Banking Expert > Letter of Credit > Standby Letter of Credit

Standby Letter of Credit Standby letter of credit (SLOC) serves as a parallel (collateral) payment source in case the primary source fails to meet its obligations in part or in full.

A guarantee of payment issued by a bank on behalf of a client that is used as “payment of last resort” should the client fail to fulfill a contractual commitment with a third party. Standby letters of credit are created as a sign of good faith in business transactions, and are proof of a buyer’s credit quality and repayment abilities. The bank issuing the SLOC will perform brief underwriting duties to ensure the credit quality of the party seeking the letter of credit, then send notification to the bank of the party requesting the letter of credit (typically a seller or creditor).

Standby letters of credit are often used in international trade transactions, such as the purchase of goods from another country. The seller will ask for a standby letter of credit, which can be cashed on demand if the buyer fails to make payment by the date specified in the contract.

The standby basically fulfills the same purpose as a bank guarantee: it is payable upon first demand and without objections or defenses on the basis of the underlying transaction between the applicant and the beneficiary. It is up to the beneficiary to decide whether he may accept a standby.

How Standby Letters of Credit Work

  1. Two parties enter into a contract that calls for one party to arrange a letter of credit in favor of the other. With a standby letter of credit, the agreement is that the L/C will not be drawn unless the applicant defaults on the contract. Standby letters of credit can be used as bid bonds, performance bonds, advance payment guarantees, and for many other purposes.
  2. The first party applies to his bank for a letter of credit, signing the bank’s letter of credit application/agreement form, and indicating what documents the beneficiary will be required to present in order to be paid. 1st Principle of Letters of Credit is Letters of Credit are documentary.
  3. After approving the application, the issuing bank issues the actual letter of credit instrument and sends it to the beneficiary. There are 3 separate contracts in a letter of credit transaction: The underlying contract, The L/C application/agreement, and The L/C itself.
  4. Having received the issuing bank’s assurance that the applicant will perform (or the L/C can be drawn), the beneficiary performs his end of the contract.
  5. In the event the beneficiary feels the applicant has defaulted, he prepares the documents called for in the letter of credit and presents them to the issuing bank.
  6. The issuing bank examines the documents. If it determines that the documents comply with the letter of credit, the issuing bank pays the beneficiary. Note that there is no inquiry into the truth of the documents and permission to pay is not sought from the applicant, who is likely to not want the bank to pay and to insist he is not in default on the contract. 2nd Principle of Letters of Credit is Letters of Credit are independent of any other contract or obligation.
  7. The issuing bank obtains reimbursement for the payment from the applicant and forwards the documents to the applicant.
  8. If the applicant feels the drawing was not justified, he can seek to get the funds returned under the terms of the contract.

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