Letter of Credit or Standby Letter of Credit: Which One Do You Need

Letter of Credit or Standby Letter of Credit: Which One Do You Need

A Standby Letter of Credit (SBLC) is a bank guarantee regarding a specific payment to a seller in case the buyer stalls the payment or does not make it at all. SBLC in banking is a legal document, and the payment made by the bank to the seller is in the form of credit. The buyer is bound to pay the credit with interest as agreed with the bank earlier. During international or domestic transactions between two parties, if the buyer and the seller are not acquainted and desire to rule out any risks, standby LC is put to use. It covers risks like bankruptcy and insufficient cash flow on the buyer’s front, which disrupts the flow of payments to the seller. 

Standby LC is a safety endeavor in favour of the seller for payments against physical goods or services rendered to the buyer in cases where the scheduled payments are not made. In such a situation, the presence of SBLC makes sure that the payments are made to the seller by the bank once the required obligations are fulfilled. This payment is in the form of credit, which the buyer must repay to the bank with interest. 

Did you Know? SBLC is used in international and domestic transactions when either party is not acquainted with the other. 

 

What Is a Standby Letter of Credit?

A letter of credit is a bank guarantee that payment from a buyer to a seller will be received on time and will be of an appropriate amount. In case the buyer defaults on any payment, the bank will cover the entire or remaining part of the payment. 

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How Does a Standby Letter of Credit Work?

It is mostly used by a business to obtain a contract. It is a standby agreement, as the payment through the bank will be made only in a dire situation. The SBLC guarantees payments to a seller, but the seller also has to follow the agreement. In case of misspelling a company’s name or delay in shipment, the bank may refuse to make the payment. 

Types of Standby Letters of Credit

The following are the types of  SBLCs:

  • Financial SBLC
  • Performance SBLC
  • Advance Payment SBLC
  • As Bidding or Tender Bond
  • Counter SBLC
  • Direct Pay SBLC
  • Insurance SBLC
  • Lease Support SBLC

Financial SBLC

This type of letter of credit is used to assure the seller regarding the financial status of the buyer. In a big trade contract, this can create trust in the mind of the seller towards the buyer. It is the most commonly applied secondary guarantee, and it removes any risk of default from the buyer.  

Performance SBLC

This SBLC serves the buyer’s interest. The buyer can ask for specific performance terms regarding production, shipping, or quality inspection through a performance SBLC. The bank will release the payment only if the performance clause is fulfilled. 

Advance Payment SBLC

The buyers can use the advance payment SBLC to adjust against the down payments. It reduces the risk for the buyer against any default or non-fulfilment of the contract by the seller.

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As Bidding or Tender Bond

An SBLC can also work as a tender bond. In this case, until the finalisation of the tender, the buyer cannot withdraw the offer. The bank issuing the SBLC can attach different terms according to the client's requirements. 

Counter SBLC

Businesses also refer to as protective standby or a backdrop. A bank in one country issues it to another bank located in another country. The issuing bank requests the other bank to issue a new standby LC to their local beneficiary. 

Direct Pay SBLC

In case of financial instability of the applicant, this acts as a security. A direct pay standby cannot be reversed and is irrevocable. 

Insurance SBLC

This type of SBLC supports the beneficiary if the applicant has committed to insurance or reinsurance but has failed to do so. 

Lease Support SBLC

The bank issues this SBLC to the landlord. The bank represents the tenant. Here the bank takes a certain deposit as collateral for the SBLC. It agrees to pay the rent to the landlord if the tenant does not do so. 

Who Can Issue an SBLC?

Once sure about the creditworthiness of an applicant, any bank or NBFC can issue a standby letter of credit. 

How Much Does an SBLC Cost?

Banks charge between 1 per cent to 10 per cent annual fees from the total SBLC amount. The charges are applicable as long as the SBLC is valid. 

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Standby Letter of Credit vs Letter of Credit 

The difference between SBLC and LC is mentioned below: 

Backup plan 

An SBLC is used as security. The goal of an SBLC is to avoid using it. Resorting to an SBLC means that something went wrong somewhere. In the case of a standard letter of credit, it is expected that the payments will happen as those letters pay after a successful shipment is delivered to an importer. 

Performance Aspect

SBLCs are different from LCs because, if so desired, they can contain a performance feature that refers to negative performance. In case a service Want to learn about Finance, Investing, and much more!, Checkout our partner blogs.