Revolving Letters Of Credit, Tenor, Draft, Discount Charges, Applicant, Bankers’ Acceptance, Self-Liquidating
REVOLVING LETTER OF CREDIT
An importer requested a bank to issue a letter of credit for ladies fashion dresses from Italy. When the importer completed the application for the letter of credit, he indicated the tenor of the drafts at 180 days sight with discount charges for the applicant. Additionally, the letter of credit was issued as a revolving letter of credit with the balance reinstated on the first day of each month until the letter of credit expired six months later. This allowed the beneficiary to make shipments each month equal to the amount of the letter of credit.
BANKERS' ACCEPTANCES INCREASED THE RISK
This arrangement permitted the bank to make payment to the supplier in Italy upon receipt of the required shipping documents. The bank would then delay payment to the buyer for 180 days and the buyer agreed to pay for the cost of interest during the 180 days period. Initially, everything went as planned. The bank received documents and found them in compliance with the terms of letter of credit. They remitted the payment to Italy, created a “Banker's Acceptance” for 180 days, and charged the cost of financing to the buyer. The bank released the documents so the buyer could clear the goods through customs, sell the dresses and collect the money before the due date of the draft.
WHERE IS THE PAYMENT?
The bank waited for the clock to wind down to the payment date, 180 days later. And wait they did. On the 180th day, when the bank requested payment from the buyer, they learned the buyer could not pay. The buyer informed the bank that he was preparing to file for bankruptcy and the unsold dresses were in a warehouse. Since the bank had a lien on the assets of the company, the bank’s lending officer began arrangements to seize them. Unfortunately, the only assets available were the ladies fashion dresses, now 180 days old and no longer in season. The bank’s loss increased exponentially because by the time they realized they had a problem with the shipment made in the first month, they had already obligated themselves for shipments made the subsequent five months.
HOW REAL IS "SELF-LIQUIDATING?"
The bank ultimately sold the dresses. The recovery of funds amounted to less than 50% of the bank’s loan and they took a loss for the balance of the unpaid loan. While letters of credit seem self-liquidating and self-securing because of the underlying transactions, banks need to cautiously ascertain the value of goods and determine if they can be readily liquidated, or face the resulting consequences as illustrated in this lesson. Once it becomes known that a bank has distressed merchandise, the value of the merchandise drops significantly. Bankers, who do not have expertise in selling merchandise, eagerly find a buyer as quickly as possible even if it results in a loss. This lesson illustrates why banks should be very cautious when issuing letters of credit; It carries the same risk as when a customer applies for a loan. Usually banks prefer not to rely on the underlying transaction as collateral. They typically will want some other collateral as well and often will require the applicant to secure the letter of credit with cash in an account at the bank.