Commercial letters of credit commercial letters of

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Commercial Letters of Credit. Commercial letters of credit are widely used in both domestic and international trade. For example, they ease the shipment of grain between a farmer in Iowa and a purchaser in New Orleans or the shipment of goods between a U.S. importer and a foreign exporter. The bank’s role is to provide a formal guarantee that payment for goods shipped or sold will be forthcoming regardless of whether the buyer of the goods defaults on payment. We show a very simple LC example in Figure 2B–2 for an international transaction between a U.S. importer and a German exporter. Suppose that the U.S. importer sent an order for $10 million worth of machinery to a German exporter, as shown in step 1 of Figure 2B–2. However, the German exporter may be reluctant to send the goods without some assurance or guarantee commitment fee The fee charged on the unused com- ponent of a loan commitment. commercial letters of credit Contingent guaran- tees sold by an FI to underwrite the trade or commercial perfor- mance of the buyers of the guarantees. standby letters of credit Guarantees issued to cover contingencies that are potentially more severe and less predictable than con- tingencies covered under trade-related or commercial letters of credit. FIGURE 2B–1 Loan Commitment Transaction Loan Commitment Agreement Begins Off Balance Sheet; No Change Made On Balance Sheet. Take Down $8m. of Loan Commitment; Loans Increase by $8m. On Balance Sheet; $2m. Commitment Remains Off Balalnce Sheet. Loan Commitment Period Ends and Is Removed Off Balance Sheet; No Change On Balance Sheet. 1 Year 6 Months 0
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Appendix 2B Commercial Banks’ Financial Statements and Analysis 13 of being paid once the goods are shipped. The U.S. importer may promise to pay for the goods in 90 days, but the German exporter may feel insecure either because it knows little about the creditworthiness of the U.S. importer or because the U.S. importer has a low credit rating (i.e., B or BB). To persuade the German exporter to ship the goods, the U.S. importer may have to turn to a large U.S. bank with which it has developed a long-term customer relationship. In its role as a lender and mon- itor, the U.S. bank can better appraise the U.S. importer’s creditworthiness. The U.S. bank can issue a contingent payment guarantee—that is, an LC to the German exporter on the importer’s behalf—in return for an LC fee paid by the U.S. importer. In our example, the bank would send the German exporter an LC guaranteeing payment for the goods in 90 days regardless of whether the importer defaults on its obligation to the German exporter (step 2 in Figure 2B–2). Implicitly, the bank is replacing the U.S. importer’s credit risk with its own credit risk guarantee. For this substitution to work effectively, the bank, in guaranteeing payment, must have a higher credit standing or better credit quality reputation than the U.S. importer.
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