Banks have started to see local customers and businesses become more nervous about payment when exporting during the recession. Terry Richardson looks at the resurgence of the old-fashioned letter of credit

In recent years, with the world becoming a smaller place, the use of traditional ‘vanilla’ trade banking products such as letters of credit have been on a slow decline, or have at best levelled off, whilst international trade continued to increase year on year. This has given rise to a significant increase in open account trade world-wide.

We are, however, seeing a reversal of this trend, anecdotally and with the actual experiences of some customers and prospective customers alike.

Whether our customer is importing, exporting or indeed both, with the worsening of the global economy, suppliers around the world are becoming nervous on the issue of getting paid and are exploring their options to mitigate this risk. What they need is a trusted adviser with experience in these matters who understands their business, who develops and maintains a good relationship with them, and who can guide them in the use of appropriate instruments that simultaneously protect their interests and enable them to open new international channels of trade. This is where letters of credit come into their own, particularly when used in a proactive and creative way.

Where the UK company is an exporter, the letter of credit may simply be a means of payment risk mitigation, which is particularly important given the widespread recent reductions in cover provided by the credit insurance market. Equally importantly, the letter of credit can potentially be used as a tool for raising either pre or post-shipment finance.

Provided the company’s bankers are comfortable with the risk of the buyer’s bank and the letter of credit wording is in an acceptable form, the instrument may be used to advance funds up to a given percentage of the maximum letter of credit value, say 80 per cent, prior to shipment having taken place.

This will enhance the company’s working capital position and, where margin is sufficiently large, allow it to fund 100 per cent of the production cost of the goods. Alternatively, the instrument could facilitate a significant reduction in the time between sales and payment for goods. This can be achieved by a simple discount of the underlying draft/bill of exchange once shipment has taken place and letter of credit-conforming documents presented and accepted.

Where the UK company is an importer, it may find that whereas in the past its suppliers were prepared to deal on an open account basis they are now being asked to provide more secure instruments such as a letter of credit for the very same reasons as those mentioned above. While there is obviously additional cost and administrative effort for the UK importer in providing this, the very fact it is putting forward a secure payment vehicle may enable the company to negotiate a marginal reduction in the unit price of the goods purchased or increase their days payables outstanding (DPO), and thus their working capital position, by requesting additional credit terms on the strength of the letter of credit.

The UK importer may argue that the raising of letters of credit requires bank facilities which are more difficult to secure. For the banks, however, with typically lower capital allocation requirements for ‘structured’ facilities such as letters of credit over ‘unstructured’ overdrafts, not only might the banks be more willing to provide a letter of credit facility – it may be at a better price.

In short, a bank with a sound Trade Finance offer has at its disposal mechanisms that suit the interests of all concerned – and it also has the know-how in employing those mechanisms in the best interests of its customers.

Contrary to the rhetoric of the last 20 years predicting the demise of the traditional letter of credit, it is in fact alive and kicking. In the hands of a bank that knows and understands customer needs and provides advice born of knowledge and experience, it is as important a tool for effective risk and working capital management as it has ever been.

Terry Richardson is the

Midlands Director of Trade

Finance for Lloyds TSB Corporate