Major source of risk exposure resulting from the issuance of standby letters of credit.

Full Answer Section

 

• Dispute: There may be a dispute between the applicant and the beneficiary over whether or not the underlying obligation has been fulfilled.
• Insolvency: The applicant may become insolvent and unable to fulfill their obligations.

In addition to these general risks, there are also some specific risks associated with different types of SBLCs. For example, performance SBLCs, which are used to guarantee the performance of a contract, carry the risk that the applicant will not perform their obligations under the contract. Advance payment SBLCs, which are used to guarantee the payment of an advance payment, carry the risk that the applicant will not repay the advance payment if they default on their obligations. How to mitigate the risks of SBLCs There are a number of things that issuing banks can do to mitigate the risks of SBLCs, including:

• Carefully evaluate the applicant's creditworthiness: Before issuing an SBLC, the issuing bank should carefully evaluate the applicant's creditworthiness to ensure that they are unlikely to default on their obligations.
• Require collateral: The issuing bank may require the applicant to provide collateral to support the SBLC. This collateral could be in the form of cash, securities, or other assets.
• Obtain a counter-guarantee: The issuing bank may obtain a counter-guarantee from another bank. A counter-guarantee is a promise by another bank to reimburse the issuing bank if the beneficiary draws on the SBLC.
• Include clear and concise terms and conditions in the SBLC: The SBLC should include clear and concise terms and conditions that specify the conditions under which the beneficiary can draw on the SBLC. This will help to avoid disputes over whether or not the underlying obligation has been fulfilled.

Conclusion SBLCs can be a useful tool for businesses to mitigate their risks, but they also carry some risks for the issuing bank. Issuing banks can mitigate these risks by carefully evaluating the applicant's creditworthiness, requiring collateral, obtaining a counter-guarantee, and including clear and concise terms and conditions in the SBLC. Real-Life Example A construction company is awarded a contract to build a new bridge. The construction company's client requires the construction company to obtain a performance SBLC to guarantee that the construction company will complete the bridge on time and within budget. The construction company applies to its bank for a performance SBLC. The bank evaluates the construction company's creditworthiness and requires the construction company to provide collateral to support the SBLC. The bank also obtains a counter-guarantee from another bank. The construction company completes the bridge on time and within budget. The client does not need to draw on the SBLC, and the construction company is able to repay its loan to the bank.      

Sample Solution

   

The major source of risk exposure resulting from the issuance of standby letters of credit (SBLCs) is the possibility of the beneficiary drawing on the SBLC, even if the underlying obligation is not fulfilled. This means that the issuing bank could be required to pay out a large sum of money, even if the customer (the applicant) does not default on their obligations.

There are a number of factors that can contribute to the risk of a beneficiary drawing on an SBLC, including:

• Fraud: The beneficiary may defraud the issuing bank by submitting false or misleading documentation to support their draw.