Once the bank issues the lc and sends it to the

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Once the bank issues the LC and sends it to the German exporter, the exporter ships the goods to the U.S. importer (step 3 in Figure 2B–2). 10 The probability is very high that in 90 days’ time the U.S. importer will pay the German exporter for the goods sent and the bank keeps the LC fee as profit. The fee is perhaps 10 basis points of the face value of the letter of credit, or $10,000 in this example. A small probability exists, however, that the U.S. importer will be unable to pay the $10 million in 90 days and will default. Then the bank is obliged to make good on its guarantee. The cost of such a default could mean that the bank must pay $10 million, although it would have a creditor’s claim against the importer’s assets to offset this loss. Clearly, the fee should exceed the expected default risk on the LC, which equals the probability of default times the expected payout on the LC after adjusting for the bank’s ability to reclaim assets from the defaulting importer and any monitoring costs. Standby Letters of Credit Standby letters of credit perform an insurance function similar to commercial and trade letters of credit. The structure and type of risk covered differ, however. FIs may issue SLCs to cover contingencies that are potentially more severe, less predict- able or frequent, and not necessarily trade related. These contingencies include performance bond guarantees by which an FI may guarantee that a real estate development will be completed in some interval of time. Alternatively, the FI may offer default guarantees to back an issue of commercial paper or municipal rev- enue bonds to allow issuers to achieve a higher credit rating and a lower funding cost than otherwise. 10 The German exporter may also receive a banker’s acceptance written against the letter of credit. FIGURE 2B–2 Simple Letter of Credit Transaction U.S. Bank German Exporter U.S. Importer 1 3 2 2
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14 Appendix 2B Commercial Banks’ Financial Statements and Analysis Without credit enhancements, for example, many firms would be unable to bor- row in the commercial paper market or would have to borrow at a higher funding cost. P1 borrowers, who offer the highest quality commercial paper, normally pay 40 basis points less than P2 borrowers, the next quality grade. By paying a fee of perhaps 25 basis points to a bank, an FI guarantees to pay commercial paper purchasers’ principal and interest on maturity should the issuing firm itself be unable to pay. The SLC backing of commercial paper issues normally results in the paper’s placement in the lowest default risk class (P1) and the issuer’s savings of up to 15 basis points on issuing costs—40 basis points (the P2 — P1 spread) minus the 25-basis-point SLC fee equals 15 basis points. Note that in selling the SLCs, banks are competing directly with another of their OBS products, loan commitments. Rather than buying an SLC from a bank to back a commercial paper issue, the issuing firm might pay a fee to a bank to supply a loan commitment. This loan commitment would match the size and maturity of the
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