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What is a Standby Letter of Credit?
Mary McMahon
Mary McMahon
A standby letter of credit is a document issued by a bank that indicates that the bank will provide a payment of last resort if a customer fails to fulfill an obligation. It is similar to a bank guarantee, which offers similar protections. A bank will issue this document only after carefully examining a customer, as most banks want to avoid a situation in which someone will make a claim and force the bank to pay.
There are a number of reasons why a bank customer might request a standby letter of credit. These documents are often used in international trade when the parties involved in a deal may have concerns about whether or not a transaction will go smoothly. In many transactions, the letter acts almost like a reference, demonstrating that a contract or transaction will be fulfilled and paid for no matter what happens during the deal.
Several different types of standby letters are available, tailored to specific situations. In all cases, the payment is provided from the bank regardless of disputes or other problems. It is a guarantee that payment will be received or that an obligation will be made good in the event that the customer does not do so. One can back bonds put up when people make tender bids, indicate a guarantee of performance in a contract, or provide assurance that payment will be provided for a shipment, among many other things.
It is possible to transfer a standby letter of credit, but only with written permission from the issuing bank and the party that benefits from the document. The beneficiary is also allowed to assign the proceeds to another party, although notice must be submitted to the issuer so that it directs a payment appropriately. Without notice of reassignment, the issuing bank will make the payment to the original named beneficiary.
Standby letters of credit are primarily used in commercial transactions. Not all banks offer them, and people usually need to apply in advance in order to give a bank enough time to thoroughly investigate all parties involved. If the bank approves a customer for a letter, it will generate the document and forward it to the bank that is representing the other party in the transaction.
Mary McMahon
Ever since she began contributing to the site several years ago, Mary has embraced the exciting challenge of being a WiseGEEK researcher and writer. Mary has a liberal arts degree from Goddard College and spends her free time reading, cooking, and exploring the great outdoors.
Learn more...
Mary McMahon
Ever since she began contributing to the site several years ago, Mary has embraced the exciting challenge of being a WiseGEEK researcher and writer. Mary has a liberal arts degree from Goddard College and spends her free time reading, cooking, and exploring the great outdoors.
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Discussion Comments
@wearedr - You bring up a good point, there are both pros and cons associated with banks guaranteeing their customers' lines of credit with third part organizations.
The benefit of banks guaranteeing credit lines and other loans is that it can potentially offer banks another form of revenue. They can charge their customers interest for loaning them money. This interest provides another cash flow for the bank.
However, a drawback to banks for guaranteeing loans is potentially losing money. This can happen when too many customers default on their third party loans at the same time. If they bank does not have enough cash on hand, then they will not be able to pay all of their customers' debt at the same time.
I am not sure why the government decided not to allow US banks to guarantee loans. Maybe it was out of fear that banks would crash if they had to take on too much consumer debt.
I studied some international banking in college. I know a little bit about banking, so I thought I should share my knowledge to supplement this article.
In most developed countries, there is no need for banks to issue standby letters of credit. Instead, banks automatically guarantee all third party lines of credit of their customers. The United States, however, does not offer bank guarantees. Banking legislation prevents banks from automatically guaranteeing their customers' loans.
To get around this legislation, American banks established the system of a standby letter of credit. This is the only way that a bank could legally guarantee a customer loan to a third party vendor. Instead of this guarantee being automatic like it is in other countries, a customer has to specially request it.
I still have not decided whether or not I think US banks should offer automatic guarantees. There are pros and cons for offering them. The fact that they do not is another example of how US policies are different than those of other parts of the world.
When I lost my job a few years ago, I could not pay the mortgage on my house. I was in a really tough situation, and I did not want to lose the house because I was just about to get married. Thankfully, I had always paid all my bills on time, so I had a good credit history.
I was able to get a standby letter of credit from my bank. They allowed me to borrow money from them at a 5% interest rate, and I used that money to pay my mortgage. When I got back on my feet, I no longer needed the standby letter of credit from the bank, so I canceled it without any problems.
If it was not for the bank that helped me out, I would have lost my house. Standby letters of credit are a way for honest people to maintain their lives while they go through hard times. I am thankful to the bank for giving me a second chance.
I work for a bank that use to offer some of our customers standby letters of credit. We pride ourselves on being a family bank that cares about our customers. So when life challenges occur and people cannot pay their car notes and mortgages, we would offer them a standby letter of credit. The greater your credit score, the more likely you were to receive the line of credit.
But, when the recession hit, more and more customers were asking for standby letters of credit. Some people had an especially hard time paying back their mortgages. Our bank could not afford to give all of these customers a line of credit, so we got rid of our standby letters of credit all together.
Hopefully, we can offer them in the future. We lost a lot of customers when we could not offer them credit. Customers like to see that their bank can back them up when they get into some financial trouble.
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