New life for letters of credit

Jul 29 2009 by Simon Dunn , The Journal

IN recent years, with the world becoming smaller, the use of traditional “vanilla” trade banking products such as letters of credit (LC) has declined.

But we are starting to see a reversal of this trend with the worsening of the global economy. Suppliers around the world are becoming nervous about getting paid and are exploring their options to mitigate this risk.

What they need is a trusted adviser who understands their business and can guide them in the use of instruments that protect their interests and enable them to open new international channels of trade.

This is where the LC come into their own. Where the UK company is an exporter, the LC may simply be used as a means of payment risk mitigation, which is particularly important given the widespread recent reductions in cover provided by the credit insurance market.

Equally important, the LC can potentially be a tool for raising either pre- or post-shipment finance.

Provided the company’s bankers are comfortable with the risk of the buyer’s bank and the LC wording is in an acceptable form, the instrument may be used to advance funds up to a given percentage of the maximum LC value, say 80%, prior to shipment.

This will greatly enhance the company’s working capital and, where margin is sufficiently large, allow it to fund 100% of the production cost of the goods.

Where the UK company is an importer, it may find that whereas in the past suppliers were prepared to deal on an open account basis, they are now being asked to provide more secure instruments such as an LC.

While there is obviously additional cost and administrative effort for the UK importer in providing this, the very fact it is putting forward a secure payment vehicle may enable the company to negotiate a marginal reduction in the unit price of the goods purchased, or increase their days payable outstanding, and thus their working capital position, by requesting additional credit terms on the strength of the LC.

Contrary to the rhetoric of the past 20 years predicting the demise of the traditional letter of credit, we can now see that the letter of credit is in fact alive and kicking.

In the hands of a bank that knows customer needs, it is as important for effective risk and working capital management as it has ever been.

Simon Dunn is North East manager of trade finance for Lloyds TSB Corporate Markets.