A Standby Letter of Credit (SBLC) acts as a financial safety net, providing assurance that payment or contract performance will be fulfilled even if one party defaults. It’s a legally binding document issued by a bank that guarantees payment to a beneficiary—such as a seller or contractor—if the applicant, the party responsible for payment or performance, fails.
How Does an SBLC Work?
The SBLC process involves three main parties:
- Applicant: The buyer or party requesting the SBLC from their bank to guarantee their obligations (e.g., an importer or project developer).
- Beneficiary: The seller or service provider who receives the SBLC as a payment guarantee.
- Issuing Bank: The financial institution issuing the SBLC, agreeing to pay the beneficiary if the applicant defaults.
Once the SBLC is issued, it remains valid throughout the contract period. If the applicant fulfills their obligations as agreed, the SBLC expires unused. However, if the applicant defaults, the beneficiary can present required documentation to the issuing bank to claim payment.
Types of SBLCs
SBLCs generally come in two forms:
- Financial SBLC: Guarantees payment for goods or services if the applicant fails to pay.
- Performance SBLC: Ensures that contractual obligations, such as project completion or service quality, are met; if not, the beneficiary is compensated.
How SBLC Differs from a Bank Guarantee
While both serve as assurances against default, an SBLC is more common in the U.S. and governed by international commercial rules such as ISP98 or UCP 600. A bank guarantee, often used in Europe, is governed by local laws and may have different documentation requirements.
| Feature | Standby Letter of Credit (SBLC) | Bank Guarantee |
|---|---|---|
| Purpose | Secondary payment method upon default | Promise to cover loss upon default |
| Common Region | Primarily U.S. and international trade | More common in Europe and other regions |
| Governing Rules | ISP98 or UCP 600 (International Chamber of Commerce) | Local laws and contract terms |
When Is an SBLC Used?
SBLCs are commonly used by:
- Small businesses engaging in international trade for the first time.
- Contractors bidding on large infrastructure or public projects.
- Businesses securing large leases or significant contracts where trust is limited.
Costs and Considerations
Issuing an SBLC involves fees, typically ranging from 1% to 10% annually based on the applicant’s creditworthiness and transaction risk. While an SBLC is not a loan, if the bank pays under the SBLC, the applicant must reimburse the bank, possibly converting it into a loan with interest.
FAQs
Q: Does an SBLC guarantee the quality of goods or services?
A: No, the bank’s obligation is limited to payment upon meeting documentary conditions, not the quality of goods or services. Quality disputes must be resolved directly between the contracting parties.
Q: Is an SBLC considered a loan?
A: No, it is a contingent credit product. No funds are exchanged unless the applicant defaults, but repayment to the bank may be required after payout.
For more detailed information on related topics, please see our Bank Guarantee article.
Sources:
- International Chamber of Commerce, ISP98
- U.S. International Trade Administration – Letters of Credit
- Investopedia, “Standby Letter of Credit (SBLC)” definition
For more on financial guarantees and credit products, explore our Glossary.