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Information > Financial Terms > This page Standby Letter of Credit A
contractual arrangement guaranteeing financial or economic performance
involving three parties - the "issuer" (bank), the "account party" (the
bank customer), and the "beneficiary".
The bank guarantees that the account party will perform on a contract
between the account party and the beneficiary.
The effect is to substitute the bank's liability for the account
party's liability. The account
party compensates the bank for the risk.
The standby letter of credit contract typically includes provisions
that allow the bank to (1) require the account party to deposit funds
to cover anticipated payments the bank must make under the arrangement,
and (4) book any un-reimbursed balance as a loan at interest and on terms
set by the bank. Standby
letters of credit have played a significant role in bank failures.
The Penn Square National bank in 1982 was such a case.
Standby letters can increase bank risk materially. Outstanding
standby letters grew from $80,8 billion in June 1982 to $153.2 billion
in June 1985 - a 90% increase. Most
of the growth occurred at the 25 largest banks, which recorded more than
a $40 billion increase in outstanding standby letters during the same
period, according to an article in Economic
Review. The
traditional commercial letter of credit is typically used to finance the
shipment and storage of goods. Currently
the standby letter of credit is being used for many additional purposes.
The current standby letter is payable upon presentation of evidence
of default or non-performance by the account party.
Such letters typically expire without being used.
It is estimated that approximately one half of banks' standby letters
back debt obligations. Surety
and insurance companies as well as other specialized providers offer guarantees
as credit risk coverage (repayment of principal and interest).
The expansion of direct financing markets has contributed to this
growth. Inflation and deflation,
resulting in volatility in asset prices and returns on investment, have
also contributed to the expansion of such entities into this market.
Banks that provide standby letters of credit to customers typically
have lending and deposit relationships with these customers, thus giving
them an advantage over the nonblank providers.
In the late 1980s, fees ranged from 25 to 50 basis points on the
outstanding amount; fees on longer-term and lower-quality credits ranged
from 125 to 150 basic points or more, depending on the risk.
Banks should consider portfolio diversification as a method for
managing the credit risk involved in standby letters of credit and place
limitations on the growth of standby letters. BIBLIOGRAPHY
BENNETT,
BARBARA. "Off Balance sheet
Risk in Banking: The Case
of Standby Letters of Credit", Economic Review, Winter 1986, Federal
Reserve Bank of |