What Is a Standby Letter of Credit (SLOC)?
A standby letter of credit (SLOC) is a legal instrument that guarantees a bank’s promise to pay a seller if the buyer—or the bank’s client—fails to meet the terms of the agreement. A standby letter of credit facilitates worldwide trading between unrelated firms that operate under separate rules and regulations. Although the customer is certain of receiving the products and the seller is assured of receiving money, a SLOC does not ensure the buyer will be satisfied with the items. A standby letter of credit is sometimes known as an SBLC.1
How a Standby Letter of Credit Works
A SLOC is often sought by a firm to assist it in obtaining a contract. The arrangement is a “standby” agreement, which means that the bank will only have to pay in the worst-case situation. Although an SBLC assures payment to a seller, the terms of the agreement must be strictly fulfilled. For example, a shipment delay or misspelling of a company’s name might result in the bank refusing to complete the payment.
There are two main types of standby letters of credit:
- A financial SLOC assures payment for products or services as agreed upon. For example, an oil refining business may prepare for such a letter to convince a crude oil seller that it can pay for a large supply of crude oil.
- The less prevalent performance SLOC assures that the customer will finish the project indicated in the contract. In the event that its customer fails to finish the project, the bank commits to pay the third party.
A standby letter of credit assures the receiver that it is doing business with a person or firm capable of paying the bill or completing the project.
The application process for a SLOC is identical to that of a loan application. The bank only grants it after evaluating the applicant’s creditworthiness.
Letter of Credit
If a firm declares bankruptcy or stops operations, the bank that issued the SLOC will pay its client’s obligations. The client must pay a fee for each year the letter remains valid. The cost is typically 1% to 10% of the entire obligation every year. 1
Advantages of a Stand by Letter of Credit
The SLOC is often encountered in contracts involving foreign commerce, which typically include a big financial commitment and additional risks.
The biggest benefit for the firm that is confronted with a SLOC is the possible simplicity of moving out of that worst-case situation. If an agreement requires payment within 30 days after delivery and it is not made, the seller may bring the SLOC to the buyer’s bank for payment. As a result, the vendor is assured to get compensated. Another benefit for the seller is that the SBLC decreases the risk of the customer changing or canceling the manufacturing order.
An SBLC helps to guarantee that the buyer receives the products or services specified in the agreement. For example, if a contract asks for the construction of a building and the builder fails to deliver, the customer may produce the SLOC to the bank to be reimbursed. Another benefit of global commerce is that a buyer has more assurance that the items will be delivered by the seller.
Small firms may also struggle to compete with larger and more well-known competitors. An SBLC may give credibility to a project offer and can often assist avoid an upfront payment to the seller.
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