Standby LCs Are Good Business – If You Know What You Are Doing!

The proposed changes to the EU’s Capital Requirements Regulation (CRR) that would define off-balance instruments, including standby letters of credit, as “medium risk” may – or may not – hike the required credit conversion factor to 50% from the 20% under the current CRR. Irrespective of this outcome, the standby LC is a robust product.

Published data on default rates of standby letters of credit are not readily available but limited findings for standbys in the 2022 ICC Trade Register and my own
opinion based on more than a quarter of a century experience in working with standbys suggests that defaults are at a very low level.

The main driver for banks to issue or confirm a standby letter of credit is usually the fact that when banks issue or confirm standbys, they charge fees based on the value of the standby outstanding. Even though the bank is taking credit risk on issuing or confirming standbys, in my experience the reality is that most standbys used to secure potential defaults in international business are issued and expire unutilised without ever being drawn by the beneficiary.

By way of illustrating this point, the European Bank for Reconstruction and Development (EBRD) introduced in 1999 a new trade finance support mechanism called the Trade Facilitation Programme (TFP). Under the TFP, EBRD guarantees (which are always issued as standby LCs) are provided to international commercial banks (confirming banks) thereby covering the political and commercial payment risk of transactions undertaken by smaller emerging banks in the EBRD’s countries of operation. I have been involved with the EBRD as a consultant and trainer for many years and trained banks on how to effectively use the standby-based programme in all EBRD countries of operation. Despite the fact that billions of US dollars of underlying trade transactions have been covered under the EBRD TFP standby programme since its formation in 1999, there had only been two claims, which were restructured without any losses.

The Trade Facilitation Programmes of other multilateral developments banks (MDBs), such as the IFC (private sector arm of World Bank), ADB (Asian Development Bank), and IDB (Inter American Development Bank), also use standby LCs to underpin trade transactions. To the best of my knowledge, these MDBs have not experienced any claims which resulted in losses despite the large amounts outstanding in standby LCs.

It must be remembered that issuing (or confirming) standby LCs provides good business for banks and opens up new lines to cross-sell further banking products to customers. Additionally, it is advantageous for beneficiary clients in that, for example, a company in a given location may proceed to securely undertake contracts with parties which are based in another country or jurisdiction, while having its exposure secured with a credible institution within its own jurisdiction at home.

It is also interesting to observe in my day-to-day practice that direct-pay standbys issued subject to ISP98 are on the increase, driven by beneficiaries seeking alternatives to commercial letters of credit issued subject to UCP600. Recently published data indicated that commercial letters of credit with the UCP600 as applicable rules do not provide the beneficiary with dependable security, especially in the current environment with ever-increasing geo-political risks.