event that the client of the bank is unable to finish the project specified in the contract.

Performance The use of SBLCs is common in tasks that have a set deadline for completion, such as building projects. The payment is a penalty for finishing the project later than expected, and it can be used to pay another contractor to take over the job or to reimburse the client for their inconvenience.

There are several categories for standby letters of credit.

• A performance standby.
• A bid-bond or tender-bond standby
• A financial standby.
• A direct-pay standby.
• An advance-payment standby.
• A commercial standby.
• An insurance standby.
• A counter standby.