by William Evans, Trade Advisory Board Member, Trade Technologies
Standby LC’s and Guarantees are becoming more important today in assisting corporates manage their international trade business. These solutions are not only valuable in managing risk but also in providing credit enhancement to allow transactions to be bankable.
Early forms of guarantees go as far back as ancient civilizations such as Mesopotamia and Egypt, where merchants relied on these guarantees to support their trade activities. Medieval Europe developed a more structured form of guarantee to support merchant transactions in trade fairs and merchant guilds. By the 19th century, a more modern approach to guarantees began with merchants and international traders working formally with banking institutions. In the last 200 years, the sophistication and complexity of uses of Bank Guarantees and Standbys have continued to grow. Today, in addition to supporting basic international trade activity, these bank instruments can be used for financial support, construction projects, real estate and other performance and financial based transactions.
Although in the U.S., banks usually issue standby letters of credit instead of bank guarantees, they both serve a comparable function. For this discussion, I will use the term Standby but the overview covers both types of instruments. The most common form of Standby from a financial institution covers financial or performance obligations and comes in to play in a transaction default.
Why are Standbys so important?
Global Business Happens with Standbys – With counterparties that could be halfway around the world from each other, these instruments ensure a level of comfort for the banks as well as the counterparties. Active users of Standbys can be viewed as knowledgeable and experienced by both the financial institution and the business clients they engage with, driving additional opportunities.
Standbys Provide Credit Enhancement - The instruments provide credit enhancement which facilitates business that would not otherwise materialize, since banks can require Standbys to mitigate their risk. Also, beneficiaries of these Standbys can use them to secure bank loans as well as more attractive terms from their suppliers.
Risk Mitigation is Addressed - Standbys reduce the risk of non-performance by ensuring that obligations are met and that is critical to banks and client beneficiaries of these obligations.
Standbys Classification as Contingent Liability Strengths the Clients Outstandings – Although issuing banks still show outstanding Standby exposure as part of the applicant’s total credit utilization, the risk profile for most performance standbys is typically lower as it is an obligation that only materializes if a triggering event like a client default occurs.
Getting Legal and Regulatory Compliance Right is Critical- Properly structured Standbys will comply with legal and regulatory requirements. They can also be used to meet contractual requirements in the terms of the contract signed between the counterparties.
The Process Improves Transaction Flow – The very structure of the Standby process through the banking system facilitates efficient business flow, building assurance for all engaged participants.
What Challenges Do Banks and Companies Encounter in Expanding Trade Business When Utilizing Standbys?
Banks and Commercial Companies that are new to international trade or are developing markets in new regions of the globe will be faced with challenges that they must understand and manage. Outlined below are some of the challenges that banks and commercial companies can face when entering new markets and/or taking on new clients.
Managing Counterparty Risk
As a company, how much risk are you willing to accept per counterparty? Do you understand the risk profile you have by counterparty? Are you contemplating transactions with clients presently operating in countries on “restricted lists” for trade or that are on “target sanction lists” for certain segments of business activities. Your banking partner should maintain active prohibited and target sanction lists to guide clients on what is possible and not possible by country.
Understanding Country Risk
When companies consider new international markets for their goods and services, it is always critical to understand those countries’ risk profiles. Countries that have extreme risk profiles make trade more uncertain, if not illegal. Risk can manifest itself in different ways. It can be financial leverage and/or economic volatility. It’s critical that countries and their banks have the economic viability to meet their commitments so in the case of an actual drawing the beneficiary does get paid. Political instability can also be a red flag that can lead to armed conflict within a country. Finally, understanding that when you are selling that you not only recognize countries on prohibited or restricted lists but also where the applicant plans to ship the goods. The shipment of goods also needs to be to countries that are not on an applicable prohibited or restricted list.
Poorly Managed Notice Periods Are Reality
The “notice period” for expiring Standbys is one factor that is very critical to managing a standby portfolio for bankers and their active clients. Banks work with their clients to provide notice periods before expiration of the credits. The notice typically ranges from 2 weeks to 60 days. Most banks that are active in this space have a regular process to ensure smooth operation. The notification is generally via email to the attention party designated by the company. The banks typically follow up with a second email, and some may call to get clarification on the instrument. What is important to note is that if the applicant does not reply to the bank, the fixed date instrument will expire. Why might this happen? The contact at the company could be on holiday or might have an illness keeping them out of the office. The designated company representative may have a new assignment within the organization or has recently left. In most cases, companies have planned well with backups, and systems to route messages to newly responsible parties, but not always.
