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Standby Letter of Credit
Source: Encyclopedia of Banking & Finance (9h Edition) by Charles J Woelfel
(We recommend this as work of authority.)

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.


BENNETT, BARBARA.  "Off Balance sheet Risk in Banking:  The Case of Standby Letters of Credit", Economic Review, Winter 1986, Federal Reserve Bank of San Francisco .  

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