Unintended Consequences of Mismanaged Notice Periods Can Happen
If a beneficiary believes that a Standby is about to expire for what they believe is an ongoing project or service, they may be forced to draw on it to protect their financial interests. Once the applicant receives the notice to draw from their bank that was sent by the beneficiary’s bank, they must move quickly to request an extension of the original Standby if their intent is to continue with the original credit.
In most cases, the extension is issued and the Standby expiration date is amended to a newly agreed date. In some cases, the beneficiary will refuse the extension and will continue with the requested drawing. It might be that the applicant wants changes to the underlying deal that the beneficiary is not willing to accept. In a few cases, a decision can also be influenced by the concern that the initial Standby almost expired and that was the beneficiary’s insurance of payment for what might have been a significant investment.
Foreign Exchange Fluctuations Need Active Management by Bankers and Clients
For international Standbys, foreign exchange rates impact all parties. From a banking perspective, understanding the exposure a client has is an ongoing credit risk management responsibility. A standby in EURO increases the US clients credit exposure when the US dollar depreciates against the EURO. A 15% percent decrease would require a 15% increase in credit line availability of that instrument for the US based client bank. On the flip side, if a beneficiary has a Standby in Mexican Peso, and the Peso depreciates by 15% against the dollar, the beneficiary will have a standby that is now worth 15% less in USD equivalent than when the standby was issued. Banks can provide FX hedges in some cases to protect spreads or costs of future deliverables. In every case, both applicants and beneficiaries of foreign currency Standbys, and their banks, need to understand and manage their foreign exchange risk.
Fraud Risk Exists Even in Trade Finance
Unfortunately, today we see investment scams in banking and commercial business that require us to be on guard. Even with Standbys, commercial clients need to ensure they know who they are doing business with. Banks should also help their clients identify a few red flags in this space to look out for. One term to be aware of is that the transaction will be coming from or through a “Prime Bank”. That statement has no value in banking and is only used to give comfort to a potential target. Fraudsters will want money up front for so-called administration or authentication fees and they always want you to move yesterday on a deal that will not last. Both of those should be big no-go’s for you! Fraudsters love to use deal descriptions and terms we don’t understand but ones that sound very comprehensive and complicated and they do so to convince you this must be a serious deal. You don’t understand it because they don’t want you to understand the underlying concept that there is no deal, just a big-worded fraud. Finally, they will talk about how exclusive this deal is and how much money you can make. They are just trying to bring you into to a fraud that sounds too good to be true because it is too good to be true…
Can Partners Assist Commercial Banks and Clients Growing their International Business?
A large portion of major multinational corporations that have been active with standbys for many years utilize a platform-based solution to manage their exposures and liabilities. For commercial banks and clients that are growing their international trade business this is not always true.
Tracking of Liability or Exposure is Possible
Having a partner that can provide a platform that shows regional and local banks their exposures in one place is a key step in active management. The same holds true for commercial clients that are presently using different sources to issue and track their active transactions based on different types of Standby or because different divisions within the same company use different processes.
Counterparty Risk Management is a Fundamental Requirement
As a bank or commercial client, a partner that can show a more detailed look at what type of exposure levels and tenors I have for each counterparty is valuable.
Understanding Country Risk and Associated Counterparty Exposure Levels is a Key
A partner that can assist me in assessing country risk exposures in aggregate and by client has great value when trying to effectively manage my book of business.
Effective Portfolio Management Requires Foreign Exchange Exposure Tracking
For banks it is extremely critical to determine client exposure to foreign currency Standbys. For an active commercial client, foreign exchange volatility can easily move 10-20%. Credit Risk Managers will need to ensure proper lines in USD equivalent are in place to support those currency movements. Just as importantly, commercial clients need to know how currency movements in their portfolio may impact them depending on if they are an issuer of the Standby or a beneficiary of same.
Having a platform to pull this all together is vital to banks and commercial clients that are serious about growth in trade, especially in the international arena.
Streamlining and Standardizing the Documentation Process Helps Business Work
Having a partner that can also streamline the documentation process is important. If there are documents required to apply for or to issue a Standby, can my partner customize and automate them to my needs. On a potential drawing, do I need to present a “beneficiary’s signed statement” or a commercial document and can my partner assist with this?
Summary
Commercial banks and clients that are growing in the Trade Finance space want to know if there is a partner in the market that has proven to be a leader in the field. Partnering with a company that understands how to automate a client’s Standby process to ensure they can effectively manage their portfolio, understand their exposure, and mitigate their risk as necessary, positions that client for continued successful international growth.
